Expecting the Unexpected: Is a Demographic Disaster Looming?


Jeffrey Kleintop

CFA, Senior Vice President, Chief Global Investment Strategist

Jeff specializes in analyzing international market trends and their financial implications. He's frequently cited in a range of national media outlets including The Wall Street Journal and The New York Times. He has an MBA from Pennsylvania State University.

October 15, 2020
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Expecting the Unexpected: Is a Demographic Disaster Looming?

Expecting the Unexpected: Is a Demographic Disaster Looming?
  • A coming change with the potential to have a big and unexpected impact on the markets isn’t policy, its people.

  • As the percentage of workers supporting the global population plunges in the years ahead, inflation and productivity may revive—something markets and policymakers are not expecting.

  • This change offers opportunity for investors and is not all gloom and doom. But it does present new challenges, especially if countries throw up trade barriers and invite a wave of protectionism at what could be the worst time.

Investors often seek to assess the impact of changes in policies (monetary, fiscal, trade, and foreign) on markets. But a coming change with the potential to have a big and unexpected impact on the markets isn’t policy, its people.

Demographic disaster?

The percentage of workers supporting the overall population is set to plunge, as you can see in the chart below. The ratio will fall from around 65-70%, or 2 workers for every non-worker, for most countries to near 50%, or one worker for every non-worker, in the decades ahead.

Working age population as % of total population by country

World working age population

Working age defined as those age 15 through 64.
Source: Charles Schwab, World Bank data as of 10/29/2017.

As the ratio of producers to consumers declines sharply, some worry we are facing a looming disaster for growth and the sustainability of social programs with dramatic consequences for the global stock and bond markets. They point to the steep plunge in the ratio of workers to non-workers that began in Japan about 25 years ago, preceding decades of stalled economic growth, non-existent inflation, and increasingly burdened social programs. These individuals worry that this is what the future holds for the rest of the world as we all begin to follow the demographic path of Japan. We see it differently.

Getting it wrong is easy

It is easy to jump to worrisome conclusions, but they may not be the right ones. While demographic trends may seem easy to predict, the impact they have is not. Economists have often misinterpreted the impact, here are a few examples:

  • In 1798 Thomas Robert Malthus, a British professor and economist, argued that any rise in food production would lead to a rise in population until it outstripped food production and lead to mass distress and ultimately a reduction in the population. He was wrong. The world’s population grew rapidly along with rising agricultural productivity.
  • In the late 1930s, when U.S. population growth slowed, Alvin Hansen, a Harvard University professor and economist, said the U.S. economy was mired in “secular stagnation.” However, the population slowdown of the 1930s was temporary, World War II led to a surge in growth and the baby boom that began after the end of WWII put to rest fears of a declining population.
  • In the 1960s, overpopulation became a popular concern. U.S. biologist Paul Ehrlich’s “The Population Bomb” in 1968 and the organization of global elites known as the Club of Rome’s “Limits to Growth” in 1972 asserted that a global collapse and mass starvation was coming as the population depleted resources. Fortunately, innovations and efficiencies allowed the population to continue to grow while lifting the standard of living.

These examples show us that interpreting the impact of demographic trends isn't as easy as it seems, and economists, politicians, and other leaders have repeatedly made the mistake of assuming the worst.

An alternative interpretation

Japan’s experience of weak inflation and productivity growth may not be the most likely outcome of the emerging global demographic trend—in fact, the opposite seems more likely. That is because just as Japan’s labor force peaked out in the 1990s, the fall of communism led the former Soviet Union and then China to join the global economy, leading to the world’s largest labor supply surge. This has since added 914 million workers available for global production, or an increase to the global labor supply of nearly 150%, per World Bank data. The shrinking of Japan’s labor force by about 1.5 million workers since the 1990s peak was just a tiny offset to the demographic supply shock that helped shaped the global economy and markets of the past 25 years, as you can see in the chart below.

Global labor supply shock overcomes Japan’s demographic decline

Global labor suppy

Source: Charles Schwab, World Bank data as of 1/15/2018.

This labor supply shock helped keep a lid on inflation and interest rates through stagnation in real wages and a collapse in the power of private sector trade unions in the west. It also sowed the seeds of populist movements by contributing to a shift in manufacturing to Asia and increased inequality within countries while it reduced inequality between countries.

This shock is now reversing—even in China. This means that as the world’s ratio of workers to non-workers shrinks, real interest rates may rise along with a pick-up in inflation and wage growth. This is the opposite of what happened in Japan and may be part of why markets do not seem to expect much of a rise in the pace of inflation.

We want to be careful not to risk the mistake that the aforementioned economists did and assume no or little productivity growth. When the global labor supply became more abundant, spending on productivity enhancing technology by businesses became less attractive or necessary. Wages stagnated along with productivity and spare capacity helped keep inflation in check. But as labor becomes more scarce, the opposite should occur: greater investment in productivity enhancing technologies, faster wage growth, and tighter capacity leading to higher—but not runaway—inflation.

Inflation may be kept from a destructive resurgence and social programs for the elderly from becoming overburdened if productivity rebounds with more business investment in productivity-enhancing technologies, including robots and artificial intelligence.

Expect the unexpected

Good investing advice is to always expect the unexpected. Not only is it wise to have a plan in the event of near-term surprises, but over the long-term we may see surprises in the form of a faster pace of inflation and productivity growth.

Inflation expectations have started to rise, but U.S. Treasuries are pricing in an implied long-term inflation rate of 2% or less and central bankers increasingly expect to keep rates low with the Fed now predicting a longer-run policy rate of under 3%, as you can see in the chart below. These rates are above recent history, but below long-term averages suggesting more upward adjustment may be needed to account for the impact of the changing trend in demographics.

Long-run projected policy rate by members of the Federal Reserve Open Market Committee

Long-run Fed policy projections

Source: Charles Schwab, Bloomberg data as of 1/21/2018.

The potential for faster inflation may benefit international stocks relative to U.S. stocks. Even though inflation is embedded in both revenue and costs for business, the way it balances out is not always even. Earnings for international companies have tended to rise and fall with the pace of inflation. One important factor behind this connection is that the financial sector is the biggest contributor to earnings for international companies while the information technology sector is the largest contributor to U.S. company earnings. Financial stocks are much more inflation sensitive than tech stocks.

There may be sector impacts of the coming demographic change, as well. The possibility of greater business spending could help capital goods manufacturers in the industrials sector and stronger wages may help companies in the consumer discretionary sector. At the same time, higher interest rates could hurt the performance of bond-like sectors of the stock market such as utilities and telecommunications services.

Of course, part of expecting the unexpected is recognizing that another demographic change could take place and offset the emerging trend. A surprise could be that another labor supply shock comes along in the next 20 years, perhaps workers from Africa and India, which contain over a billion workers and will make up a growing share of the world’s working-age population. But many educational, logistical and other hurdles will have to be overcome to fully integrate these economies into the global labor pool.

Not all gloom and doom

Demographics are a powerful force, but they aren’t the only force. For example, Venezuela has good demographics, but they have been overwhelmed by bad governance. The emerging change in the global demographic backdrop for the market and economy offers opportunity for investors and is not all gloom and doom. But it does present new challenges, especially if countries throw up trade barriers and invite a wave of protectionism at what could be the worst time.