S.3 Ep. 1: Greying and Growing: The Investment Impact of Demographic ChangesS.3Ep.1:GreyingandGrowing:TheInvestmentImpactofDemographicChanges

Episode Transcript

>> November 15, 2022. It was a remarkable morning. As the sun rose over Hyderabad, India, a miracle was taking place. A young couple was welcoming their baby girl into the world. There are over a billion people in India, more than four times the population of the United States. In 2023, India will surpass China to become the world's most populous nation. With nearly 70,000 babies born in India each day, what makes this baby so special? She may be the one who pushed the global population to 8 billion people. The United Nations designated November 15 as the day of 8 billion, a major milestone in the earth's history. Forecasting errors make November 15 more of a symbolic date, but the significance goes well beyond this chosen date. Population growth has fueled economic growth for the past three decades, especially for countries like China and India. Along with globalization, population growth has spread prosperity worldwide. But what goes up must come down. China, for example, is now experiencing a declining population growth rate. That's triggered major structural changes to its own economy. And as the second largest economy in the world, that's impacting global economic growth. But China is not alone. Most of the top 10 economies in the world are now seeing lower population growth rates. They are also aging because fewer births naturally lead to an older population. What will the world's shrinking and aging population mean going forward? To understand today's investment landscape, it's important to know how we got here. This is The Outthinking Investor, a podcast from PGIM, that examines the past, the present day opportunities and the future possibilities across global capital markets. In this episode, we'll talk with two experts on the global economy and the effects of population growth. Charles Goodhart's long and distinguished career includes tenure with the Bank of England and the London School of Economics and the eponymous Goodhart's Law. In 2020, he published the Great Demographic Reversal: Aging Societies, Waning Inequality and an Inflation Revival, with his coauthor, Manish Pradhan. Charles will guide us through the world's major demographic changes over the past few decades. Catherine Nice is Chief European economist for PGIM Fixed Income and a former Bank of England economist. Catherine will help us understand the effects of demographic changes on market dynamics. Eight billion is an astonishing number, especially considering that it's double the earth's population just half a century ago. And while it's expected to hit 9 billion in the next 15 years, that does mean a slower rate of growth. Looking back at the past 30 years, we can clearly see the structural forces that had an immense deflationary effect on the global economy. Here's Charles Goodhart.

>> Over the last three decades, favorable demographic and geopolitical forces led to a quite extraordinary increase in the available labor supply to the world's trading system. That included the arrival of China and Eastern Europe into that trading system. And China by itself has a population equivalent to about a fifth or a quarter of the world's total population. And there was a very large increase in the working age population.

>> As globalization led to increased wealth across many countries, broader access to education and modern conveniences meant that women who were doing unpaid household work were finally able to join the paid workforce.

>> When I was young, the proportion of married women who actually worked in employment was not more than about 10 to 15%. Since then, it's risen to about 70%. So we've got a huge increase in women working in the workforce. You've got a massive increase in the working age population. And you've got a huge increase in the availability of low wage workers from China and Eastern Europe. And naturally, with a huge increase in the available labor supply, what you got was a relative decline in the return to labor compared to the return on capital. The last three decades have been the greatest decades for capitalists, including those who got good human capital ever been much less good for those who have only unskilled labor to sell.

>> That coincided with another shift in wages. Across many developed economies, workers who went from producing goods to services ended up with less bargaining power because of the fragmented nature of the services sector. Ultimately, the great deflationary period seems to have ended quite abruptly, even if it wasn't easily predicted.

>> It was really COVID with the effects that that had on a reduction in the available labor supply, particularly in the US and UK, that provided the trigger for the change between the disinflationary decades that we've just had and the more inflationary decades that we expect to have from now on. And the great mistake that central banks made in 2021 was they didn't see how tight the labor markets were going to become. And that would lead to a considerable increase in wages, wage demands, which, of course, was much amplified and exacerbated by the effect of Putin's attack on Ukraine and the rise in energy prices and costs.

>> The impact of an ageing population on economic growth is being felt across much of the world. But it may be strongest in China, where the demographic transition was made worse by the country's one child policy.

>> China's growth is going to fall from about 8 and 1/2%, which it has been for the last three decades, down to about 3 to 4% at most. And that is going to mean also that with the shortage of workers, costs will go up. And so they'll have to rely more on internal consumption to keep such growth as they can manufacture alive.

>> Across the developed countries, healthcare advances have increased longevity, particularly adding years to retirement. Unfortunately, macroeconomics has mostly failed to appreciate the impact of demographics and, to some extent, globalization. Here's PGIM's Catherine Nice.

>> It was hard for me to believe that the central bank somehow has lost the ability to control inflation simply because people are living longer, healthier lives, and choosing to have fewer children. Central banks should be able to adjust their toolkit to a situation that is generally a real positive in terms of advancing as a people.

>> That raises a key question. Is it inevitable that the global economy will swing back to less prosperous times and our demographics, our destiny?

>> The economic impact from the demographic decline might not be inevitable. If, for example, women across the globe were participating in the paid labor market at the same level of men, it would be like adding another China to the global economy.

>> Economies are constantly evolving with known and unknown risks coming into play. Unlike China, Japan experienced a very different outcome going through its demographic transition. Does that make Japan an outlier? An exception to the rule?

>> Japan is only one country within the world. And at a time when Japan's population was beginning to age, there were massive increases in available workers close by in China. So what happened in Japan, as is now happening everywhere else, was that Japan offshored much of its manufacturing, much of it to China. Japanese workforce shifted from being largely in manufacturing to being overwhelmingly in services, where, again, it's much harder for labor to bargain for higher wages. And it also went from largely fulltime employment to part-time in services, all of which led to a weakening in labor costs. The world as a whole will now be suffering from continuing shortages of labor, except and unless we can make use of the continuing very considerable birth rates, high birth rates in Africa and the expected availability of a large number of working age people in Africa. Africa is going to become much more populous. Within a decade or two, the population of Nigeria by itself is going to be bigger than the population of the United States.

>> Could Africa become the world's next deflator as China moves out of that role? Charles Goodhart suggests that it depends on two factors.

>> What you need is a combination of good government and a better educated workforce. If Africa can achieve those two objectives, and one devoutly hopes that they will, then Africa could become China of the future. And many of the problems that we foresee would be much less. It's uncertain. Take, for example, Ethiopia. That was growing in Africa, one of the fastest clips, again, for many years, several years at about 7 or 8% per annum. And then, of course, you've had internal civil wars been going on more recently. And that totally shows the problems. You've got have good stable government and an educated workforce. China had both. Whether Africa can achieve that remains to be seen.

>> Though the pace of population growth has been slowing, the world's population is still growing rapidly. Even so, Charles Goodhart doubts that this will dampen the inflationary impact.

>> Outside of Africa, what is happening is that the ranks of the elderly over 65 are growing very rapidly. And they're growing so rapidly that they are more than offsetting the decline of those of working age. The demographic projections have world's population, much of which is coming from Africa, peaking at about 10 billion at about 2050 and then declining. The decline in the working age population is already underway, severely underway in China because of the one child policy, underway in Russia, much of Europe, and it would also be underway in my own country and the US if it were not for immigration into our two countries.

>> An aging population generally means higher consumption and lower productivity, although people are aging in a healthier way. Retirement age hasn't adjusted much yet. But even small increases in labor participation among older people could offer a deflationary tailwind. With higher interest rates across most of the globe, financial markets are expecting inflation to come down in 2023.

>> We will see a depressive effect on economic activity generically. In terms of what that means for developed markets, I see really three key areas of an impact. First, that we see more strains on government debt levels, as higher interest rates mean that interest payments on past debt acquired by governments will need to rise. I would also expect to see a pretty sharp reaction coming from interest sensitive parts of the real economy, such as the housing market. And finally, I think there's a concern that as interest rates rise, particularly given the length of time that interest rates have been so extraordinarily low, that we'll see whisks popping up in corners that we're not really expecting. So for example, like the situation we saw in the UK with certain types of pension investments. In emerging markets, I think the impact is likely to be a little bit different. Higher. US interest rates in particular could trigger disorderly outflows of capital from emerging markets and just generally make it harder for emerging markets to continue to recover, coming out of the pandemic. They are, of course, a little bit behind developed markets.

>> Some countries more than others will add to growing concerns as interest rates rise. As Catherine Nice points out, Italy is often the poster child of risk in the Eurozone.

>> Italy, of course, has a very large government debt levels that have been increased even further, during the pandemic, as the Italian government, like many other governments, work very hard to support households and businesses through that crisis. And if interest rates go up at the European Central Bank, then that will increase the strain on the Italian government because it will need to spend more on interest payments on that past debt. And of course, there's a big concern that investors could take flight from Italian investments.

>> As for emerging markets, she sees real institutional improvements in monetary policy and on the fiscal policy side.

>> And that does, other things equal, make them less sensitive to US interest rates. They have actually operated monetary policy in a way that was quite forward looking even coming out of this pandemic. For example, a number of emerging market economies were raising interest rates well before what we saw coming from, for example, the US or Europe. All of that should help to stand them in reasonably good stead in this current environment of rising interest rates.

>> Add to this the risks that quantitative tightening presents as central banks continue to shrink their balance sheet. Will past be prologue here? Catherine says as central banks dial back their sovereign debt holdings, expect a lot of volatility.

>> As the demand tries to match this new supply on the secondary market, there is a general sense that as interest rates rise, expect more financial skeletons to fall out of the proverbial closet. We've seen in Europe, for example, European energy trading being strained by these margin calls against the backdrop of this incredible rise in European wholesale energy prices where there was the prospect that, you know, utility companies face -- suddenly face a shortage of cash and fold. And what would be the ripple effect of that? So it's really the risks that we haven't thought of, and that we don't see now that are probably the most concerning, and ones, and frankly, that we should be expecting in an environment where interest rates are going up, that these risks are going to bubble up to the surface and reveal themselves.

>> Market dynamics are likely to be impacted. For one thing, the price discovery mechanism is going to be enhanced.

>> I think it's going to take time for the market to figure out what is the new equilibrium between supply and demand. So I would say expect a bumpy ride. And we're seeing shades of that now. And we've got a bit of a chicken and egg problem. So on the one hand, there's a lack of supply of safe assets because central banks have essentially stepped in and become a significant buyer of these safe assets. So there's a lack of supply out there. But on the other hand, investors are not really keen to buy these assets at the current price because it's simply too high. And it's not worth it to a number of investors. So as central banks step back, that supply-demand balance is going to need to adjust. And I would expect that to be a very bumpy ride. And indeed, we're seeing it now with a significant increase in bond market volatility. And in particular, I'd say we're seeing bond market volatility in Europe. You're seeing it in the German government bond market. You're seeing it in the Italian government bond market. And of course, we've seen really quite severe bond market volatility in the UK.

>> Globalization is certainly adding an interesting wrinkle, particularly as governments and central banks implement policies designed to blunt the effects of inflation while fighting inflation.

>> The debt levels that most advanced economies now have, around 100%, is so high that monetary policy cannot necessarily bring inflation back to target without the support of fiscal policy. The reason for that is that as interest rates rise, it lowers growth, maybe bringing about a recession. Whether mild or more serious, we don't know yet. That lowers tax receipts, raises expenditure on unemployment benefits, and the higher interest rates themselves also increase the amount that has to be funded in the public sector debt market.

>> Of course, any number of things could happen across the globe to influence the macroeconomic environment in the short term. But longer term, signs are pointing to higher cost of goods and cost of capital.

>> The underlying context of a much-reduced labor force, as the waking age population declines in much of the advanced world, will lead to a stronger labor bargaining power and upwards pressure on wages. And we doubt whether the society and the politicians would be prepared to run the economies at the higher unemployment level that would be necessary to counter the stronger labor bargaining power. Even if invasion temporarily comes back to target at some stage with, say, in 2024, we think that there will only be temporary and that the attempt by workers to restore their real wages, which have been cut down severely, particularly in Europe, by the higher energy costs will lead to inflation coming back to a level of, say, 3, 4 or 5% from 2025 through towards the end of this particular decade. So don't be surprised if a return to target temporarily does not necessarily hold, because the underlying conditions, particularly of demography and geopolitics, are going to make that much harder than it was over the previous three decades up till now.

>> Could we see the target level of inflation start to float out? Charles Goodhart notes that a former chief economist of the International Monetary Fund has already argued for a 3% target.

>> One of the great economists of our time, Olivia [inaudible], has already argued for a 3% target. And the suggestion that may come about is that over the -- much of the next decade, that although the target will be kept initially at 2%, the average will creep up to about 3, 3 and 1/2%. And that in due course, with the average of inflation at about 3% or slightly greater than that, people will adjust and think that that's not too bad. They don't want to have much higher unemployment to force it down, and that by the end of the decade, say by 2030, it's perfectly possible that we might move from a 2% target to a 3% target.

>> And that brings us back to the possibility of monetary and fiscal policy working at odds.

>> If you have a situation where the monetary authority is tightening financial conditions, the economy is generally expected to slow, unemployment could go up. And that generally will lead to more spending on the part of government via a social safety net. So for example, unemployment insurance. So it's normal to expect these policies to move and to complement each other in this way, naturally, over the course of the business cycle. But what you can't have is policy settings that are actively working against each other. So for example, if the central bank is having to tighten and raise interest rates significantly because the economy is overheating, then the fiscal authority shouldn't try to pursue an expansionary fiscal that's aimed at stimulating demand. These two things will just be working against each other and make the job of the central bank even harder.

>> Case in point. The United Kingdom's budget debacle over unfunded tax cuts, which ultimately forced out Prime Minister Liz Truss after just 44 days.

>> The financial markets had a severe allergic reaction to this combination because it was clear that monetary and fiscal were working at odds with each other. And in the end, much of these fiscal proposals were not only rolled back but reversed. And I think there are lessons for other governments from this UK experience that, you know, government spending does need to be restrained against a backdrop where inflation is high and where the central bank is raising interest rates to cool demand. But we also need to accept that we are experiencing an exceptional period where people are really struggling with the cost of living. So government support needs to be targeted towards those that are most vulnerable to, you know, these increases in energy prices, be they vulnerable households for vulnerable firms because of their business model, for example. A second important lesson is that against the backdrop of low potential growth, and where there is going to be some government spending, it should be focused on investment to try to rebuild the supply capacity of the economy in order to help bring inflation down in future as well.

>> The global economy will continue to evolve and absorb the effects of an aging population, higher debt and higher costs of capital. It's likely we'll see other countries in Asia, Africa and Latin America go through their own demographic transition. Will they learn from the policy successes and missteps of Japan or China, the UK or the US? Even the major developed countries are ill equipped for the level of resources needed to sustain an aging population. What will the world look like in 2037 when the population is expected to reach 9 billion? The investment implications are yet to be revealed. But no doubt, demographics will continue to be an important driver of the financial markets. Thanks to our experts, Charles Goodhart and Catherine Nice, for their insights on the global economy and the impacts of population growth rates. Join us for the next episode of The Outthinking Investor, when we'll explore the case for upside risk in a bear market. The Outthinking investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.

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