Ageing and Financial Markets, a revisit ...
It is difficult not to be a little bit impressed by the work done by Stephen Jen and his co-workers over at Morgan Stanley's GEF. Consequently, the GEF team has on several occasions in the past year or so, with Jen as the front runner, written about the impact on financial markets from the emergence of the so-called sovereign wealth funds. Of course, Morgan Stanley is not the only place that you have been able to read about these SWFs and their economic impact but I still think as it were that the coverage and analysis have been particularly good from Morgan Stanley. So, where are we now then? Well, in a recent note Stephen Jen and Charles St-Arnaud take the discourse a step further thereby also including what they coin as sovereign pension funds (SVPs). Many have of course, and perhaps with some justification, tended to somewhat lump the SWFs and pension funds together but for the sake of argument and also analysis I do think that the distinction is important. Turning to Jen's main argument he applies much the same logic towards the SVPs as he has applied to SWFs. Firstly, the SVPs as the SWFs are big and will grow bigger; currently Jen estimates that the funds under management in the G10 economies amass a whopping USD 4.4 trillion. Secondly, these SVPs are currently not very strongly exposed to foreign assets. Thirdly and related to the second point Jen operates with the inbuilt assumption that home bias is set to decline significantly. This means apart from the obvious that these funds along side the SWFs will tend to move beyond the borders of their home country also that they will lean towards more risk appetite as the search for yield intensifies.
So, why am I so interested in this then?
In order to answer this question it would serve us well to revisit one of my previous notes on financial markets and more speficially the impact of ageing (Ageing and Financial Markets - Going for Yield?). In this note I argued, also somewhat based on Jen's work, that ageing would have a profound impact on financial markets (as a demand and thus also derivative supply factor) in the years and decades to come. In the most general sense I argued that ageing would be a strong source of global liquidity in the decades to come as the developed world ages and as we can see Stephen Jen is taking up the same baton with his recent invocation of the importance of sovereign pension funds. However, it is important for me also to stress that behind my main argument lies a crucial theoretical assumption which is also somewhat spelled in the note linked above.
In essence and specifically in the context of sources of global liquidity, I believe that modern macroeconomic analysis requires a firm anchoring of analysis in a modified conceptualization of Modigliani's life cycle theory of consumption and saving. At this point in time me and my fellow researchers are far from a clear picture but still some stylised facts emerge.
Firstly, there is a tendency for an ageing economy such as for example Italy, Germany or Japan to experience a sustained depression in domestic consumption. The nature and driving forces of this effect is yet to be sketched out in detail (although some indicative work has already been done as is also hinted below) but at least for now the data seems to conform with the theory.
The second point is related to the saving behaviour of the working age population. It is widely argued in many studies that one of the profound effects of the global process of ageing would be a process of rapid dissaving on an aggregate basis as many economies entered the final stages of the demographic transition. This might be true in principle but I have argued many times why I don't think it is fruitful to see it like this and I have two main reasons. First of all is the simple yet crucial observation that while it is indeed true that all global economies are ageing (expect perhaps those still stuck in some form of a Malthusian poverty trap) this process is occurring with vastly different tempi across both developed and developing countries. Moreover, there seems to be significant non-linearities at work here which suggests that the effects of ageing are skewed and essentially centered towards the economies whose median ages are above an hovering somewhere around 40-45 and of course beyond. In this sense it serves us to remember that only a handful of countries at this time are set in this category. However, even if we concede the after all very relevant observation that the entire OECD group of countries are ageing rather rapidly we still need to confront the idea of dissaving with a skeptical perspective. As such, the real notion of rapid dissaving hinges on the matter and turn of events as they may unfold in 2040 and 2050 and in the light of the current global situation I believe it is very difficult to say anything constructive about this after all distant future. My point here is simply that before we get to a point of dissaving we also need to understand how unattractive this would be from a macroeconomic perspective since dissaving on the back of a process of rapid ageing implies an erosion of current and future saving/investment dynamics (and thus future growth!) without the promise of a renewal of these dynamics since it would not be possible to finance a deficit on the external balances in a context where the economy had an inverted population pyramid (unless of course you could expect a reversion of the pyramid back to normal in which case debt could be issued on the basis of future sources of revenue, but this is a question for another day).
Thirdly, this of course brings us right smack into my own and to some extent Stephen Jen's points about the sources of liquidity in the near future in financial markets. The point is simply that before we see some kind of rush to the exit in terms of rapid dissaving it is much more likely that two things will happen to a greater or lesser extent. First of all and as an inbuilt factor in the changing consumption/saving schedule it is likely that the relatively smaller working cohorts will be prone to save more of their disposable income in order to compensate for the rising dependency ratio as well as to secure an adequate level of life in retirement. This effect would be seen from two main angles. The first would be forced or mandatory savings in the form of higher taxes and/or forced pension schemes. The second would be an exogenously induced change in the marginal propensity to save as workers anticipate to live longer as well as have high demands for their relative life conditions in retirement. These assumptions leads to the incorporation of another stylised fact which seem to be characteristic for a rapidly ageing economy venturing well into the mid 40s in terms of median age; namely export dependency. You need only to look at Germany and Japan in order to see that such a claim is not entirely off the mark. In this way, net exports and the subsequent savings they represent are seen as not only a significant contribution to real economic growth but also as a compensation for what would have been (and what essentially is) a process of aggregate dissaving as the ratio of retired people to working people grows.
As a final point we can then see that there are powerful structural forces at play affecting the nature and supply of global liquidity conditions. In this respect ageing is of course but one of them and as I argue in my note (linked above) also the ongoing nature of global imbalances and thus Bretton Woods II contributes significantly to the accumulation of reserves of which a substantial amount is channeled into the SWFs. In the light of my own theoretical assumptions which are, at least somewhat anchored in the data, especially two things stand out in Stephen Jen's work which tend to conform with my own conceptualization:
- Operationalization of ageing and liquidity (i.e. SVPs and SWFs). Obviously the pension funds are a very direct proxy for how ageing can act as a source of global liquidity. But if I am also right in arguing that ageing economies will be prone to running current account surpluses as well my theory on the consumption/saving schedule changes for working households SWFs could also be a natural end-result in a rapidly ageing economies even if Bretton Woods II at the moment is a stronger driver of SWFs' and their liquidity reserves.
- Decline in home bias. This could seem as an obvious result of the arguments above but it clear that only by talking by a rapid deterioration of home bias can we also talk about real global repercussions. It is also important to note that a decline in home bias also follows somewhat instinctively from the theoretical assumptions fielded above. In this way, if an ageing economy confronted with structural depression in domestic aggregate demand tries to make an ever larger pool of amassed reserves seek yield in the home market only, this will drive down yield very fast. In fact, as I am have also tentatively argued before the current environment with both Bretton Woods II and the sustained process of ageing could result in a situation where too much liquidity chases to little yield.
As a very final note you should of course realize that Stephen Jen in no way should be aligned with the theoretical assumptions fielded above which are entirely my own. Moreover, as you might have noticed I am specifically talking about the demand side here in the sense that (global) liquidity in this case is a proxy for assets and ultimately yield. For an analysis which combines this view with the supply side I recommend once again to revisit my note on financial markets linked above.