Saturday, August 9, 2008

Demographics and Financial Markets: Existing Studies

Yes, there have been studies on what could happen to financial markets in developed countries when the baby boomers retire. These are some materials from a conference, as linked by Global Economy Matters.

The studies take off from public knowledge that demographically large numbers of people will retire from active working life more or less at the same time, and tries to project the implications to saving and investing. Philip Davis in his study posits the following hypothesis:

The permanent income hypothesis, while not explicitly basing saving on age, has the insight that the individual’s consumption is likely to depend on permanent rather than current disposable income. People will only consume if they believe it will be sustained. Consequently, if increases in their income are expected to be temporary, they will save rather than increase their consumption. The underlying assumption is that people seek to avoid fluctuations in their consumption when income fluctuates. Furthermore, when actual income is below permanent income, that is, in retirement, they may decumulate wealth.

Following this insight, the life-cycle hypothesis of consumption suggests that in one’s life, consumption may well exceed income as individuals may be taking major purchases related to buying a new home, starting a family, and beginning a career. At this stage in life, individuals may borrow based on their expected labour income in the future (human wealth), if financial markets are sufficiently developed and liberalised. In mid-life, these expenditures begin to level off while labour income increases. Individuals at this point will repay debts and start to save for retirement in equities, bonds, pension schemes, etc. At retirement, income normally decreases, and individuals may start to dissave. This involves selling off some of their assets, including pension fund decumulation.

A study by Robin Brooks, however, yielded empirical results that run counter to the hypothesis:

Empirical evidence does not point to a strong historical link between demographics and financial markets. While the existing literature has found that the relative importance of middle aged cohorts tends to be associated with relatively high real stock and bond prices, this paper holds that this relationship does not hold for countries with strong equity market participation among households, such as Australia, Canada, New Zealand, the UK and the US. In these countries, higher real financial asset prices tend to be associated with a large share of the population in the old tail of the age distribution, consistent with survey evidence from the US that shows that households build up financial wealth well into old age and then do little to run it down in retirement. Taken at face value, this suggests that real financial asset prices in these countries will actually rise as the population continues to age, though a number of considerations – including the changing nature of markets over time and general equilibrium considerations – caution against drawing this conclusion. Nonetheless, this finding underscores that historical evidence provides little support for the hypothesis that asset prices and returns will fall abruptly when the baby boomers retire.

By my own best guess, I don’t think anybody would be able to know for certain where financial markets are headed. It takes more than just national demographic data nowadays to know for sure. With global capital mobility, who knows where money could be going next. Perhaps long before the big retirement bulge comes, a significant amount of First World money may have moved somewhere lese. Then perhaps by the time that mass retirement happens, all the money in the world are already in the developed countries.

The sea change in economic events are now global, and any study done to determine financial flows should now study the whole world’s demographic data. And even then, an ever-changing changing macroeconomic mix everywhere constantly rebalances the playing field elsewehere.

In any case, perhaps when the developed countries’ boomers retire, they will likely be replaced by the much younger, but equally numerous Gen Y of the same countries as the bulk of the new generation of savers and investors. Since they are less likely to look forward to sufficient Social Security pension, they will probably be much more aggressive investors. Once retirees shift from equities to fixed income securities, these Gen Y could probably become the big equity players of the day. Insurance and pension firms who find themselves paying out on policies to boomer clients would do well to recruit more of these Gen Y investors as new sources of placements. (See graph of US birth trend, closely approximated by that of developing countries)
The case might be different for sovereign bonds of the ageing countries. More retirees means less income taxes and more benefit payouts. So more bonds may be forthcoming from sovereigns in the future.

But then, who has a crystal ball that sees this long into the future? Did anybody guess five years ago where we would be this year? I wonder how we’re doing if I check back on this post in five years’ time.

1 comment:

Aaron Weber said...

Five years ago, many sane Cassandras said that within the next five years the housing price bubble would, and that global increases in demand for oil would lead to prices well over $100 per barrel, and that Bush's fiscal and foreign policies would be driving the US to bankruptcy. Sure enough, this is exactly where I thought we'd be.