Will the developed countries be able to adapt? It’s not likely. Japan, despite its massive trade surplus, still hasn’t saved enough foreign assets to address this problem. And the United States, in aggregate, has neglected to save at all! If the United States is to import the goods and services to meet retiree demand, it will have to do so through a further increase of the already historically high debt levels—also an unlikely outcome. Furthermore, the nature of the goods and services demanded by retirees is unlikely to be available for purchase abroad. Consumer goods such as cars and textiles and oil are easy enough to import, but retirees will also seek services such as health care and non-importable goods such as housing. International trade looks to be at best a partial fix and at worst no help at all.
Because we can’t adjust previous birth rates, these demographic curves are a deck of cards already dealt. There are, however, a few options to help prop up declining support ratios. Anything that provides more workers or fewer retirees will do the trick. For example, higher levels of immigration will help. All else being equal, higher nominal developed world wages and projected low unemployment rates will create incentives for workers from emerging countries to fill the demand for open jobs. However, the developed world will demand immigration levels far beyond anything we have witnessed historically. To maintain support ratios at their current level in the United States, we estimate the need for an additional 4 million new workers each year through 20304— on top of current legal immigration levels of 1 million annually. Immigration could help ameliorate the problem, but certainly can’t solve it by itself.
If increasing the working population won’t suffice, the other alternative is to decrease the number of retirees. Retiring abroad is one route to improving the support ratio, although incentivizing an additional 1.4 million U.S. residents each year to spend their golden ages overseas won’t be easily achieved. The remaining option is for retirees to remain in the workforce longer. A shift in the average retirement age from 65 to 72 over the next 20 years would keep support ratios stable. Realistically, the outcome will be a combination of the options, though the changes will not come without a contentious national debate.
Implications for the Economy
The underlying demographics cannot change; but we expect that, as always, prices can and will adjust to create the proper incentives. The result will be a combination of increased inflation and interest rates, an increasing trade deficit, slower GDP growth, delayed retirement, and increased immigration. This world will undoubtedly take some adjustment. Instead of stubbornly high unemployment, we will be faced with a dearth of workers. Instead of historically low inflation and interest rates, we will likely see both rising well above long-term averages.
Inflation in particular may be driven higher by two distinct pressures. First, we expect the scarcity of production and labor to drive up wages and prices for goods. Second, the huge debt burdens across the developed world, including unfunded retirement benefits, simply cannot be paid in today’s dollars. Given the political difficulty of reducing these benefits, a logical and perhaps unavoidable policy path will be to reduce the real value of these promised benefits through inflation. We see that foundation being laid today with the huge amounts of quantitative easing being conducted by central bankers around the globe.
Implications for Investors
As investors, how can we best position ourselves to respond to these changing conditions? First, we should prepare ourselves for a future with lower expected returns across most major asset classes. Slower GDP growth and rising interest rates are certainly enough to give both stock and bond investors convulsions; coupled with historically low stock and bond yields, there is little hope of growing our way to retirement. Second, we should prepare to work longer, save more, and expect lower consumption levels.
Finally, we should seek out a margin of safety in our investments. A period of rising inflation and declining GDP growth is hardly the time to load up on risky assets. Investors should look for lower risk and/or higher returns for given levels of risk. As we have discussed previously, building a “3-D” shelter that comprises an inflation hedge in addition to traditional equity and bond allocations is critical.5 And we have noted many times how investors can increase their prospects of obtaining higher equity returns by adding non-price-weighted equity index portfolios to their core equity holdings.6
But investors should examine their fixed-income portfolios as well, where the argument for non-price-weighting indices is even stronger. Traditional fixed-income indices allocate the highest weights to the largest debtors, resulting in extreme allocations to those countries and companies least able to service their debt obligations. Our research shows that extending the RAFI™ methodology to U.S. high-yield bonds, U.S. investment grade bonds, and local currency emerging market debt would have generated significant added value over market-cap-weighted indices.7 Subsequently, we launched the RAFI U.S. corporate bond indices in conjunction with Ryan ALM.
The Citi RAFI Bond Index Series applies the methodology to the sovereign debt market, potentially reducing the risk of our fixed income portfolios while providing an opportunity to enhance returns. Instead of using traditional accounting measures to set country weights, the Citi RAFI series uses measures of economic size—GDP, population, land area, and energy consumption—and thus tends to overweight countries with high debt service capacity. These countries tend to have lower credit risk and lower duration as well, thus lending some protection against both rising interest rates and sovereign defaults. Furthermore, applying the Fundamental Index™ strategy to fixed income takes advantage of the well-documented RAFI return advantage that comes from regular rebalancing and contra-trading against noisy price movements. Our research estimates the return advantage to be 80 bps annually in the Sovereign Developed Markets and about 125 bps annually in Sovereign Emerging Markets debt. In a world of slow growth and low expected returns, these advantages are significant indeed.
The incentives of Dirt Economics from my grandparent’s generation have been left behind—at least in most developed countries—so my generation faces a challenging road to maintain our standard of living. As we travel that path, we all need to position our portfolios for turbulent economic times—ones that promise to be very different from the post-World War II expansionary period to which most of us are accustomed. Low expected returns, significantly higher inflation and interest rates, rising deficits and debts, and worsening demographics all figure into a “New Normal.” Adding a third “pillar” of inflation protection to our portfolios and creating the possibility of significantly enhancing index returns through application of the Fundamental Index strategy to stocks and bonds alike strengthen our hopes of avoiding a future of diminishing prosperity.