4 questions

The big issues that long term investors must address when looking for investments

The UK’s population is ageing. What does this mean for investors?

It will come as no surprise to many readers that the UK’s ageing population will be a major theme for markets in the future. The UK is sitting on a demographic timebomb. Advances in technology and medicine mean we are living longer but this is coming at an increasing cost to the UK taxpayer. This ageing of populations is a global phenomenon, being witnessed not only in Britain but in such developed countries as the US, Germany and Japan.

In fact, in terms of the cost to governments, an ageing population will have a far, far bigger impact on sovereign indebtedness than the current financial crisis. The IMF last year released a paper estimating that the costs of ageing will be the equivalent of 335% of UK GDP, which is about ten times the cost of the current financial crisis. The UK is by no means the worst hit either – the IMF reckon the equivalent figure for the US is 495%, Australia 482%, Korea 683%, and for Canada a whopping 726% of GDP.

Ageing populations have more than just an impact on debt levels; if more people are retiring than entering the workforce, there will be a decline in the ratio of workers to pensioners (the dependency ratio), placing a greater pension burden on those in work. The proportion of the UK population of working age is expected to fall from 65% to 59% in 2033. At present, 16% of the population are aged over 65. This is expected to increase to 23% by 2033. This is a massive increase which is the result of the retiring baby-boom generation.

Worsening demographics also have big implications for long term economic growth. If older people do not save or run down their savings while a smaller working age population does not save enough to compensate for the shortfall, then a shortage of savings could seriously affect economic performance.

There are a number of social costs too, such as gaps in the jobs market, with businesses and public services lacking the workforce required. With the elderly being the fastest growing age group in Britain, increasing pressure is being put on healthcare and social services. Personal savings is another potential dilemma; societies must save to be able to allocate funds for investment for the future, in such things as factories, offices, transportation, schools, energy and hospitals.

Funding this cost will prove incredibly difficult, and it is difficult to see how this can be paid for without significantly increasing government bond issuance and hence sovereign indebtedness. While supply of government debt is very likely to rise, it is worth noting that demand from pension funds will also increase, as pension funds seek to match assets with their upcoming liabilities. But will this demand be enough to finance the UK’s spending plans in entirety? Unlikely.

What impact will large budget deficits have?

We all know the British government has had to undertake extreme measures to prop up the economy and its financial system. Extraordinarily, loose fiscal and monetary policy has had the desired effect of stopping the free fall in economic growth. But these policies do come at a cost.

A recent analysis by the EU commission found that the UK has a sustainability gap of 12.4% of GDP which is almost double the EU average. This means to put the public finances back on a sustainable path, the UK should improve its primary budget balance by 12.4% of GDP.

Essentially, the report concludes that the UK is going to have to address its spending plans or face a credit rating downgrade. This adjustment could take place through higher taxes and cuts in expenditure. Alternatively (and most likely) the social system will need to be reformed to address the projected increase in pension and health-care expenditure. If the budget is not addressed and the UK is downgraded, pension funds may prefer to own assets that are better rated.

In its report, the EU Commission found that “The UK appears to be at high risk with regard to the long-term sustainability of public finances”. Unsurprising given that the same report forecast that debt-to-GDP would rise from 52.0% in 2007 to 212.7% by 2025.

Of course, Japan is an example we can look at when talking about the prospects for the UK in coming years. The possibility of a ‘lost decade’ like that experienced in Japan is real for the UK and indeed the rest of the developed world. The Japanese government during the 1990s was been unable to cut back meaningfully on spending or increase taxes, since such behaviour would have risked plunging the economy back into recession and deflation. Sound familiar? It should do because the UK is in the same perilous state that Japan was in a decade ago. We do not have the Japanese culture of saving a large proportion of our earnings but this may have to change in the coming decade.

Is government debt really risk-free?

Given the perilous state of the UK budget and outlook for the economy, it would not surprise us at all if highly rated corporate bonds are perceived as a safer investment than government bonds. In fact, this is not an expectation for 10-15 years down the line as we have evidence of this phenomenon occurring today. As things stand today, the credit derivatives market believes that 148 western European corporates – ranging from Tesco to Nestlé – have less probability of defaulting on their debt than the UK government does.

There are also a number of historical precedents in emerging markets where companies are able to borrow at better levels than governments – Brazilian oil giant Petrobras, for example, was able to issue bonds at a significantly lower cost than the Brazilian government in 2003-06. At the moment, Greek telecom operator OTE can raise finance at a cheaper cost than the Greek government.

In 10-15 years time, we may find that highly-rated companies with hoards of cash and diversified earnings streams are the new ‘risk-free’ asset rather than highly indebted sovereign nations with rising debt-to-GDP ratios.

How should monetary policy react to asset price booms?

The financial crisis we have experienced over the past couple of years has challenged the conventional view on how economists think monetary policy should respond to asset price booms. Before the crisis, the common view was that a central bank should not react to asset price movements like the run-up in house prices that the UK experienced over the last decade. A central bank would instead stand ready to respond if and when a collapse in the prices of some assets threatened its ability to meet its inflation target. Now, in the aftermath of the financial crisis, there are increasing calls for central banks to be more proactive in responding to signs that an asset bubble may have emerged. This notion is often described as an imperative to ‘prick’ or ‘lean’ against a bubble, meaning that the central bank should act to lower asset prices that seem unusually high and out of kilter with underlying fundamentals.

This thinking is not radical, in fact it was around at the time of the last great crisis; The Great Depression. This position can be traced back to the so-called ‘liquidationist’ view, which was widely held view held by mainstream economists in the 1920s in the United States.
The view had some high-profile advocates within the Federal Reserve at the time, who substantiated their view for a strong policy reaction to market bubbles on the grounds that the central bank, by acting decisively, could prick the bubble without inflicting further damage on the economy more broadly.

This thinking fell out of favour and most economists currently believe that the monetary policy instrument is too blunt a tool to allow the type of intervention that the ‘pricking’ of a bubble would require, however there are many other things that central banks or governments can do, such as increasing commercial banks’ reserve requirements (indeed the Chinese did this very recently).

Financial markets change, economic policies evolve and I believe that the view that central banks should only target inflation will come under some heated debate over the next decade when (or if) interest rates return to more normal levels.