CHG Issue #206: FIRE
The mounting signs that financial asset outperformance is coming to an end
The great thing about demographics is they are slow moving and relatively straightforward in their cause-effect relationships. Over the long-term we know that economic growth = population growth + productivity growth. In the short term we may experience divergences from the underlying trend that are ultimately mean reverting. We can have confidence in the mean reverting nature because the underlying facts are immutable: the economy can only grow because there are more people doing things or because the things they are doing are more productive. Natural constraints, such as population growth = births - deaths + net migration, provide a foundation for alpha generation because when the economy continues to grow at a healthy rate despite lower population growth, we know it must be due to productivity growth. From that, we can investigate the causes of lower population and higher productivity growth so that we can have a better understanding of their strength and durability.
The baby boomers represent a large demographic force due to the size of their cohort and as they came of age and have now started moving into retirement their activities have had large impacts on our economy, politics, and society; just to name a few.
The combination of the aging of the baby boomers and lower birth rates has led to an aging US population which present all sorts of economic headwinds.
Aging countries have fewer prime age (ages 25-54) workers which leads to lower labor force participation. All else being equal, lower labor force participation means lower economic growth because there are fewer workers producing and consuming goods and services. Additionally, a higher share of older people acts as a drag on economic growth as they divert economic resources towards healthcare and away from human capital development.
Beginning around 1990, the US’s age dependency ratio line started moving higher and has recently increased upside velocity. Given that increase we should expect to see lower labor force participation and lower productivity.
The labor force participation rate has declined as expected, but we have not seen a decline in productivity.
We are producing dramatically more with fewer workers. What is going on here? Technology has enabled us to not just produce and consume more but also do it for longer as healthcare technological advances have increased lifespans. This has been one of the most important macro-observations over the past thirty years with far reaching and underappreciated consequences.
All else being equal, the aging of America since 1990 should have caused productivity to decline and inflation to rise; but it did not. We are well aware of the impact of technology, and most recently AI’s impact on productivity, but what other forces could be at work? We must ask this because we have experienced a change in inflation recently while productivity growth remains healthy with prospects to accelerate, so what else might be at work that has caused inflation to rise?
Demographics contributed to the global glut of capital in the 1990s and 2000s mainly through 1) aging populations in advanced economies that increased saving rates, and 2) rapid income growth with high saving rates in emerging markets like China and India. In the late 20th century, the combination of demographic aging, which leads to asset accumulation during working years, and financial globalization created large capital flows from high-saving countries to low-saving advanced economies such as the US. This capital surplus pushed down global real interest rates and contributed to the “global saving glut.”
The fact that lower interest rates did not result in higher inflation confounded economists in the 2000s and 2010s. The oversupply of capital increased financial asset prices but did not increase prices for goods and services because the savings were used to build excess capacity. Low interest rates enabled productive capacity to expand, and they also enabled governments to borrow more to stimulate their economies. This led to an increase in debt and a decline in the productivity of that debt, especially government debt.
Economic output declines when a factor of production (land, labor, capital technology) is overused. Confirming this situation, the U.S. has experienced a decline in the dollar amount of GDP produced by a new dollar of government debt. In 2024, a new dollar had only 80 cents of GDP, down from about $3.15 in 1981, thus dramatically illustrating diminishing returns.
-Hoisington Investment Management Company’s First Quarter 2025 Quarterly Review and Outlook
This effect can be seen clearly in the chart below which contrasts the long-term moving average of economic growth with federal debt.
The surge in worker productivity combined with abundant global savings allowed policymakers to meet every economic downturn or financial crisis with a surge in debt-financed spending. Increasing debt burdens resulted in a higher frequency of financial crises which created a self-reinforcing loop of debt accumulation shifting towards public sector balance sheets. While doing something in a crisis was politically expedient, economically all it was doing was pulling future spending forward and this is why we have seen such a precipitous drop in what Hoisington calls the Marginal Revenue Product of Debt (MRPD). Flooding the market with dollars and those dollars typically being recycled back into investment assets drove asset prices higher and put pressure on the velocity of money.
Declining velocity of money in the economy was an important factor that contributed to the disconnect between interest rates and inflation. Although recently velocity has turned higher contributing to the recent rise in inflation. The velocity of money is influenced by things like MRPD, demographic trends, credit growth, consumer attitudes and confidence, employment growth, and so on. Up until recently the declining MRPD and aging demographics have acted as a strong anchor on velocity, but the recent turn higher suggests that the balance of forces weighing on velocity is shifting.
The aging baby boomer generation in the US and other advanced economies is now entering retirement and increasingly selling equities or shifting toward safer assets to fund consumption, potentially leading to a decline in capital accumulation, and financial asset values and an increase in consumer goods and services. Previously, baby boomers were spending their marginal dollars on financial assets but now that is not necessarily the case. We have heard anecdotes of parents supporting their kids well into adulthood. This is an example of how demographic, financial, technological, and economic trends intersect with the current social issues around depression, anxiety, teen suicide, and so on which can feed back into velocity through other channels. It is vital to remember that financial assets have massively outperformed physical assets since the 1990s with the impact stretching beyond the economy and financial markets into society via increasing inequality. It is foolish to formulate any view on the economy without taking this chart and its manifold effects into consideration.
At the same time, declining birth rates due to social attitudes towards marriage and the economic challenges of raising a family reduce the future working-age population, which reduces the potential for savings and investment demand in the future. As we have seen, it was the abundance of resources and capital that were the predominant forces underlying the secular disinflationary trend. While technology has a major impact primarily through increased productivity the tradeoffs of those technologies are now being felt throughout society. While inflation is a monetary phenomenon, as we have seen in other countries that have experienced prolonged deflation, like Japan, it is also a psychological phenomenon. Consumer attitudes towards spending today are heavily influenced by their perception of the availability of the products, their want and need for them, and their perception of their ability to afford them. Perhaps the biggest force underlying inflationary dynamics today is the shift in mindset from one of abundance during the 1990s and 2000s to a scarcity mindset today.
For example, the rising cost of capital for AI capex is due to the scarcity of capital today. This has been disguised by the private markets where most of this capex is being financed but not entirely. Last week we saw ORCL CDS spreads blow out on concerns related to their heavy AI capex spending.
One of the “solutions” to this scarcity of capital is allowing retirees to invest in private assets. While it is unlikely that this is the real motive behind the movement towards the democratization of private assets, it is an example of the invisible hand at work. There is a growing need for capital and as the baby boomers move deeper into retirement their large pool of capital is increasingly unavailable, and the market is trying to bring it back online.
Everything is connected and if you pull on certain threads for long enough you will discover the cause-effect relationships that are worth spending time thinking about. They reveal the real forces quietly moving under the surface which are behind the outcomes we are experiencing.
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