Wednesday, March 9, 2011

Demographics Determine Longer Term Market Trends

I was first introduced to the work of Dick Hokenson when he was an analyst and then chief economist at Donaldson, Lufkin & Jenrette. After stops at other Wall Street firms, he currently has his own company (Hokenson & Company).

Dick's specialty is demographics. More specifically, Dick attempts to come up with investment ideas and themes based on his work on areas like population growth; labor force trends; and productivity. The idea is that factors like the average age of a population will have a greater impact on areas like, say, housing than interest rates.

For example, Dick has always used the age of a country's population as a means to predicting future economic growth and stock market returns. He was bullish on the emerging markets long before the consensus simply because stronger population growth in countries like Brazil. Younger people buy houses and consume more products than older citizens, which helps the overall economy.

His work has always been unique. Unlike most Wall Street analysts, Dick tries to figure out how demographics will impact the investment markets. Although his views are naturally longer term in nature, his work is always thought-provoking.

The most recent issue of CFA Magazine carried an interview with Dick. Here's a couple of excerpts, with the full link below.

First, Dick notes that many parts of the world - notably Japan - are not only seeing an aging population, but are also seeing a shrinking population. This is one of the reasons that Japanese interest rates are so low:

What’s the relationship between shrinking populations and low interest rates?

There is a very strong relationship between nominal long term interest rates and nominal long-term GDP growth. I have seen studies that tracked this relationship back to the 1800s. If you do a supply-side decomposition of the GDP,in terms of population, labor force, and productivity, you end up with a very strong causal relationship between labor force and nominal GDP. And labor force growth is slowing—it is slowing worldwide. That will continue to pull down nominal GDP and nominal interest rates

And then there's the themes that Random Glenings has been sounding for at least the past year:

What’s the biggest demographic story investment-wise?

If you think about one of the most important things somebody who manages money has to make a decision about, it’s the outlook for inflation. If you get that wrong, you are going to have a big negative impact on your performance. In the 1960s and 1970s, people underestimated inflation and got burned. But for much of the past 30 years, it has been the other way around. People have underestimated the structural disinflation. Otherwise, in 1981, you would have bought the 14¾ U.S. 30-year Treasury bond. In 1981, there were no buyers. And as interest rates were falling, there were still no buyers. Those people said, “They are declining, but they will start rising again,” and that has been part of the issue for the past 20 years. I have talked for 20 years about low interest rates, and people look at me and say, “You went to too many Grateful Dead concerts and inhaled too heavily.” If you look in the press, everybody believes in inflation—that [Federal Reserve Chairman] Bernanke is going to reflate us, that inflation is going to be back next year or a year after, and that interest rates will be higher.
Why don’t you think there will be inflation?

If you have very low interest rates and you have an age structure where people don’t borrow money (aging populations), it doesn’t matter what the price of money is. You can push out money, but it doesn’t go anywhere.

So that’s the question—is inflation caused by money supply or money demand? If it is money supply, then it is a central
bank issue and the Central Bank is going to control it. But if it’s money demand, then it is a demographic issue. I think it’s a demographic issue. The age structure of the population matters in terms of whether you can reflate. And since the population of the world is aging, reflation becomes less and less likely.