Demographics are driving wages lower, which is negative for investment returns
For managers of money, the post-crisis low growth world has had major implications for asset allocation strategies. Assumptions about returns are greatly affected by both monetary easing used to counteract the slowing and the yield curve flattening that is indicative of easing’s ineffectiveness. Recent research on demographic trends and wage growth suggest trends now in place may continue, with grave implications on returns.
My biggest macro thesis for the past two years is based on the belief that the low rate environment will continue due to the ineffectiveness of monetary policy to create sustained growth. And this means that over the medium-term, there will be a flattening of yield curves that will be most pronounced in countries that have the steepest yield curves — with relative value coming from differences in short-term rates, thus favouring investment in bonds in countries like Australia and New Zealand.
The last post I wrote on the ineffectiveness of monetary policy gets at why we should expect the bond bull market to continue as yield curves flatten in all developed economies as they had done in Japan earlier. My worry is about wage growth, because without wage growth, sustainable spending growth for the whole economy is dependent either on population growth or leveraging, either by the state or private actors.
Now, wage growth has been stagnant in the US for some time. Early in my blogging career, I even noted that real hourly earnings peaked in 1973, which is 43 years ago. Despite that peak in wages, household income was bolstered by increasing labor participation of women. But, at some point in early 2000, the labor force participation rate began to decline.
And to maintain spending growth, the US economy in the 2000s depended on the notorious housing ATM associated with that period’s unsustainable rise in house prices. But when the housing bubble popped and the US lapsed into recession, interest rates at zero percent limited releveraging in the household sector since the Fed could no longer cut rates. Yield curve flattening has allowed for some marginal releveraging, as long rates have fallen. But it has not been enough to drive the kind of growth we saw last decade.
So now the question is this: when will wage growth resume its upward path? A lot of research into this question has been focused on productivity. But the Federal Reserve of New York has just released some research that points to demographics as a defining issue. They write that across the US economy, all segments of the population “display rapid real wage growth early in a worker’s career, with positive real wage growth ending when the worker is in his/her forties. This is followed by a period of either flat (high school graduates or less) to declining real wages (some college or more). By age 55, all education categories are, on average, experiencing negative real wage growth.”
In a subsequent post, the New York Fed spells out what this means for the economy:
We have shown that U.S. real wage growth has been slowing down over the past thirty-five years with the aging of our workforce. Abstracting from cyclical factors impacting the labor market, this slowing is likely to continue in the years ahead as more individuals near retirement and experience negative real wage growth… Consequently, the aging of the U.S. population will continue to act as a headwind to labor productivity and wage growth.
The conclusion for asset allocators: Japan is the model for a demographically-challenged country. While their demographics are worse, what is clear is that as a workforce ages, wage growth remains low or wages contract. And this will negatively impact nominal GDP growth, corporate earnings and fixed income yield pickup. The likely policy response is monetary easing and fiscal stimulus – but with mixed results at best. In this context, monetary stimulus can be seen as facilitating lower private sector interest costs rather than a tool to increase savings or investment, since yield curve flattening will mean lower interest income. In this context, fiscal stimulus can be seen as both a releveraging and a risk shift, with debt moving from the private sector to the government.
Broadly speaking, we are talking about a growth malaise that companies cannot possibly escape. So equities will be hit with lower returns to match the lower returns from bonds. For fund managers, that means lower returns that cannot be massaged away by rejiggering bond/equity allocations. For insurance companies, this means serious reinvestment risk, higher costs associated with deferred acquisition costs, and balance sheet risk via liabilities revaluing more than assets in a low rate environment.
We are already seeing the low rate environment negatively impact pension and insurance companies. But I think this impact will continue through the next cyclical downturn, adding financial stability as a concern to policy makers even if the next downturn is a garden-variety one. Moreover, the New York Fed pieces suggest that fiscal stimulus in the form of generalized tax cuts or infrastructure spending will not actually change the direction of growth if the root cause is demographics because we are talking about structural issues rather than cyclical ones.
Overall, I believe recognition of these forces is poor — such that, when the economy turns down, municipal revenues turn down, corporate earnings turn down and yield curves flatten or invert. Asset managers will be caught out. And the result will be a larger than expected fall in asset prices, which will present buying opportunities for sure. I don’t expect any real fireworks until then and see the real economy leading and the financial economy following in tow.