Data covering the 45 years to 2005 from the largest global 85 economies shows a consistent pattern: people tend to consume capital (i.e. spend it) when they are young, build up capital from middle age through to retirement, and then gradually at first and then suddenly eat into that capital. This matters a lot for future investment returns. The demography of many developed and less developed countries is forecast to shift dramatically over the next few decades with the share of older people (consumers of capital) likely to increase significantly.
The chart below from Gavekal shows the global capital providers ratio (a weighted coefficient of the numbers of people in the capital providers relative to the total population) and plots it against the nominal yield on US 10 year Treasuries. Between 1960 and 1980 an increase in the share of capital consumers (both young and old) lowered the savings rate. In turn this meant that the real equilibrium interest rate increased since if capital is to be directed to where its needed and that capital is scarce its price must go up to. After 1980 this relationship reversed and resulted in the favourable tailwind of gradually declining interest rates that we’ve seen ever since.
Could the relationship just be a one-off resulting from the Baby-Boomers? It comes down to whether we are as inflationary in retirement as we are in our youth. Older people typically (but not always) spend their money on different things depending on their health; hopefully foreign holidays and a new sports car and not medical care. If pensioners are not in a position to contribute to inflation directly then another way older people can do this by passing some of their savings to their grandchildren.
In the future older people’s appetite for inflation will also depends on their investments and any income they receive. Traditionally they have reliant on fixed incomes and so have been wary of inflation eroding its value. That could change in the future if more pensioners have to manage their own investments, rather than relying on the state or final salary pension schemes.
Nevertheless, a look back at history suggests the the relationship will remain. The Bank of International Settlements (BIS) looked back over previous cycles going all the way back to 1870. It reveals the same stable relationship between age structure, the capital providers ratio and inflation. Although there are outlier’s, its also consistent across countries.
So what to make of this? Well, inflation is very likely to make a strong return over the next 30 years. Aside from the demographic impact there are another two D’s. First deglobalisation is also likely to be inflationary as trade moves towards more regional systems and technology fails to deliver the same deflationary pressures that we’ve seen over the past two decades. Second, debt (government debt specifically) is likely to increase as central banks and governments are forced to move beyond quantitative easing to finally get their economies moving through fiscal policy.
From an investment perspective it says buy those assets that are cheap and that do well in inflationary environments. Right now, that’s commodities. We are entering a period very similar to 1890-1920 and 1950-1980. Both periods exhibited high inflation with rising commodity prices. Notwithstanding the bleak recessionary outlook in the short term, anyone with a 20-30 year time horizon could do worse than consider increasing their exposure to commodities.