Aging Population Affects Economic Growth but Not Stock Returns

The economic impact of changes in population growth rates and age structure can dramatically shift as countries transition from high to low rates of mortality and fertility.

Initially, mortality declines faster than fertility, producing a bulge of young dependents that tends to depress economic growth. However, if fertility decline accelerates, the bulge of young people moves into the working stage, and economic growth can accelerate. The growing ratio of working-age people in the total population raises labour input, promotes productivity, and frees resources for saving, educational attainment, and innovation. This is called the “demographic dividend.” To receive a demographic dividend, a country must go through a demographic transition, switching from a largely rural agrarian economy with high fertility and mortality rates to an urban industrial society characterized by low fertility and mortality rates. China is a good example of a country that benefited from the demographic dividend over the past four decades.

The Demographic Drag

The demographic dividend period generally lasts a long time—four or five decades or even longer. However, the reduced birthrate eventually lowers labour force growth, while improvements in medicine and better health practices lead to an ever-expanding elderly population, putting an end to the demographic dividend. At this stage, all else equal, per capita income grows at a decelerated rate, and the demographic dividend transitions to a “demographic drag.” Japan is a good example of a country that has seen the negative impacts of the demographic drag.

Aging Effects on Economic Growth

Rainer Kotschy and David Bloom, authors of the August 2023 study “Population Aging and Economic Growth: From Demographic Dividend to Demographic Drag?,” examined how changes in working-age shares associated with population aging affect economic growth and then built a model to determine the demographic impact on individual countries.

They began by noting that the transitions from demographic dividend to drag are not as clear as they might seem, as people’s age-specific functional capacities change across time and can vary across countries. They noted that gains in age-specific functional capacities thanks to changing age patterns of health can help counteract the negative consequences of population aging for growth by enabling people to expand economic activity into older ages.

Thus, one should consider the effects of aging populations from a prospective point of view, not just in retrospect.

Key Findings

Their analysis began with building a growth model that described the effects of population age structure on economic growth and fit the model to data covering 145 countries and the period 1950 to 2015. They then combined the model with demographic predictions to estimate the implications of population aging for projected growth of income per capita over the period 2020 to 2050. Following is a summary of their key findings:

• Shifts in population age structure significantly affected economic growth, with population age structure correlating positively with economic growth.
• A 1% increase in the working-age share (0.5 percentage points on average) raised income per capita by about 1%.
• A 1% greater working-age share amplified growth by 0.1% to 0.4% in subsequent periods.
• These patterns were stable across both Organization of Economic Cooperation and Development, or OECD, countries and non-OECD countries.
• Their model successfully predicted the economic effects of population age structure shifts.
• Their model was able to reproduce growth patterns at different development stages, starting from a lower level. For example, China had grown 5 times faster than the U.S. over this period. In addition, the projections matched economic growth in other aging economies, such as Germany, Japan, and the Republic of Korea. However, the model did not predict the economic stagnation in Italy, where factor productivity and competitiveness have stalled for structural reasons unrelated to population aging.
• Without population aging, income per capita in OECD countries is projected to grow by 2.5% annually on average between 2020 and 2050. With population aging, growth is projected to slow by 0.8 percentage points when measuring working ages retrospectively but only by 0.4 percentage points when measured prospectively. Whether or not these gains can be realized depends on labour markets and institutions.
• Population aging is projected to spur average growth of income per capita in non-OECD countries.
  
  

Their results led Kotschy and Bloom to conclude that a demographic drag will be the norm as developed countries advance through the later stages of the demographic transition. Aging populations will slow economic growth in 70 countries—virtually all those whose working-age shares contract in the near future.

The authors explained: “When these large cohorts leave working ages, labour quantity will decline and resources that otherwise could promote productivity will be bound for consumption at old age. Without sufficient migration or increases in functional capacity, education, automation, and technological progress to compensate for these effects, a demographic drag follows the demographic dividend.”

In other words, some of the demographic drag can be compensated if economic activity expands into older ages.

Kotschy and Bloom offered this advice: “Caution in interpreting projected economic growth is necessary. How much economies will grow depends on factors that are not fully foreseeable today such as technological progress.”

Therefore, demographics is not necessarily destiny.

Kotschy and Bloom’s findings are consistent with those of the authors of the 2016 study “The Effect of Population Aging on Economic Growth, the Labor Force and Productivity.” Nicole Maestas, Kathleen Mullen, and David Powell used predicted variation in the rate of population aging across U.S. states over the period 1980 to 2010 to estimate the economic impact of aging on state output per capita. They found that a 10% increase in the fraction of the population aged 60 and older decreased the growth rate of gross domestic product per capita by 5.5%. Two thirds of the reduction was due to slower growth in the labour productivity of workers across the age distribution, while one third arose from slower labour force growth. They concluded that their results imply annual GDP growth will slow by 1.2 percentage points this decade and 0.6 percentage points next decade because of population aging.

The Relationship Between Economic Growth and Stock Returns

While it’s true that population growth and productivity determine the rate of growth in a country’s economy, the conventional wisdom that faster-growing economies lead to higher investment returns isn’t true. The wrong conclusion is reached because it fails to account for the fact that markets are highly efficient in building information about future prospects into current prices. There are also other explanations.

First, there is a general tendency for markets to assign higher price/earnings ratios when economic growth is expected to be high, which has the effect of lowering realized returns. Countries that are expected to have strong economic growth can be perceived as safer places to invest. That translates into higher current valuations—and higher valuations forecast lower, not higher, returns.

Second, the conventional wisdom fails to account for the fact that the markets price risk, not growth. High expected GDP growth rates of countries are built into current stock prices. The expected return is a function of the discount rate applied to future expected earnings. The lower the discount rate (reflecting lower perception of risk), the higher the current price but the lower the future expected return.

Third, economic growth is good for people, producing not only higher standards of living but also longer life spans, lower infant mortality, and so on, for those who live in countries with higher incomes. But equity investors don’t necessarily benefit. For example, a country can grow rapidly by applying more capital and labour without the owners of capital earning higher returns. And productivity gains can show up in higher real wages instead of increased profits.

Empirical Evidence

The research, including the 2016 paper from Dimensional Fund Advisors, “Economic Growth and Equity Returns,” the 2015 study “What’s Growth Got to Do With It? Equity Returns and Economic Growth,” and the 2012 study “Is Economic Growth Good for Investors?,” has found no significant relationship between short-term economic growth rates and stock returns.

The lack of relationship is evident in comparing the returns of the SPDR S&P China ETF GXC to those of the S&P 500. Over the period April 2007 to September 2023, GXC returned 3.6% per year, underperforming Vanguard 500 Index Admiral’s VFIAX return of 9.1% per year. While China’s economy grew at a much faster pace than the U.S. economy, U.S. stocks dramatically outperformed. One reason could be that while the Chinese economy grew rapidly, perhaps it did not grow as fast as investors anticipated, which negatively had an impact on valuations. That can be seen today. As of Aug. 31, 2023, while the P/E ratio of Vanguard 500 Index was 20; the P/E ratio of GXC was just 10. Another explanation is that the benefits of economic growth went to Chinese citizens, not investors.

Investor Takeaways

Kotschy and Bloom note: “As many countries complete the demographic transition, their populations age. While a growing working-age share thanks to aging has been a source for economic growth, contracting working-age shares now threaten to turn the former demographic dividend into a demographic drag.”

While their findings document that a demographic drag could be the new normal in the upcoming decades for most OECD countries, economic growth depends not only on how cohorts change but also on how labour productivity changes with improvements in functional capacity as longevity rises. Improvements in functional capacity can cushion much of this slowdown. Thus, perhaps the consequences of population aging will be less severe than demographic predictions suggest, as immigration and technological progress can reduce the demographic drag by cushioning labour shortages, automating physically demanding tasks, and creating age-friendly jobs.

Another caution is that a rising cohort of elderly will put fiscal pressure on pensions, healthcare, and long-term care of the elderly, which could require increases in taxes, negatively affecting economic growth.

A third caution is that demographic changes are one of the most easily forecast events. Thus, any economic impact from them should already be embedded in current market prices.

The takeaway for investors, therefore, is to not allow demographic forecasts to influence their asset-allocation plan.

The views expressed here are the author’s.

Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.