Global Solution: Foreign Investment Will Save the Developed World

Wharton Economic Summit | It was almost enough to make you choke on your filet mignon. In a luncheon speech at the Wharton Economic Forum, held at New York’s Pierre Hotel in February as part of the school’s observance of its 125th anniversary this year, Dr. Jeremy Siegel told the attendees—who were indeed dining on steak—that the aging of the U.S. population, blamed for a coming crisis in Social Security, could also wreak havoc on the private sector.

“A lot of people come to me and say, ‘Jeremy, we all know about the crisis in Social Security, but even if it closed down, I have enough private assets to live the life I want to lead even if I get zero Social Security’—I dare say nearly everyone in this room is thinking that,” Siegel said. “The fact is, maybe not.”

Just as the basic problem with Social Security is that too few workers will be supporting too many retirees, when the flood of retiring baby boomers are looking to liquidate the assets they’ve accumulated, they may be faced with a shortage of willing buyers. “If there’s not enough people with enough wealth to absorb these assets, then they can not be absorbed at the prices we expect to get to,” Siegel said.

Calling the aging of populations “the critical long-term economic issue facing the developed world,” Siegel, the Russell E. Palmer Professor of Finance, drew on material from his books, Stocks for the Long Run and the more recent The Future for Investors: Why the Tried and True Triumph Over the Bold and New, to show how population trends would shrink the ratio of workers to retirees from 7:1 in 1950 to about 5:1 today to 2.5:1 by 2050. This is in the U.S., he added, the “youngest” among the developed world’s populations. In Japan, the ratio will be more like 1:1, and the most densely populated segment of that country’s population will be people between 75 and 80 years old.

Meanwhile, exacerbating the problem, the average
retirement age is dropping and life expectancy is rising. In 1950, the average retirement age was 67 and life expectancy was about 69. Today, the retirement average is 62, and people live 14.4 more years after retiring.

This prompts two key questions for the developed world, Siegel said: Who will produce the goods—will there be enough workers to meet needs? And: Who will buy the assets that the baby boomers plan to sell for a comfortable retirement? “What’s going to happen to the stock and bond markets when trillions of dollars come onto the market and all of a sudden there aren’t many buyers? There will be markets, but at what price? How much down will the market have to go?”

Also similar to the Social Security debate, there are a series of more optimistic scenarios, which Siegel took up—and shot down—in succession:

People will just work longer. Possible, but “you’ll have to work longer than you live longer.” The average retirement age would have to increase by a decade, to 73; that jump is more than life expectancy is projected to increase, so it would mean an average of 9.2 rather than 14.4 years of life after retirement, a 30 percent shrinkage and the first time that retirement years would actually decrease.

Higher productivity will make up the difference. The long-term historical average for productivity increases is 2.2 percent annually, said Siegel. Plugging in 3.5 percent—a “blockbuster” number—only gained 2-3 years compared to the average. The reason is that higher productivity also boosts wages and income, and that’s what pensions are based on, so it raises both sides of the equation, “like a dog chasing its tail.”

Immigration? In order to maintain the average retirement age of 62 for the next 30 to 40 years, Siegel calculated that a half-billion new people would have to be added to the U.S. population. “I’m a liberal when it comes to immigration, but this is a big number,” he said.

But, there may be hope, he added.

Outside of the developed world, the populations are much younger. Historically, the old have sold assets to the young. These days, Florida retirees sell to the other 49 states. In the future, when we are a nation of Floridas, so to speak, the U.S. (along with fellow old-timers Europe, Japan, and Canada) can sell assets to the developing world.

Today, the developed world accounts for 13.2 percent of the world population, and controls 56 percent of world gross domestic product (GDP). By 2050, Siegel projects, the number will be more like 12 percent of the population and 23 percent of GDP. The remaining GDP will be in the developing world, and China (20 percent) and India (16 percent) will together account for “more than twice the output of the entire developed world.”

These figures are conservative, he insisted, noting that China’s per-capita income is currently 12 percent of the U.S. and India’s is 8 percent. It’s generally accepted that China will reach 50 percent of U.S. per-capita income by 2050—which, since they have four times as many people, means they will be twice as big. “It’s the simplest math there is.”

“What does this buy us?” Siegel continued. “Put the whole world in the market, have everyone trading with everyone else. The young people in the developing countries are going to be
acquiring assets; the older people in the developed world are going to be selling assets and importing goods.

“If we can make that work,” the retirement age will still have to rise, but only to 67-68, much more in line with Social Security projections and life-expectancy and “nowhere near as much as if we had to rely on just our own people,” Siegel said. “I call this the global solution.”

All this selling and buying will mean that developing countries will end up owning most of the world’s capital, and most of the world’s major multinational companies.
By 2050, two-thirds of the world’s capital will be in the developing world, compared to just 7.7 percent today. “We are going to see some of the most massive shifts of capital that we have ever seen.”

To those who object to the resulting loss of control, Siegel’s computer models offer a stark answer: Shutting foreigners out of the U.S. market would mean a drop in value of 40-50 percent. “You will have to work until you’re 73—that’s all the wealth you’re going to have,” he said, to laughter—a little nervous—from the audience. People “must realize that demand is the key ingredient to support the financial markets.”

This does not necessarily make India and China the best places to invest, though, Siegel added. In fact, when he looked at emerging markets for the past 20 years, he said, he found a “negative correlation between how fast a country grows and returns to investors.” The reason is that investors are seduced by growth, and drive equity prices up too high. This is a reminder of how important price is to long-term returns. “Some slower growing sectors have outperformed faster growing ones.”

Siegel recommends a stock portfolio composed of 60 percent U.S. and 40 percent international equities “because the U.S. will be a smaller piece of the pie.” Just as one would not want to invest in just one sector of the U.S. economy in the past, he said, a significant portfolio of international stocks makes sense “not necessarily because of better returns but because you have to diversify.”

Among the three main asset classes—stocks, bonds, and real estate, which each represent about $15 trillion—stocks continue to be the very best long-term investment, with far better returns than either of the other two, he said. This is true even considering the recent spectacular gains from real estate, which may, however, have run their course. However, in part because many investors have gotten this message, and tend to hang onto their equity investments even in hard times rather than dumping shares, he expects average returns to decline slightly from their historical average to 5.5-6 percent annually.—J.P.

©2006 The Pennsylvania Gazette
Last modified 05/05/06

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