I. What does Aging Mean for the U.S. Equity Market?
Their argue that the age structure of the population, measured by the M/O ratio of middle age(40-49) over old age(60-69), seems to explain the PE of the stock market quite well. They postulate this process is driven by the fact that middle age people are saving thus buying stocks, while old age folks are dis-saving thus selling stocks. Therefore, when M/O is high, demand exceeds supply; when M/O is low, supply overwhelms demand. By projecting the historical trend, they painted a very bleak picture for the stock market going forward.
Figure 1: M/O ratio(Red) and PE(Blue), Dash is the projection
In response, John Cochrane wrote a blog arguing that age structure may not be the only variable that can explain the PE movement. In fact, it could be as simple as the mean reversion of the on-going cash flow. For example, when market is expansive in terms of PE, people expect the cash flow will lower, which pushes down the PE going forward.
Nevertheless, the "grumpy economist" does seem to agree that the expected real return on equity market is not likely to be 8%, and aging is not the only suspect.
Professor Cochrane did not stop there, however. He laid out another sharp observation:
The right statistics to look at is not PE but the equity premium. When people are young, they take more risk and thus have a stock dominated portfolio. When people grow old, they shift their portfolio to a bond dominated portfolio. Thus if Liu&Spiegel is right, we should observe that the equity premium is trending with the age structure.
II. What does Aging Mean for the Chinese Financial Market?
What light does the two paper shed on the Chinese financial market?
According to Liu&Spiegel, if M/O ratio is the driver, China appears to have a couple more good years before the M/O ratio starts to heading south. But that is too optimistic because the life cycle consumption pattern is different in China from that in U.S.
In U.S. it is reasonable to assume that inter-generational transfer is relatively unimportant, considering the well developed mortgage market and the cultural emphasis of culture independence. Thus the peak saving rate may occur around 45 when the student loan and the first home mortgage are about to be paid off and people start to save for their own retirement.
In very contrast, the life cycle consumption decision in China cannot ignore inter-generational transfer. Parents
provide finance the children from college to marriage, which is likely to deplete the bulk of their savings. The second generation, starting with a very healthy balance sheet, will save right away. And they had better save enough, because they are about to shoulder the financial burden of financing the retirement of their parents and the expenditure of their children. Consequently, the peak saving rate in China is likely to be earlier than that in the States, possible around 30-35.
If we are only concerned by the the gross demand for saving, I am afraid China may have already passed its peak of saving. Household balance sheet is likely to deteriorate very soon once my generation start to feel the pain of the a 2/1 supporting ratio.
Not all hope is lost for the equity market, though. Another major difference between U.S. and China is the strength of the bond market. While their U.S. counterpart can effortlessly phase their portfolio into a conservative allocation, the Chinese household do not enjoy such luxury. Thanks to the ill-developed bond market, the saving account becomes the only viable solution for less risky allocation. To make things worse, the real return on the saving account is negative for half a decade. Simple portfolio optimization tells us that to shoot for fixed expected return(which may not be the case), the Chinese household has to over-allocate on equity market, and subsequently take more risk. Thus Chinese stock will experience less shock than the U.S. counterparts because Chinese households are forced into holding more equity position than they would like.
The flip side of the argument above is that Chinese bond market is going to be BIG in the next decade .
III. What does Aging Mean for the Global Financial Market?
Previously I am confining myself to ignore the global flow of funds.
There are a few good reasons why that may not be a bad idea. For one thing, home bias is a well known mis-allocation pattern. For another thing, quirky regulation makes household difficult to diversify their asset globally, especially for countries that have capital control.
If all frictions are off and households are doing optimization correctly in a global scale, what will aging means for the global financial market?
It is an incredible hard question if one thinks twice about it. I have to leave it here for future exploitation. However, if the world consists only China and U.S., I would guess that Chinese people will be very interested in holding U.S. bonds rather than U.S. equity, which is contrary to John Cochrane's postulation of 1 billion Chinese buying S&P 500.
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