Idanna Appio spent 15 years at the U.S. Federal Reserve Bank of New York analysing the history of sovereign debt crises. Now, as a fund manager at the US$138 billion First Eagle Investments, she’s reached a conclusion: U.S. Treasury bonds are too risky to hold.

The call looks far beyond the timing of much-anticipated Federal Reserve rate cuts. It’s tied to a new era of faster inflation, higher government health spending and bigger deficits. And behind all of that? The fact that the world is getting older, fast, and it’s time to get portfolios ready.

Rather than buying what’s deemed the world’s safest asset to balance out her equity and credit holdings, Appio is adding gold. Yields on long-dated Treasuries just don’t offer enough compensation, she reckons, pointing to the surge in U.S. government borrowing that many fear could precipitate a debt crisis in the coming years.

Appio’s strategy is to eschew longer-dated bonds, which could take the hardest knock if burgeoning age-related state spending worsens the public debt picture. Other big money managers, including BlackRock Inc., Royal London Asset Management and Germany’s DWS Group, are also looking at ways to invest – and protect — clients’ money in such an environment.

The impact on financial markets will be felt across asset classes and geographies, and there’s no one-size-fits-all solution. But many of the strategies being put in place to trade the graying of the world reflect inflationary concerns: Fewer bonds, more stocks and commodities. What’s also clear is that it’s a challenge that can’t be postponed.

“We think of demographics as a slow-moving train and it’s not,” said Erik Weisman, a portfolio manager at the $607 billion MFS Investment Management in Boston. “It’s a train that’s barreling toward us and if you don’t get off the tracks you’re going to get run over.”

Weisman is among those coming around to the view that as birth rates fall and populations age, companies will have to fight for workers, boosting wages. For him, it means positioning for interest rates — and bond yields — that will potentially be higher in the coming years than many currently expect.

Recent evidence backs up the calls for urgency. South Korea’s birth rate is at a record low, both Italy and Germany have reported declining numbers, and there have been warnings from BlackRock Chief Executive Officer Larry Fink and investor Stanley Druckenmiller of a looming retirement crisis. When Fitch downgraded the U.S. last year, it cited the costs of an aging population among its reasons.

The U.S. is running “very high debt levels and we’re just about to hit a lot of these aging-related challenges that are unfunded,” Appio said. Yields on longer-dated Treasuries are “really not compensating for the longer term risk.” 

Inflation buffer

The inflation case is partly built on a simple idea of more old people spending, fewer young people producing. Given that view — not universal, but widely held — certain asset classes are attracting particular attention.

Royal London Asset Management is leaning into equity and commodity markets rather than debt. Trevor Greetham, head of multi-asset at the $205 billion asset manager favors commodities, commercial property and the resource-heavy U.K. equity market to safeguard his portfolio in a world with aging populations and higher inflation.

“We absolutely think about the inflationary consequences of demographics in our strategic asset allocation,” Greetham said.

Inflation tends to hurt bond investors by eroding the value of their holdings over time. That's because the fixed coupon income is worth less in real terms each year, while the bond itself can depreciate if central banks tighten policy to quell price pressures.

Inflation concerns appear at odds with the experience in Japan, with the world’s oldest population, and its era of slow growth and deflation, a backdrop that would favour bonds.

But Japan’s experience was likely unique, and partly influenced by disinflationary pressures from cheap Chinese goods this century, according to “The Great Demographic Reversal”, a 2020 book by Manoj Pradhan and Charles Goodhart.

Now, a shrinking population and trade tensions with the U.S. and Europe, mean those disinflationary forces from China are waning.

“If we take China as the face of demographics, the future looks more inflationary,” said Pradhan, a former Morgan Stanley strategist and founder of Talking Heads Macroeconomics. “Almost every economy has green policies, and deglobalization has meant more armed forces spending. There is a willingness to stimulate demand and China is not able to offset that demand quite as adequately as it did in the past.” 

Equity switch

The United Nations predicts that one in six people will be aged 65 or more by 2050. Getting investments right for that world is a particular concern to pension funds, a massive cohort managing about $50 trillion globally which must align investment strategies to ensure they meet liabilities to future retirees.

At DWS, which oversees €941 billion (US$1 trillion), it’s meant shifting pension money from fixed income into equities, according to Western Europe CIO Vera Fehling. Alongside that, it’s buying inflation swaps and investing in infrastructure projects with revenues linked to future inflation.

“In an environment where we have long-term inflation expectations at a higher level than previously, pension portfolios will want more exposure to assets that might help mitigate that effect,” she said.

Typically, as people get closer to retirement, their pension managers favor holding more bonds in order to protect the portfolio from equity-market swings. That may need to change, says Nathan Thooft, chief investment officer of multi-asset solutions at Manulife Investment Management, where a switch to stocks has been underway.

“Even at retirement, we’re advocating for clients to have 50 per cent or more in equities,” he said. “Most people undersave and so they need that equity risk.”

Governments also need to get ready, along the lines of Japan’s 2014 decision to take more equity risk in its Government Pension Investment Fund. Eurizon SLJ Capital’s Stephen Jen urges the U.S. and Europe to be even bolder than the GPIF which has a 50/50 equity/bond split; instead they should emulate Norway’s 70/30 model, he says. 

Underpriced risk

It’s tricky terrain for fund managers to navigate, given their investment horizons tend to be far shorter than the years over which the full impact of aging populations will manifest.

Nor is it yet clear what the eventual impact will be, given variables such as immigration flows, advances in technology and automation, and productivity gains.

But if many funds see demographics as too long-term to bother with, BlackRock, the world’s largest asset manager, sees opportunities. The $10 trillion asset manager has upped allocations to European and U.S. healthcare stocks on the view that future demand is not fully baked in.

Markets “can be slow to price in the impact of even predictable demographic shifts,” Jean Boivin, head of the BlackRock Investment Institute, said in a note last month. Plus, the world isn’t aging at exactly the same pace and outcomes will vary.

BlackRock favors India, Indonesia, Mexico and Saudi Arabia — developing nations where working-age populations are still growing — anticipating that stronger economic performance will fuel higher returns. 

Many investors say they pay close attention to immigration to narrow down where to park their cash. That movement of people affects labor markets, with implications for inflation and monetary policy, big factors when determining potential returns. Here, countries such as China and South Korea, with low birth rates and immigration barriers, are seen at a disadvantage, with less vibrant growth than others like the U.S.

For Luke Templeman at Deutsche Bank Research, the issue isn't that fund managers are unaware of the growing elderly cohort but that the impact on assets and markets will be far more pervasive than the majority anticipate.

“The maxim ‘buy healthcare and cruise stocks’ is way too simplistic,” he said.