Demographic changes are slow, measured in years and even decades rather than months. But they are powerful. Charles Goodhart and Manoj Pradhan have written an excellent book, The Great Demographic Reversal, in which their broad thesis is that demography has been a force for low inflation and low nominal and real interest rates for three decades; but that all those downward pressures will be reversed in the coming decades. 
The most dramatic shift has been in China. Its policy changes and admittance into the WTO in 1997 more than doubled the workforce available to produce tradeable goods. On top of that, it’s Working Age Population (WAP) increased by 240 million over the period, four times the growth in WAP in Europe and the US.
The fall of the Berlin Wall added another 200 million people to the working age population from Eastern Europe. And the trends in Western Europe and the US were favourable too, with the number of children falling faster than the rise in retirees - hence the ratio of dependents to the WAP improved.
With world trade growing at twice the rate of GDP, globalisation crushed the bargaining power of labour, leading to low inflation, greater inequality and good corporate profits. The deflationary effects allowed monetary policy to be accommodative and, as a result, nominal interest rates to fall to historically unknown levels and debt to explode. Asset prices were inflated.
This sweet spot is souring. In the coming decades there will be an absolute decline in the WAP in China, much of North Asia, Japan, Germany, Italy, Spain, and Poland; the US and the UK will see lower rates of growth. There are reasons to doubt that India and Africa can play the role of China in coming decades. Meanwhile the number of retirees will increase rapidly.
Goodhart and Pradhan’s thesis is that this combination will see the savings rate contract and the ‘savings glut’ disappear, leading to higher interest rates. This is because workers consume less than they produce, pensioners the reverse. With even higher conviction, they believe that the improved bargaining power of labour will lead to higher real wages and higher inflation.
One frequent objection to this thesis is to point to the example of Japan where a falling working age population has not yet led to rising inflation. The most important rebuttal, among several, is that the dynamics determining both inflation and real interest rates are worldwide, not local. The rest of the world was “overflowing with labour” as Japan’s was ebbing. Interestingly, a recent paper from the Fed also discusses the importance of international rather than country specific factors in determining interest rates. The same can be said for inflation.
The book argues that, with ex-ante savings falling faster than investment, long-term equilibrium will require higher real interest rates. But it is worth quoting parts of a passage on the next few years:
Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate. The excessive debt, amongst nonfinancial corporates and governments will get inflated away. The negative real interest rates that may well be necessary to equilibrate the system, as real growth slows in the face of a reversal of globalisation and falling working populations, will happen. Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile... Only when indebtedness has been restored to viable levels can an assault on inflation be mounted.
The final point that comes out of the study is that growth will be in short supply. Broadly, growth in GDP is the product of productivity and growth in WAP. Productivity in Japan was among the best of any advanced economies in the last decade, but the contraction in its WAP meant that growth was modest; similar outcomes will prevail in the remainder going forward. Growth is likely to be lower and a considerable headwind for corporate profits.
So, if Goodhart and Pradhan are correct, the coming years will be characterised by elevated inflation, poor growth, and corporate profits that are constrained by the greater power of labour relative to capital. On the other hand, the debt trap will push real interest rates even lower for an extended period. It will be an interesting and challenging environment for investors to navigate.
Peter Spiller is chief investment officer of CG Asset Management. The views expressed above are his own and should not be taken as investment advice.