Europe’s Demographic Dilemma

Our Chief Europe Economist Jens Eisenschmidt and Europe Equity Strategist Regiane Yamanari discuss the strain of an aging population on the future of Europe’s economy and markets.

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Jens Eisenschmidt: Welcome to Thoughts on the Market. I'm Jens Eisenschmidt, Morgan Stanley's Chief Europe Economist.

Regiane Yamanari: And I’m Regiane Yamanari from the European Equity Strategy Team.

Jens Eisenschmidt: Today we are discussing one of the most urgent challenges Europe is facing right now, a declining working age population – and its implication for Europe's economy and potential solutions.

It’s Wednesday, October 23rd, at 3 pm in Frankfurt.

Regiane Yamanari: And 2 pm in London.

So Jens, people are getting older around the world, living longer. Although the rate of change is different from country to country, can you tell us what's the situation in Europe right now?

Jens Eisenschmidt: Yes, Europe faces a declining working age population, so much is sure. We have just put out a big report, where we come up with numbers around this issue. We think for the large four Euro area countries – Germany, France, Italy, and Spain – we see a decline in Euro area working population by 2040 by 6.4 per cent. People also get older, so that doesn't necessarily mean the overall population is declining by as much. It simply means that working age population, as a sort of most direct, relevant measure for the economy, is declining.

Regiane Yamanari: Why does an aging population hamper economic growth?

Jens Eisenschmidt: So, think about the economy producing, in a very stylized sense, with two factors. One is capital and the other one is labor. And typically, these two factors are connected. So, you can't really produce just with one factor. Typically, you need at least some labor to produce something or at least some machinery to produce something with labor.

So we just; I mean, it's a very simple way of looking at the economy, but typically very powerful in explaining what's going on. So, if we take this approach and look at our economy through the lens of these two factors and we have one factor declining significantly, this will affect the amount the economy can produce.

So, we are talking here about so-called potential growth or potential output. And we think the declining working age population will lead to a decline in potential output. For the Euro area economies I was just mentioning, we think it could be around 4 per cent over the period 2000, from now to 2040. And that amounts to on an annual basis around 25 basis points lower growth potential.

Regiane Yamanari: Suppose policy makers want to boost Europe's working age population, which they do. What options do they have? Which European countries most benefit from these policies or options?

Jens Eisenschmidt: Yeah, the oldest policy measure, or if you want the most discussed one, typically has been birth rates.

Now, many of the policies being implemented here – and they have been implemented for decades already – have been found to be not really changing [the] situation in a profound way. So, birth rates have either stopped increasing again or actually continued dropping. So, policy makers’ attention probably for this reason has turned to other measures.

Other measures we think of here mostly in the current debate is increasing net migration, so you're basically getting your working age population replenished to some extent from the outside. Changing participation pattern in your own domestic labor market – typically, it's framed around the question, how much or how high is the share of one cohort versus the other.

For instance, males versus females. We have countries where there is a large gap between these two groups, just to name an example here. And you know, closing that gap could help you increasing or offset; some of the projected decline in working age population.

Another measure that's often discussed is increasing, retirement age. So essentially working age population is defined by those age between 15 and 64. And of course, if you work for longer, so you increase retirement age, that will also help, to stem against some of the projected decline in working age population.

Now, if you look around for the countries that we are discussing in the report, um, then there are different ways these policies affect these countries.

So, for instance, in Italy, closing the gap between male and female labor force participation would offset a large part of the projected fall in its working age population because that gap is so large. In France, in terms of our numbers, the most effective measure would be increasing the retirement age. And again, in Germany and Spain, it would probably be migration policies that are most effective.

Okay now let's consider the alternative, Regiane. Suppose nothing changes. There are fewer and fewer working age people in Europe. How would this affect companies earning growth?

Regiane Yamanari: So, if there are no policy action, and here assuming all else equal, I mean, no change in productivity, for example. Due to a lower GDP growth, we estimate the headwinds of European demographics could lower companies long term earnings growth by 90 basis points. So, from 5.1 to 4.2 per cent by the end of the decade. And this compares to an average growth of 6.4 per cent that we had in the past 10 years.

Jens Eisenschmidt: And how would this be reflected in the stock market?

Regiane Yamanari: Yeah, so potential lower earnings growth is negative for European equities, right? But it's worth highlighting two points here. First, is that European companies have been diversifying their activities and revenues across the globe in the recent decades. And the revenue exposure of European companies to develop Europe, including the UK has reached a 30-year low. So, we estimate that just 38 per cent of European companies’ revenues are generated in develop Europe, on a free flow market cap weighted basis.

And second, I think we see this impact being more idiosyncratic at sector at stock level. Just to give an example, so we have this factor analysis that we have done. We found that companies reducing headcount in Europe have been outperforming companies increasing. So in our view, this impact, it will be idiosyncratic, and it will depend by sector and the the stock.

Jens Eisenschmidt: What sectors and industries then do you expect to be most affected by an aging population and the declining labor force?

Regiane Yamanari: Yeah, so first of all, I think one thing to mention is that it's very clear that the theme of, aging population is gaining traction in European C-suite commentary. So we found using AlphaSense Large Language Model, when we analyze companies transcripts, a notable rise in mentions of aging population – and in particular, if we compare to the US, to the US companies, we know that labor intensive industries like kept goods, construction and materials, business services are among those at the top of the list.

And those mentions have been increasing in most cases when we compare to the average of the last five years.

Jens Eisenschmidt: So how are companies adjusting their business models to account for these challenging demographic trends? 

Regiane Yamanari: So we see, for example, industrial automation, robotics, and software adoption accelerating in the face of declining working age population across Europe, which might surprise some people as some people is relatively under-penetrated by technology.

Regiane Yamanari: For example, if we look at industrial robot density in Germany, that is less than half of South Korea. And there are some sectors, for example, like hospitality that our analyst has flagged that the companies have been changing and adopting initiatives related to recruitment, technology adoption, portfolio rationalization – just a few examples here – and adjusting their business models as well to navigate a scenario of reduced labor availability and higher costs. And well, not to mention AI, which we have seen a rapid development and pace of adoption as well.

Jens Eisenschmidt: I'm glad you mentioned AI. It was on my mind. I was about to ask you. So, what do you think, uh, the role of AI could be in helping with the demographic challenge?

Regiane Yamanari: Our view is mainly on productivity gains. So, we them to start materializing, but they are likely to be small and grow consistently over time. An important portion of AI adopter companies cost base are related to R&D, marketing, distribution costs – and these areas we still are to see broad based application of AI, if this is really to be meaningful at the corporate level or even a national level.

So the way we see is that the productivity gains being reflected on margins, but still to be small at this level.

Jens Eisenschmidt: So, this one remains to be seen. We will surely be watching closely whether AI can deliver what it seems to be promising to generate productivity gains to offset the demographic challenge.

Regiane, thanks a lot for taking the time to talk.

Regiane Yamanari: Great speaking with you, Jens.

Jens Eisenschmidt: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.