By Darius Dale, analyst, Hedgeye

We try to avoid hyperbole as much as possible at Hedgeye, the research firm where I work as an analyst. But after researching Japanese demographics and pension obligations, we have to say that in our opinion, they present one of the most dangerous potential risks to global investing over the next 10-20 years.

For background, let’s explain Japan’s demographic headwinds, which often get bandied about without much supporting data. For starters, with 22.7% of its population above the age of 65 (as of 2009), Japan has the world’s oldest population. That figure will continue to grow; Japanese government projections raise the ratio to 29.2% by 2020 and 39.6% by 2050.

Currently, the ratio of retirees to working-age Japanese is 35.5%. In just 10 years time, retirees will make up 48%. In a society notorious for luxurious pension packages, going from a 3-to-1 to almost a 2-to-1 ratio in contributors-to-retirees in a matter of just a decade is frightening to say the least. And it doesn’t get any better: By 2050, the ratio of retirees to working-age population will reach 76.4%, according to projections from Japan’s Ministry of Health, Labour and Welfare.

The obvious conclusion here is that there will be more and more people in line for pension payouts and fewer and fewer people to fund them. The funding outlook looks even more bearish when one considers that 56% of Japanese workers rely on financial support from their parents or other sources to cover their living expenses (Japanese Labor Ministry). In other words, the people Japan is counting on most to fund ever-increasing pension liabilities are being supported by the very payouts they are supposed to be covering. This is not good.

This year, we’re already starting to see the ill effects of funding gaps, with Japan’s public pension fund (the world’s largest, at $1.433 trillion) increasing its asset sales by a factor of 5x, year-over-year, to bridge the gap between insurance premiums and payouts. According to Takahiro Mitani, president of the fund, the now 4 trillion yen ($48 billion) figure can be raised (according to “market conditions”) by selling any combination of assets—67.5% Japanese Government Bonds (JGBs), 12% Japanese equities, 10.8% international equities, and 8.3% in foreign bonds, including U.S. Treasuries. We expect the asset sales by Japan’s public pension fund to continue accelerating as the first of Japan’s baby boomers turn 65 in 2012.

The heavy hand of Japanese selling will weigh on global markets in the coming years. Mitani remains convinced that interest rates on Japanese government bonds will not increase even with the potential glut of new supply on the market. We beg to differ. What happens when marginal supply outweighs marginal demand is that prices decline.

Demand for Japanese debt: declining

On the demand front, Japanese government debt (which is north of 200% of GDP) has largely been financed by domestic investors (94%; IMF). Japan’s savers, however, are increasingly becoming consumers as they age: Japan’s household savings rate (as a percent of disposable personal income) has declined 1,170 bps over the past 20 years to 2.2% (IMF; OECD).

Much has been made of the fact that direct holdings of Japanese Government Bonds, or JGBs, by Japanese households are only around 5% of the total outstanding amount. When indirect channels are taken into account, however, Japanese households actually finance 61.5% of JGB issuance, through banks and pension funds and their future liabilities.

Supply of Japanese debt: increasing

As to supply, Japan’s budget deficit as a percentage of GDP is currently 8.7% (IMF), and more spending initiatives, such as Prime Minister Naoto Kan’s recently announced 915 billion yen ($11 billion) stimulus plan, don’t suggest that that figure will come down meaningfully over the next few years. In fact, baseline IMF projections have Japan’s budget deficit as a percentage of GDP at 7.2% in 2015. This means that they will need to continue to issue large sums of government debt to finance deficit spending.

Take all these factors together, and the outlook for future JGB supply and demand is one of gross disequilibrium to the supply side—a situation which should, in theory, push down prices substantially and send yields soaring, making it ever more expensive for Japan to finance itself.

Potential “solutions”

These types of problems typically don’t end well, but as cures, austerity measures, if implemented, could actually help counteract all the drag Japan’s massive debt creates on GDP growth. Unfortunately, the Japanese government is moving in the exact opposite direction of austerity, choosing instead to lever up incrementally and “stimulate” the economy more.

One of the key problems with Japan is that the bulk of investment over the past twenty years has gone to the manufacturing sector, with capital and R&D spending in more domestic-oriented sectors lagging (healthcare, IT, retail services, etc). This is a serious impediment to growth going forward as Japan transitions into a non-saving, consumption economy. Less funds will be available for investment than ever before at a time where they are needed most, particularly since Japan is not a big target for foreign investment to begin with.

Also, high corporate tax rates, unfavorable tax policies, and just pure policy uncertainty will weigh on business and consumer confidence and investment spending. These policies also raise the bar which entrepreneurs must leap to get new businesses—sources of jobs and tax revenue—going. Reforming tax policies to benefit the corporate sector could go a long way towards stimulating future growth.

Of course, continuing the vicious cycle, the government needs revenues badly right now. Handing out tax breaks would likely exacerbate the situation. It’s hard to see where Japan can find the political wherewithal or the acumen to get out of its own way. If it can’t, the country may have to follow the path of so many of the European ones before it, and turn hat in hand, to international institutions, for a rescue.