PERSPECTIVE3-5 min to read

Three trends are reshaping the economy. What investors need to know.

Three key trends are reshaping our economies and societies: deglobalization, decarbonization, and demographics. The new importance of the “3Ds” will have implications for investors that will play out in the years to come.

16/05/2023
building-blocks

Authors

Johanna Kyrklund
Group CIO and Co-Head of Investment

Three key trends are reshaping our economies and societies: deglobalization, decarbonization, and demographics. The new importance of the “3Ds” will have implications for investors that will play out in the years to come.

After years of low inflation and zero interest rates, this shift in regime may feel like something totally new in the markets, but in many ways it’s a reset to how things were just a few decades ago. This “3D reset” brings new challenges, but for active investors it also brings opportunities.

For one, investors should expect higher inflation and tighter economic policy for longer.

In the near term, central banks have probably already done enough to lower inflation from the peaks we saw last year, when U.S. inflation hit a 40-year high. However, there has been a drastic change in the trade-off between growth and inflation.

Following the global financial crisis, central banks stepped in to support the real economy and markets at the first sign of each downturn. Interest rates were cut to record lows and trillions of dollars worth of quantitative easing were all seen as necessary to fight the risk of deflation.

Amid rising political pressure, central banks are now actively trying to slow growth to lower inflation—even if that means causing recessions.

Inflationary pressures brought about by the 3Ds mean that monetary policy could remain tighter and more restrictive than before the Covid-19 pandemic if central banks are to meet their obligations to maintain price stability.

First, on the demographic front, ongoing worker shortages could push labor costs higher. Since the pandemic began, the labor force participation rate has fallen both here in the U.S. and in other economies, such as the U.K. In December 2022, there were 11 million unfilled job vacancies in the U.S., with only 5.7 million unemployed people. Basic economics dictates that where demand exceeds supply, prices, or in this case wages, must rise.

Next, deglobalization is adding to long-term inflationary pressures. The pandemic further intensified the already strained relationship between the West and China as widespread blockages in the Chinese supply chain exacerbated inflation and highlighted the over-reliance on imports. The Russia-Ukraine conflict exposed similar dependencies, particularly regarding energy and agriculture in Europe.

In response to the disruption, we are seeing a new world order develop. Companies are diversifying their production and relocating it nearer to home in a process known as “reshoring.”

This means one of the great deflationary forces of recent decades, the growth of low-cost production in China, may have run its course. Globalization can still play a role in lowering costs as production moves to new countries, but the easy gains—the globalization dividend—could be over as firms place increasing importance on security of supply.

Commendable as it may be, the third D of decarbonization is also likely to have a significant inflationary impact. Although the cost of producing renewable energy is falling sharply, the cost of replacing carbon-based energy will raise energy inflation for many years to come.

What does all this mean for investors?

Higher interest rates for longer will clearly have significant consequences for investors and financial markets. From the implications for asset valuations, to the additional volatility that will be introduced, investors may have to adapt to a world where the “Fed put” cannot be relied on to bail out risk assets.

Suddenly every asset has had to reprice to compete with a yield on cash. Valuation matters.

Gone are the one-way streets of “FOMO” (fear of missing out) equity markets dominated by the U.S. and vanishingly small bond yields. It’s time to return to careful analysis of winners and losers among companies—not just in the U.S.—and seeking interest rate opportunities as monetary policy diverges once again.

In many ways, as an investor you now need to think about what you did in the last decade—and then do the opposite.

The appeal of bonds in recent years was their negative correlation with equities. When bond prices rose, equities fell and vice versa. However, recent market activity indicates that investors may no longer be able to rely on the historical correlation between the two asset classes. Indeed in 2022 bonds moved in lockstep with equities both upward and downward. Bonds’ appeal is now their yield.

In the case of equities, a renewed focus on valuations rather than speculative growth may be required. As touched upon earlier, a broader geographic focus would also be required. Investors would be wise to look further afield for the best opportunities when in an environment where the leadership by the U.S. market is unlikely to be maintained.

The way investors look at commodities has also changed notably. Amid deflation they did not diversify a portfolio, but now look more interesting as a potential hedge against inflation and geopolitical tension. The decarbonization trend is also likely to lead to additional demand for metals as part of the energy transition, as well as underinvestment and under-supply of traditional fossil fuels.

On the face of it, a great deal has changed as a result of the 3D reset. Investors need to value assets differently, consider new risks and broaden their horizons. However, in many ways, this is a return to normal for active investors. It’s time to be discerning, analytical and valuation-focused once again.

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Authors

Johanna Kyrklund
Group CIO and Co-Head of Investment

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