As this economic cycle ends, we shouldn’t expect to see the patterns of the past decade repeated. A new regime in policy and market behaviour is unfolding which investors need to understand if they are to find the best opportunities and safeguard their portfolios.
The re-opening of economies after Covid sparked a phenomenon investors have not experienced in decades. Strong demand met limited supply, causing inflation to rise sharply. Central banks were slow to react, blaming transitory factors such as the war in Ukraine for temporary spikes in energy and agricultural prices. However, healthy economies and low unemployment meant that these shocks prompted higher domestic inflation, and central banks were left with little choice but to play catch-up.
Higher interest rates are the most conspicuous result – and they are likely to persist – but they are just one facet of the five key macro trends we expect to define the coming years as we move into a new economic regime.
Since the global financial crisis, central banks have always stepped in with support for the real economy and financial markets at the first sign of a downturn. Interest rates cut to record lows, even below zero in some countries, with trillions of dollars worth of quantitative easing, were all seen as necessary to fight the risk of deflation.
Now, with inflation at its highest levels in some 40 years, political pressure has risen and central banks have shifted their response and are now actively trying to slow growth to lower inflation – even if that means causing recessions.
No longer transient: how central banks have responded to inflation
The scale of inflation means that interest rates have to rise further in the short term and remain higher for longer, with central banks unlikely to loosen policy to support growth for some time.
The probability of this scenario is apparent in “real” (after-inflation) policy interest rates, as shown below. These became very negative in recent years, contributing to higher inflation, but for most countries are now rising again.
Further to rise: real rates remain at levels last seen in the 1970s
Because central banks’ actions are set to bear down on growth, we expect governments to become more active in their tax and spending decisions. They will try to support households and firms through the economic downturn. These fiscal measures could conflict with the actions of central banks, and cause heightened uncertainty.
Government balance sheets have yet to recover from the costs of the pandemic, and rising interest rates are putting pressure on governments to apply austerity. Yet populist political movements, which are strong in many countries (see chart, below), broadly oppose austerity measures and gather their support on platforms of increased spending.
The rise of populism in Europe
Governments could use redistributive policies and impose higher taxes on wealthy individuals or on companies viewed as beneficiaries of current circumstances, as a way to maintain or increase certain spending. But any fiscal stimulus risks stoking inflation, opposing the actions of central banks.
Conflict of precisely this type surfaced in the UK’s disastrous fiscal announcement of 23 September 2022, where newly-installed Prime Minister Liz Truss proposed unfunded tax cuts just as the Bank of England was raising rates. This policy clash and the resulting market turmoil led to Truss’s removal after just 44 days in office.
There is scope for similar disarray elsewhere as governments, central banks and financial markets fall out over policy direction. The independent role of central banks, whose objectives do not include providing low-cost funding to governments, is already facing hostility. Central banks may come under further fire as politicians’ sensitivity to higher interest rates becomes more pronounced.
China and the West have had some differences over the years, in particular around issues of trade and technology. The pandemic brought a new, physical dimension to these existing political risks, and broadly affected supply chains. This has added to inflation.
Separately, but with related outcomes, the war in Ukraine is re-shaping the global energy landscape, potentially leading to more protectionism.
Stuck in transit: Chinese shipping congestion
In response to the disruption and these wider developments, companies are planning on diversifying their production – and relocating it nearer to home. Our analysis of the text of US companies’ earnings reports (see below) highlights a striking increase in firms’ talk of “reshoring”.
In retreat: increased talk of bringing production back home
This means one of the great deflationary forces of recent decades, the growth of low-cost production in China (see the expanding pink dataset, below), is weakening and may have run its course. Globalisation can still play a role in lowering costs as production moves to new countries, but the easy gains are over as firms place increasing weight on security of supply.
Globalisation kept inflation low for decades: is it over?
Companies are not only facing rising production costs due to higher commodity prices, but also higher staffing costs.
Labour shortages, which are stemming from the demographic factors we have outlined previously among our “Inescapable Truths”, as well as political causes such as curbing migration, have tilted the power in wage negotiations back towards the workforce. This is allowing workers to demand bigger pay increases in response to the rising cost of living. Offshoring as a way of limiting these costs is becoming less attractive, as described above.
Elsewhere regulatory costs are rising, as is taxation. These factors will drive up costs and prices in the near-term. Overall companies’ share of economic growth is under threat, meaning a squeeze on profit margins.
Higher wage growth will eat into profits
To protect profit margins, companies have one clear route to increase productivity: technology. This means investing and adopting greater use of robots and artificial intelligence where feasible, rather than an over-reliance on labour.
In recent years use of robotics has grown strongly in Asia and Australia, but there is impetus now for a catch-up in Europe and the US. Likewise some sectors, such as auto manufacturing, have been major adopters while others, like agriculture, have lagged.
The long-term economic impacts of unchecked climate change would be unavoidably huge. In the near-term, the actions being taken in an effort to cap global warming are also proving disruptive. Governments have been slow to coordinate and act in response to the climate emergency, and so companies have taken the lead.
The transition to renewable energy will drive inflation structurally higher in several ways. First, there is the cost to create the needed capacity. This is not a linear path as there are shortages of rare earth elements and other key materials. Second is the higher initial cost of switching to a more expensive source of energy. Third will be the costs imposed through regulation to force the switch, as individual countries and blocs accelerate their policies.
Regulatory measures will include carbon pricing (where environmental harm is captured in the prices consumers pay) and carbon border adjustments. The latter – which involve “taxing” imported goods based on the emissions or other harms involved in their production – serves as a form of protectionist policy. There is a risk that this could be used as front to serve other political objectives as mentioned earlier.
The threat from climate change will likely prompt greater investment in technological solutions, which if successful, could help lower the inflationary impact, and improve the outcome for economies worldwide.
The regime shift brings with it a need for a fresh perspective towards the investment landscape. After a 40-year cycle of deflation, many investors will be in unfamiliar territory as they adjust to a period in which higher levels of inflation are here to stay.
Such an environment means we need to change the way we look at fixed income – for example – in the period to come. With tighter monetary policy comes higher bond yields, and the case for owning bonds now rests on the yield they offer, rather than their diversification benefits.
How we value assets will change. When it comes to country or company selection, investors will need to be active and discerning as they seek out the winners and losers.
Countries less reliant on external funding and that have shown policy discipline may be rewarded, while others may be punished. We expect an increased divergence in interest rate cycles across different countries and regions.
Similarly, companies that have survived as a result of low borrowing costs may soon find themselves struggling against a backdrop of higher rates.
It will be essential to assess which companies are able to pass on higher costs to their consumers: those that can’t will see margins come under pressure.
Price-to-earnings ratios are likely to be lower, and investors will be more focused than ever on the earnings part of that coupling.
Elsewhere, commodities are likely to become a very helpful source of diversification once again, having fallen by the wayside in the “loose money” period of quantitative easing.
The regime shift is about more than just inflation and interest rates. A surge of investment in technology and structural changes to supply chains and energy policy will create opportunities among a new wave of companies. Some of the investment themes that have emerged in the last few years will only strengthen – and new ones will emerge.
Meanwhile, a rise in populist policies and political volatility will require a greater focus on risk and the premiums associated with it.
In this new era, it’s clear that much will change for investors: how to value assets, where to find the best opportunities, how to manage risk. But the ingredients for success remain the same. We need teamwork, rigorous analysis, open-mindedness, flexibility and, above all, an active approach: plus ça change, plus c'est la même chose.
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