investment viewpoints
A stark new decade, two years in
At the beginning of 2020, our alternatives team predicted the pandemic would usher in A stark new decade that accelerated certain trends while also breaking decisively with the past. We are soon two years into this new era: what calls have proved prescient? What’s changed? And what might come next?
In this Q&A, Christophe Khaw, CIO 1798 Platform, and Florian Lauwers, Investment Strategist 1798 Platform, take stock of the outlook and consider why conditions merit specialised expertise.
You described the COVID-19 crisis as a “heart attack in the real economy,” prompting unprecedented government stimulus and supply-demand disruptions that would ultimately fuel inflation. What dynamics do you see arising from the inflation vs growth debate? How do emotions and geopolitics come into play?
Our key concern today is the ratio of inflation to economic growth. For the last 20 years policymakers were able to deliver some growth at the cost of greater debt burdens but without fuelling inflation. This created an ideal equilibrium resulting in strong overall price stability, a lack of volatility, a cost of capital that continually cheapened, and strong performance by financial assets.
Since the pandemic, however, this equilibrium has been destabilised: inflation is clearly rising but the rise in growth risks failing to keep pace. That puts the focus on growth, where we see social and political factors coming into the fray.
Economic growth provides two key results. It creates political stability (if the wealth of the majority of people increases, it is easier to govern) and it enables financial creativity (higher growth makes increased debt more manageable, for instance). If inflation is structurally much higher than growth, it helps solve the debt problem but the average happiness of the population is likely to decline.
One of the clearest signs that we are reaching a turning point is the behaviour of politicians. If politicians are not convinced they can achieve growth for a majority of the population they will look to focus the debate on emotions (rather than facts). No one wants to be judged on faltering growth. As such, we believe that the rise of emotionally focused debates – such as populism and protectionism – will endure. Unfortunately, such issues tend to increase inflation through a vicious cycle: increases in the cost of labour, goods and capital give way to greater protectionism and in turn fuel higher costs, for instance.
We see rising geopolitical tensions contributing to this dynamic as well. The control of south east Asia, the Russia-Ukraine situation and the shift of Turkey towards the east are some of the more immediate examples. Economic growth and stability were previously achieved by a coordinated effort between countries. Current geopolitical undercurrents, however, will likely stall this process as countries turn inward. For instance, China did not attend the COP26 conference. Greater geopolitical fragmentation means economic wealth and growth will turn increasingly unequal.
Key trends – such as the triumph of technology, rising populism and protectionism, the pressures to rethink globalisation and an increased role for the state – continue to play out. Which ones do you see gaining further traction as the decade unfolds?
Trends such as increased dispersion, rapid wealth effects and private-sector participation in sustainability are likely to become further embedded, in our opinion.
We see greater dispersion in two key areas: between technology and non-technology, and in the varying ability to transmit cost increases. First, the dispersion between technology and the old economy will continue to grow. Roblox1– an online game platform and game-creation system favoured by eight-to-12 year olds – today employs 1,200 people and is as valuable as Ford1, which employs 186,000 people. Greater dispersion here means that only highly specialised and skilled workers in select areas will benefit at the expense of the majority.
Second, cost rises will differ widely as a function of goods and services. Scarce natural resources (water, farmland and mines, for example) are likely to experience structural inflation. Holidays in the Maldives are likely to increase by at least 10% over CPI, for instance, in our opinion. Most importantly, the ability to impart higher costs to end users will vary hugely depending on the type of business. The wealthier the end client, the easier it will become for providers to increase costs.
Wealth transfers will continue to accelerate. The largest personal fortunes in history have been created in the last few years. At a country level, if the valuation of Tesla1 is accurate, it suggests that Germany has missed much of the electric vehicle revolution. The country will probably catch up somewhat but market share could be substantially impacted. What does that mean for Germany, or for Europe? Perhaps it means little and Tesla’s valuation will correct naturally. Still, the overall speed of wealth creation, transfer and destruction is here to stay.
Obviously, regions could experience different outcomes. The US appears likely to have better growth with anchored inflation. Europe and Japan might be able to deliver some growth with contained inflation whereas many emerging-market (EM) countries could see very little growth but pronounced inflation.
Entrenched in emotional politics and centred on themselves, governments are likely to under-deliver on the necessary seismic shifts in government spending on sustainability, and the private sector will take over much of that responsibility. Former Bank of England governor Mark Carney is leading a USD 130 trillion alliance within the financial sector focused on aligning investment portfolios to net-zero emissions, for instance. The good news is that typically the private sector has been better at allocating resources efficiently and driving much-needed innovation. With innovation should come outsized financial returns for investors, not to mention that overall market-cap growth on those companies should substantially outpace the traditional market.
How might the current environment prove fruitful for a disciplined, process-orientated active investor?
Investing in the last decade was fairly straightforward: given a goldilocks economy and strong equity and bond markets that were sufficiently de-correlated, a balanced portfolio seemed like a very robust all-weather portfolio. After a long rally in both equities and bonds, and historically compressed risk premiums, the path forward appears more difficult.
The overall context – of lower growth, potentially more expensive capital, increased political instability and dispersion of outcomes – means a dedicated and active approach to investing is required. The ability to use a broader set of investment tools to capture opportunities should prove fruitful, including: recognising the strong megatrends; benefiting from market inefficiencies and mispricings; and being nimble and reactive to market conditions.
It is likely also that the trend of investing in a barbell approach is here to stay. This approach involves increasing allocation to risky assets alongside an increase in tail hedges. With widespread risk-premium compression, the search for returns and yields will force investors to increase the risk in their portfolios in order to achieve sufficient returns. This is occurring in a period where ample liquidity could prove supportive of continued risk compression; still, markets are at all-time highs amid increasing risks, meaning a sudden and widespread loss in risk appetite could drive sharp reversals. As such, the ability to invest in truly diversified or even de-correlated assets should prove invaluable, in our opinion.
Sources
[1] Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
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