A whole new paradigm: the next decade

We are tracing the birth of the long cycle/paradigm of recent decades back to 1981 and the actions of former US Federal Reserve Chairman Paul Volcker. 

Seeking to put a stop to the 1970s era of high inflation, Volcker raised interest rates to a record 20%. That set the stage for decades of disinflation and a one-way direction for both nominal and real rates − downward. The trend accelerated sharply after the global financial crisis 13 years ago and culminated during the Covid crisis of the past two years, when real rates delved further into negative territory (between 2% and 3%).  

Interest rates and inflation have declined globally – up to now

Source: LOIM, Bloomberg

Real rates are negative as in the 70s – but with very low nominal yields

Source: LOIM, Bloomberg

None of it would have been possible without the actions of governments and central banks in the developed world, which have tried to avoid recession after recession and the risk of a 1930s-type of downturn ending in deflation and depression. With a combination of ever-more extreme fiscal policy (stimulus payments) and monetary policy (zero and/or negative nominal rates and quantitative easing), they foreshortened the pain by stimulating consumption, which has been growing consistently as a portion of GDP and is culminating at 70% or more in the US and Europe.

These measures intensified after the 2008-2009 global financial crisis, and especially in the past two years (2020-2021) during the pandemic. The consequences are full compression of rates in the credit markets, rapidly increasing equity valuations, especially for the growth bucket (unprofitable tech and biotech companies, for example), real stability in currencies (USD, EUR, JPY, GBP, and CHF) and abnormal performance of multi-asset strategies (equities and bonds). 

Credit premium abnormally compressed with huge QEs

Source: LOIM, Bloomberg

Low nominal and real yields has led to high valuations (PE)

Source: LOIM, Bloomberg

Low nominal and real yields has led to still overpriced growth stocks

Source: LOIM, Bloomberg

It has been the combination of four long-term trends, or excesses, that created the conditions for abnormally low/negative nominal/real rates, low inflation and low currency volatility.

We list them here, and then explain their consequences.

1. Economy over environment. The whole global economic system has relied on the exploitation of natural capital, which has infinite value but no market price. Around 50% of all economic activities rely on healthy and abundant soil, forests, water and ecosystem services. The abuse of nature allowed global GDP to grow in recent decades while restraining inflation. That is because natural capital and both negative and positive environmental externalities have never been priced properly and are not reflected in GDP measurements. 
2. Asymmetric capitalism. Fiscal policies and central bank monetary policies have increased substantially in the last 15 years and even more during Covid. Government intervention in the largest economies of the Western world is now above 50% of GDP – and matching levels of Cuba (almost 60%) in countries such as France and Italy!⁴ As low/negative interest rates fuelled gains in bond and equity markets, capital holders have grown much richer, while those relying just on their salaries have grown relatively poorer. This asymmetric capitalism is unusual in economic history. It would be natural to assume that more government intervention would lessen inequalities, but in fact the opposite has occurred.
3. Demographic dividend. We can point to four major demographic factors in the last 30-40 years that caused GDP growth to exceed wage growth on a global basis a) The post-war baby boom sparked a surge in the working-age population starting in the 1960s; b) large numbers of women have joined the job market every year starting from the 1980s; c) the end of communism in the early 1990s and China’s inclusion in the WTO in 2001 have put 1.5 billion more people in the global workforce with much lower wages than their equivalents in the Western world; and d) the flow of immigration has been constant in Europe and in the US and has consequently put pressure on wages in these geographies.
4. Globalisation. While benefiting from cheap labour, the US and Europe have also reorganised their global production capacity to reduce goods inflation as much as possible, with a growing inter-connection between the three large blocks – North America, Europe and Northern Asia. China has been the main beneficiary, growing from 4% of world GDP to 18% within an astonishing 20 years. Goods inflation has been much lower than GDP growth, with all of those imports coming from the Far East.

In summary, the four long, secular trends have created the conditions for an extended period of disinflation for both goods and services, which has allowed interest rates to remain low or (more recently) negative and favoured currency stability. However, they have also generated anomalies (which are not just temporary imbalances), with severely negative consequences for our economic and social systems, as well as our global Environment. We believe these trends could now be set to reverse.

We will first outline the unfortunate anomalies and then explain the catalysts for correcting them.

1. Higher temperatures and the destruction of natural capital. The nine planetary boundaries that define a safe living environment for humanity have already been crossed or are under threat. Temperatures have been pushed to dangerous levels, and many parts of the world face water scarcity and other threats.
2. High inequalities. Government intervention has counterintuitively fuelled massive social inequalities. From the post-war period through the 1990s, wages increased 8% per year while the value of capital grew 6%. Since 2010, capital has returned almost 9% while labour’s gains dwindled to less than 4%.
3. Compressed wages and high savings. The most impressive labour force expansion in the history of capitalism has meant there has been little need to pay more to attract workers, leading to relatively stagnant wages. At the same time, savings have disproportionately increased as a percentage of GDP (from 40% in 1950 to 65% in 2021 in the US). This enormous pool of savings has helped to push interest rates down or negative.  
4. Low goods inflation and stable currencies. Globalisation has also led to much lower currency volatility (5% in the last decade versus at least 10% in the 1970s-80s), with a strong alignment of economic policies between the main blocks. This period also saw relatively little geopolitical tension, which helped ease financial integration among countries and limit forex fluctuations.

Global financial synchronization leading to an abnormally low fx volatility

Source: LOIM, Bloomberg

In our view, each of these anomalies is the outcome of trends that cannot continue. To quote the economist Herbert Stein, “If something cannot go on forever, it will stop.” (16th January 1986, Symposium on the 40th anniversary of the Joint Economic Committee)

We expect the next decade will be dramatically different. Four corresponding mega shifts are likely to lead to structurally higher inflation, and by extension higher interest rates (both nominal and real). In other words, a complete reversal of the last 40 years’ paradigm.

FIG 1. End of the anomalies: click on the image to see the corresponding mega shifts

1. Environmental transition. The investment required to move to a more sustainable economy could drain savings. We estimate that a combined USD 5 trillion needs to be spent by the US, Europe and Asia on infrastructure and production to reduce reliance on fossil fuels and limit temperatures to 1.5⁰ to 2⁰ above pre-industrial levels. Even if solar and wind are free, the amount of capex needed to transform cities/infrastructure/factories will probably absorb excess savings⁵ (pushing up rates) and promote goods inflation (for more sophisticated products). Preservation of biodiversity will also add USD 400 billion of annual investment to protect nature. We believe the next 10 to 20 years will show us that externalities have a price, and market participants will have to factor the cost of destroying nature into their decision-making.
   
   Rising inflation puts the system to a test
   
   Source: LOIM, Bloomberg
    
2. Symmetry returns to capitalism. The extreme level of wealth inequalities increases the risk of social and political disruption. Corporate margins and earnings are also at all-time highs (with real return on capital employed of about 15%). Government debt at wartime levels is coinciding with commitments to fiscal expansion. Collecting sufficient tax revenues is now not only an economic necessity, but also a political tool to rebalance capitalism’s excesses. We envision a shift from taxing labour to taxing wealth (higher wealth and inheritance taxes). Building a fairer system that will reward labour and reduce the ability of global corporations to seek out the lowest-tax regimes is taking shape. It is therefore likely that corporate tax will increase.⁶
   
   Negative real rates have allowed an exceptional level of government debt
   
   Source: LOIM, Bloomberg
   
   But real returns on equity (RRoE) are high…
   
   Source: LOIM, Bloomberg
3. Demographic shift. We estimate that the global workforce will shrink by an average of 4-5% every five years over the next five decades.⁷ Such shrinkage is unprecedented in modern history and will force companies into a race for skilled workers. At the same time, an ageing society will require new labour-intensive services. This competition is likely to push up wages worldwide.
4. A regionalised world. Regional polarisation could prevail with increased macroeconomic fragmentation. Each block (North America, Europe, Northern Asia) will probably now move according to its own strategic and economic priorities. Globalisation has elongated supply chains across the world and the search for efficiency has normalised just-in-time systems. Covid/political crises, and now the war in Ukraine, are deeply exposing the flaws of such practices by creating bottlenecks and disruptions across regions, and more importantly putting strategic independence in sectors (medicines, energy, food, etc.) at risk. Governments and corporates will probably reconsider the trade-off between efficiency and security in terms of supply in key areas. Regional independency and self-sufficiency are set to coincide with higher costs as environmental concerns take centre stage, in our view.  

We believe that the mega excesses that have shaped the world in the past four decades and made capital so cheap and plentiful are unlikely to persist. The four mega shifts are each inflationary by nature for goods and wages, while the investment in the environmental transition could absorb all available savings. These shifts that we envision are therefore likely to drive up both inflation and rates.

As the chart below shows, the equity market has already partially adapted to what could be the new world. The equity risk premium has surged to levels last seen in the 1970s if we use spot inflation to calculate the current real rates. In the coming months, it remains to be seen whether the EQRP falls sharply (because of either a deterioration of corporates’ real return on capital employed and/or real rates coming back to 0) or remains elevated in a scenario where inflation is structurally high like in the ‘70s.

The next decade is likely to bring both shocks and opportunities for investors, who must be prepared to adapt to the new paradigm. 
 

Equity Risk Premium remains relatively attractive

Source: LOIM, Bloomberg