Since our last publication, the most significant developments in the global economy continue to be in China, where a pivotal strategy shift is underway, and in the West, with its evolving stagflation. After achieving their quantitative growth and poverty-reduction targets over the last 20 years, China’s policymakers have shifted their focus to the inclusiveness of growth by leveling playing fields on many dimensions inside the country. “Common prosperity” is the watchword.
A rapid-fire succession of regulatory changes have already unfolded, capping market excesses in a growing number of industries – with private education and platform technology industries among the most prominent examples. Yet it is the real estate sector, which accounts for upwards of 25% of China’s growth, that will likely have the greatest impact. The inequity of this sector is in policymakers’ crosshairs as they seek to address the burdens of the “three mountains” for young families – with housing being the largest, along with education and healthcare. These three burdens are preventing many young families from having more than one child and threatening to shrink the overall population. While we expect these regulatory and policy changes can only go so far, we nonetheless expect a significant growth drag for multiple years. While policymakers will redirect support to other parts of China’s economy – including small to medium enterprises (SMEs) and strategic initiatives, such as semiconductor development – such transitions, even when successful, take time.
In the meantime, China’s transition is likely to reverberate through many parts of the global economy. Economies and sectors that rely on China’s unmatched demand for commodities and real estate-related goods will feel the brunt of this strategic shift. It could also act as a broad disinflationary force if China’s consumption does not step up. This isn’t all bad, since inflationary trends are still spreading through the Western world.
The third quarter also marked a continuation of the swing in the global pendulum toward bigger government. In addition to Norway, there was also a critical election in Germany: At the time of this writing, the new government had not yet formed, but we expect the Green party to be an important coalition partner in most scenarios. Regardless of the specifics, we detect a groundswell of support for higher government spending, particularly on ‘green’ investments, and a willingness across parties to move in this direction.
This may have important implications for the rest of Europe, as leaders look to agree on the path forward for the Stability and Growth Pact. Will fiscal rules be loosened? Will Europe move toward wider deficits to enable more investment and thereby finally generate more domestic demand, rather than relying on exports? These will be crucial developments over the next few years as political dynamics shift steadily toward more government activism to curb climate risk and inequality. Shortly into October, Japan also joined the list of political “pendulum swingers.” This could not come at a more pivotal time, as China’s ongoing slowdown will be a significant drag on Europe’s export engine.
In the US, we expect fairly large fiscal packages to be enacted eventually, providing sustained support for growth in the latter part of our five-year investment horizon. Given this support, combined with the strength of a deleveraged consumer flush with cash, we see good prospects for US growth and for the Federal Reserve to finally begin exiting its decade of excess. The midterm elections in 2022 will be a crucial test of whether fiscal dominance will become a lasting reality. Despite the historical tendency for incumbent governments to lose control in the midterms, we see good reasons to expect the Democratic party to retain control and proceed with further fiscal programs for the rest of the Biden administration’s term.
Of course, we did not foresee that this would catapult us right to stagflation and the need to throttle back toward reflation. Stagflation witnesses rising prices paired with hard-to-fill demand, thus slowing growth. In contrast, reflation is healthier, characterized by higher (but not high) trend growth and inflation. We may be in a post-World War II-like environment, where prices at first rose rapidly as the war interfered with the supply curves and demand could not be met, but shifted in a few years to a freeing-up of supply and a move to more balanced economic conditions with faster trend growth and pricing than in the prior decade. An era of new technology and disruption should push the supply side to meet these stagflationary challenges. Overall, we remain confident that a regime shift toward reflation and away from “stall speed” is underway, particularly in the US and Europe. We still foresee somewhat faster trend growth and pricing power as fiscal drags and private sector deleveraging abate.
The main counterweight to this dynamic will be China’s slower growth trajectory amid a shift in its strategic objectives, along with the impact on China-dependent parts of emerging markets (EM). This counterweight is an important disinflationary force that will dampen overheating in the US and should help us navigate back from stagflation to reflation.
One of the implications of the new regime is higher nominal cash flows, and we have been reflecting these in our forecasts for some time now. But will the new regime come with much higher bond yields? While they will undoubtably drift up, we think not too far, for a key (and largely unrecognized) reason: the twin liquidity gluts from private sector savings and central bank balance sheets. These factors are instrumental in setting the level of yields, and these twin gluts will take significant time to slowly dissipate. Not until these liquidity gluts meaningfully diminish can bond yields rise materially. Nonetheless, the duration of stocks and bonds is historically high, so it will not take much to act as a headwind. While credit spreads cannot tighten much more, equity risk premiums are at only historically average levels and do have room to tighten, and have a historical tendency to do so during reflationary times.
At the geopolitical level, we see two key developments that will shape the cycle ahead: the rise of economic nationalism, and the intensification of the US-China rivalry and decoupling.
The recent “AUKUS” defense pact between Australia, the UK, and the US is a strong indication of the US’s intent to confront China on multiple fronts. Yet this confrontation is more likely to manifest in the form of competition. The US-China trade war and the pandemic have exposed the vulnerabilities of nations to the status quo. A lack of domestic capabilities as a result of hyper-globalization has resulted in shortages of key products such as pharmaceuticals, healthcare equipment, and semiconductors used in a broad range of industries. Global powers have already developed “national strategic plans” to address these weaknesses and will be more bold about intervening in markets to achieve their goals. Politicians prefer the comfort of “resilience” over a pure focus on economic efficiency.
The drive toward decarbonization overlaps with this shift in strategic thinking, and we expect the UN Climate Change Conference (COP26) to accelerate commitments to transition the global energy system. Most major governments have now pledged to reduce or eliminate their carbon footprint over the coming decades and are developing concrete proposals to achieve these goals. Infrastructure schemes to develop renewable energy assets and electrify transportation, among other initiatives, will contribute positively to growth. Yet sectors that employ large workforces will also see many jobs eliminated, and carbon and other taxes to fund these schemes will be a further drag.
The net economic effect is still likely to be positive, and the impact on carbon reduction may be substantial; however, the scale of this global project and the pressure to pursue the targets rapidly may also lead to inefficient allocation of capital. Recent spikes in energy prices provide a glimpse of how difficult it is to assess and manage the knock-on effects of these policies, and commodity prices may prove to be an important de facto determinant of the “speed limit” on these initiatives.
Our CML continues to have a moderately positive slope and a high degree of dispersion, signaling good reward for selective risk-taking. Return prospects remain anemic for risk-free bonds in developed markets (DMs) where quantitative easing has been in place, whereas EM credit assets continue to provide attractive real yields. Overall, cyclical and high-quality equities will benefit from the healthier growth and inflation environment resulting from the policy mix shift, leaving more “bond-like,” defensive equities as clear underperformers. Real estate as an asset class has become extremely bifurcated, with interesting opportunities in certain segments, such as single-family residential and industrial assets serving e-commerce; an active approach is paramount, however, to avoid both overvalued assets and segments that are in secular decline.
Capital Market Line as of 30 September 2021 (Local Currency)
Insights From Today’s CML
Moderately sloped Capital Market Line (CML) with a high level of dispersion. The slope of our CML remained steady over the last quarter, as performance of risk assets was mixed. In combination with high dispersion, our CML signals decent reward for selective risk-taking. Equities remain the most attractive asset class as safety assets struggle with initial yield levels. The reflation of the 1950s brought about an expanding middle class and somewhat higher growth and pricing power, yet lower equity risk premiums.
A challenging environment for nominal risk-free bonds. The twin liquidity gluts from private sector savings and central bank balance sheets continue to repress bond yields. Although we expect these gluts to begin to dissipate, it will be a long, slow process. In parallel, the global economy will slowly absorb the current excess slack. Addressing climate change alone is now estimated to require $50 trillion of investment. If so, this will be the largest replacement cycle in history. In contrast, the decade that followed the global financial crisis saw very little demand for capital. As a result, we expect yields to rise from recent lows. The challenge for risk-free bonds in developed markets is stark; even without the drag from rising yields, the starting point of negative real yields implies that large parts of most institutional portfolios will be losing purchasing power. We expect large segments of core bonds to give way to absolute return types of multi-strategy hedge funds and liquid alternatives.
Equities to benefit from higher nominal cash flows, but partly offset by negative repricing. The policy mix of the next cycle will support higher nominal cash flows as governments lean on fiscal policy to address societal demands. Equity risk premiums remain a bit above historical averages, while most risk, illiquidity, and credit premiums are scraping their lows. Historically, after long periods of stall speed, an uptick in growth and pricing power toward reflation has lowered equity risk premiums. This will prevent a sharp de-rating in most equity markets, particularly as bond yields slowly edge up. Higher taxes may become more widespread, as will wage pressures, partly due to the intensifying policy focus on righting inequalities. We expect productivity to rise as companies feel margin pressures and supply constraints. We remain confident that technological solutions are available to take out substantial costs while freeing supply and protecting margins.
EM fixed income remains more attractive than EM equities. In contrast to the negative real yields of most DM fixed income assets, emerging market debt offers an attractive yield pickup. The caveat is that, as evidenced by recent default situations in China, an active approach is essential. Our ongoing lukewarm outlook for EM growth, given the drag from China’s deceleration along with deglobalization trends, leaves EM equities looking relatively unattractive yet keeps capital spending away with improving balance sheets to the benefit of EM corporate debt.
Pockets of real estate are increasingly attractive, benefiting from higher nominal cash flows. The fiscal thrusts building in many key markets are likely to benefit real assets by way of higher nominal cash flows, only partially offset by the gradual rise in yields. Real estate has become a bifurcated market: Structural losers include retail assets and certain hotels, due to weaker prospects for business travel, while industrial real estate catering to e-commerce continues to benefit from secular tailwinds. In the US in particular, household formation trends are very supportive of residential real estate. We strongly favor a selective, opportunistic approach and see many ways for managers to add value – including, for example, revamping assets to improve their carbon footprints.
The Fundamentals Driving Our CML
A global rise in fiscal policy to address inequality and climate change after inertia in the last decade. From China, to the US, Norway, and Germany, and now to Japan, we see a succession of governments focusing in on inequality and climate change through fiscal policy. The result will be higher government spending on “green” infrastructure and social support, likely funded through higher deficits and higher taxes.
Fading of inflation, but not back to pre-pandemic levels. The new cycle has kicked off with high inflation and has sparked fears of overheating or stagflation. We believe the current situation is due to supply bottlenecks, income and demand props, and labor market distortions that will clear. Does this mean we will go back to the below-target inflation dynamics of the last decade? We don’t think so. The new policy mix, with fiscal policy no longer a drag on growth, will contribute to a firmer growth footing and allow central banks to achieve their inflation targets and to slowly exit from double-duty.
China’s pivot to achieve ‘common prosperity’ will reverberate through the global economy. While this strategic shift is entirely consistent with the global policy trends noted above, it will be much more rapid and tightly controlled than elsewhere. The real estate market is the biggest driver of China’s growth and, more than any other sector, is in the crosshairs of this strategic shift. Housing is the biggest of the “three mountains,” which also include education and healthcare burdens, that China seeks to address. Policymakers will fine-tune fiscal and monetary policy in an attempt to avoid disruptions, yet the impact on growth will likely be felt globally. In parallel, the pace of changing regulations across several sectors has already dented private sector confidence. While the longer-term gains for China may be more sustainable growth and more equitable distribution of wealth, the transition is likely to involve greater volatility.
Excess capacity will be absorbed, but excess liquidity will linger. In the last cycle, it took more than a decade to chip away at the excess capacity that had built up over the 2001-2008 period, though substantial progress had been made before the Covid pandemic struck. Due to the exogenous nature of the shock, a snap-back to healthier conditions is more likely this time, and excess capacity may be fully absorbed within our five-year forecast horizon. In parallel, the twin liquidity gluts of global savings and central bank balance sheets have ballooned due to the pandemic and will likely take over a decade to absorb. Financial conditions shouldn’t become tight until that happens. The result will likely be accommodative liquidity conditions, along with yields that rise very slowly for many years.
Intensification of economic nationalism. The US-China trade war and the pandemic have exposed nations’ vulnerabilities to the status quo of global logistics. A lack of domestic capabilities resulting from the quest for more efficient, just-in-time deliveries has caused shortages of key products such as pharmaceuticals, healthcare equipment, and semiconductors during the pandemic. Global powers have already begun to develop “national strategic plans” to address these weaknesses and will be more bold about intervening in markets to achieve their goals. “Just in case” supply chains make politicians look more in charge, yet could dent corporate efficiency and productivity. Nonetheless, this is becoming a new norm and could be analogous to a “space race” that spurs innovation through competition. Stay tuned. Geopolitics will also be dominated by the ongoing evolution of China from “vertical integration” to “horizontal competition,” and the US appears to be hardening its resolve to compete more actively with China, likely in concert with its closest allies. The US’s recent military alliance with the UK and Australia is further confirmation of this pivot to confront China on multiple fronts.
A challenging backdrop for most emerging market economies. We believe EMs may struggle to thrive in a world where 1) China is turning inward and will be less supportive of global growth; 2) structural reforms are nowhere in sight, leaving these economies with very limited competitive advantages globally and making them more vulnerable to global inflation; and 3) AI and robotics, along with “just in case” supply lines, are striking at the heart of labor arbitrage. The recent need by several EMs to hike rates to tackle inflation, even as their economies continue to struggle with the pandemic, demonstrates the structural challenges that persist. In the era of economic nationalism, EMs will find it even more difficult to attract foreign direct investment, as companies are encouraged (or even coerced) to develop domestic facilities in DMs. Proximity and trade interconnectivity with the US and Europe will be supportive of economies like Mexico and Poland.
Acceleration of decarbonization. The COP26 summit is likely to witness further pledges as politicians hear loud and clear what their constituents are demanding with regard to tackling climate change. Infrastructure schemes to develop renewable energy assets and electrify transportation, among other initiatives, will contribute to growth. Yet sectors that employ large workforces will also see many jobs eliminated, and carbon and other taxes to fund these schemes will be a further drag. The net economic effect is still likely to be positive, and the impact on carbon reduction may be substantial; however, the scale of this global project and the pressure to pursue targets rapidly may also lead to inefficient allocation of capital. Recent spikes in energy prices provide a glimpse of how difficult it is to assess and manage the knock-on effects of these policies, and commodity prices may prove to be an important de facto determinant of the “speed limit” on these initiatives.