The global pandemic triggered a new cycle that is shaping up to be significantly different from the last one. The decade following the global financial crisis (GFC) was characterized by slow and fragile growth, persistent inflation undershoots, and inexorable declines in bond yields. To our eye, the contours of the post-pandemic cycle can be summarized as the end of fragility: Higher growth and inflation, with moderately rising bond yields, mark a regime shift away from “stall speed” to reflation.
Several key factors are behind this shift. First is the policy mix. The post-GFC regime was characterized by fiscal and monetary policy pulling in opposite directions. Fiscal drags at a time when consumers were deleveraging forced central banks into ever-more extraordinary policies, which led to negative real yields in an attempt to shore up growth. It didn’t work, and instead fed into markets, helping them advance far beyond what fundamentals alone justified – the most extreme being developed market government bonds, which went into negative territory. Post-GFC, consumers were coming off a debt binge and firmly in de-leveraging mode, with little interest in re-levering merely due to the offer of cheap financing. Corporates were also sitting on debt-financed excess capacity, resulting in a dearth of investment activity. The result? A “stall speed” economy characterized by weak and fragile growth, with an unusually negative correlation between stocks and risk-free bonds.
Yet the post-Covid cycle appears to be pushing behavior in virtually the opposite direction. The combined policy response to the virus-induced crisis saw both fiscal and monetary stimulus running in the same direction with overwhelming force. At a minimum, even if the fiscal thrusts are not sustained, we expect fiscal drags to be off the table. The private sector is in remarkably good shape. Consumers are sitting on the lowest levels of debt on record, with record-high excess savings from fiscal stimulus. Corporate profits recovered rapidly, and the nature of the pandemic required an acceleration of investment activity to cope with excess demand, changing consumption patterns, and supply bottlenecks. Companies are also restructuring their supply chains to reduce their dependence on China and to take advantage of automation technology, which has fundamentally changed the equation on where to locate production capacity.
We therefore see a cycle ahead where growth is no longer fragile.
Meanwhile, the pandemic appears to have triggered important shifts in labor markets as well. Early retirements and low immigration appear to have contributed to tight labor markets early in the current cycle, with participation rates that may not bounce back rapidly. This will accelerate the transition to firmer wage growth, forcing companies to automate or face diminishing margins. Lower labor force growth would typically also contribute to lower growth, and we agree with this tendency over long periods of time. Yet the strength of the private sector, pent-up demand from the “forced savings” phase of the pandemic, and shrinking excess capacity have all led to a period of excess demand despite limited growth in labor supply.
The result will be firmer core inflation and a strong basis for central banks to accelerate their normalization process. The Federal Reserve is likely to begin a hiking cycle in the first half of 2022. Yet more crucial to watch will be what the Fed, and other central banks, choose to do with their bloated balance sheets. Should they attempt rapid quantitative tightening (shrinking their balance sheets to control inflation, which is prudent over the long term), we would become increasingly cautious about most risk assets over the next nine to 18 months. While the end of fragility leaves us sanguine about the impact of quantitative tightening on the economy, as well as cash flows, we believe a pivot in central bank balance sheets, from growing well above nominal GDP to trailing it, will be a material drag for markets (via capitalization rates) in the period ahead versus what one might have expected given healthy cash flow growth.
The main counterweight to this firming tone in the US over the next five years will be the slower growth path in China and China-dependent parts of EM, as the nation transitions toward much firmer control over its economy. Fittingly, this is an important political year in China, as Xi Jinping looks set to become confirmed as “leader for life.” While the lead-up to this event later this year is likely to stimulate growth, beyond that the pivot to “common prosperity” will manifest in accepting lower growth if this can reduce inequality and financial leverage while boosting the party’s control over society. A key issue to watch is the degree to which this dampens private sector vibrance and willingness to invest. The lower growth trajectory could have even more of an impact on areas of the global economy that have become reliant on Chinese demand, particularly EMs dependent on commodities exports, such as iron ore.
In the pre-GFC cycle, EM growth accelerated in absolute and relative terms. China’s commodity-intensive growth spurt was a driver, together with expanding globalization that brought foreign direct investment (FDI) into EMs that could provide cost advantages. Combined with healthy demographic trends, this led to high growth and enviable productivity gains. Yet in the post-pandemic cycle, we see these tailwinds unwinding. China’s commodity-intensive growth phase is over. Global corporates are reassessing supply chains and in many cases reshoring, with automation now changing both cost and risk calculations. Some of the cost advantages are now being assessed in terms of neglect of the environment, along with selective pockets of modern slavery. Many key EMs, such as China, Brazil, and Russia, are increasingly DM-like in their aging demographic profiles. Together with China’s structural slowdown, we see emerging economies as a source of disinflation, in contrast with the reflationary dynamics set to play out in DMs. This keeps us more interested in EM fixed income rather than growth-sensitive assets such as equities.
2021 was the year in which decarbonization become cemented as a global priority. Starting in our own backyard, we see frantic activity in our industry to integrate environmental, social, and governance (ESG) factors into investment portfolios, and with time this will drive a change in corporate behavior through allocation and cost of capital. Although the UN Climate Change Conference (COP26) has been largely portrayed as a disappointment, we see the glass as more than half full. Further commitments were made, and the development of a global carbon market will be an important addition to financial markets. But perhaps most importantly, the frequency of such forums looks set to rise, with annual events likely to maintain pressure on governments to add new commitments and execute on existing ones. The current state of being should lead to a sizable rise in investment activity at a global level, making this an important tailwind for growth and job creation over our forecast horizon, particularly in years three to five; the annual investment gap to meet net-zero is estimated at US$2.9 trillion. That said, recent spikes in energy prices give a glimpse of the difficulty in assessing and managing the knock-on effects of these policies, and commodity prices may prove an important de facto determinant of the “speed limit” of these initiatives. Higher macro volatility may be part of the cost.
Our Capital Market Line (CML) continues to have a moderately positive slope, with a high degree of dispersion, signaling good reward for selective risk-taking. Risk-free bonds remain challenged in terms of future returns, even if yields don’t rise, as do most pockets of DM investment grade, with spreads near historical lows, while EM credit assets continue to provide reasonable prospects. Overall, cyclical and high-quality equities will be beneficiaries of the healthier growth and inflation environment resulting from the policy mix shift, leaving defensive equities as clear underperformers.
Capital Market Line as of 31 December 2021 (Local Currency)
Capital Market Line as of 31 December 2021 (USD View, Unhedged)
Insights From Today’s CML
A moderately sloped Capital Market Line (CML) with a high level of dispersion. The slope of our CML declined moderately over the last quarter, as risk asset performance was positive overall. In combination with high dispersion, our CML signals decent reward for selective risk-taking. Equities remain the most attractive asset class, while safety assets struggle with initial yield levels that lag inflation, even if the rise in yields is gradual.
DM government bonds become largely uninvestable. The starting yield levels for DM nominal bonds are the single biggest challenge facing the investment world. The fundamental insights from our CML process point to higher inflation and yields as a result of the shift toward a reflationary regime – a clear headwind for fixed-rate safety assets. Yet even if yields were to remain unchanged, real returns from safety assets would be negative and pose a serious problem for portfolio total returns net of higher inflation. To add insult to injury, in a reflation scenario, the correlation benefits from safety assets diminish and render the hedging efficacy more muted. We believe the benefit of safety assets has shifted from a secular buy-and-hold asset for strategic asset allocations to a cyclical tool for use in dynamic asset allocation strategies.
Emerging market (EM) bonds are the bright spot in fixed income. In contrast to the negative real yields of most DM fixed income assets, EM debt offers an attractive yield pickup. This yield bump comes with a higher risk profile due to the structural challenges facing many EMs (see the “Fundamentals” section below), and therefore an active and selective approach is required. Scarring from the pandemic and other factors, such as decarbonization, will be more of a challenge for EM sovereigns than corporates, as governments will likely expand their deficits to cope rather than curtail spending elsewhere. EM corporates continue to demonstrate remarkable skill in navigating rapidly changing operating environments and maintaining a disciplined debt management approach.
Equities face less-generous capitalization rates, but faster nominal cash flows will provide a partial offset. The policy mix of the next cycle will support higher nominal cash flows as excess capacity is absorbed and a healthy private sector ramps up its spending. Equity risk premiums remain reasonable (in contrast with credit spreads and illiquidity premiums) and are likely to come down, providing another offset to rising rates, as reflation relieves fears of deflation. We don’t see a sharp de-rating in most equity markets over our five-year horizon as bond yields rise but still remain relatively low historically. We expect productivity to rise as companies feel margin pressures, and we remain confident that technological solutions are available to take out substantial costs and protect margins. Our ongoing lukewarm outlook for EM growth, dragged down by China and de-globalization trends, leaves EM equities looking relatively unattractive despite recent underperformance. That said, there will always be pockets of opportunity.
The Fundamentals Driving Our CML
The end of fragile economic growth. Unlike the decade after the GFC, the current cycle is unlikely to feature weak and fragile growth. The GFC damaged consumer balance sheets and led to a decade of deleveraging. At the same time, fiscal policy shifted into austerity, further weakening growth down to “stall speed.” Neither of these dynamics are in the cards this time around. The consumer balance sheet is pristine, with record-low debt and record-high excess cash, while at the same time there is no political will to revert to outright austerity. A global green investment wave is also a powerful driver of growth and job creation, which was largely absent in the last cycle. These dynamics will shift the regime from stall speed to reflation, with moderately higher growth, inflation, and bond yields, but also higher macro volatility.
Fading of inflation, but not back to pre-pandemic levels. The current cycle has kicked off with high inflation and sparked fears of overheating or stagflation. Supply chain disruptions have contributed to higher energy prices and abnormal goods inflation. Moreover, labor markets appear to be undergoing structural changes that are limiting the supply of workers, including early retirements and a sharp fall in immigration. We expect goods inflation to normalize, yet labor participation rates may be slow to rise and remain capped relative to the previous cycle, leading to firmer wage inflation. This potential outcome is already motivating central banks to accelerate monetary normalization.
Global corporate investment wave. The pandemic was a unique exogenous shock requiring companies to adapt their business models rapidly. The unprecedented policy response also supported companies directly and indirectly, leading to a strong rebound in profits and capacity utilization in many sectors. As a result, corporate capex has recovered strongly and is likely to signal the beginning of an investment wave. A dearth of investment activity in the post-GFC decade, a need to restructure supply chains, and an imperative to digitize and optimize operations are all factors driving a willingness to invest. And decarbonization spending is a separate, independent source of investment activity that will accelerate in the coming years.
Reshoring and the restructuring of supply chains. The combination of the US-China trade war and the global pandemic have cemented the need for companies to restructure their supply chains to avoid costly disruption. The optimal destination for production capacity depends on several factors, including the level of labor as a share of total costs, the level of interconnected supply chains, and the availability of automation solutions. Yet some broad trends are becoming clear. Lower value-add products will continue to shift from China to ASEAN, with India as a primary beneficiary. Higher value-add products and services will be reshored to DMs as automation neutralizes long-standing advantages, namely cheap labor, that EMs had held. The overall impact should be net positive for productivity and may help offset inflationary pressures stemming from labor shortages.
A different China growth model. 2022 is a politically important year for China, which will likely cement the pivot toward “common prosperity” and a strategic focus on sustainable and inclusive growth, with more centralized control. The real estate market is the biggest driver of China’s growth and is in the crosshairs of this strategic shift, representing the biggest of the “three mountains” of housing, education, and health care burdens. Policymakers will fine-tune fiscal and monetary policy to avoid disruption, 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. The gains for China in the longer run may be more sustainable growth and more equitable distribution of wealth. Yet the transition is likely to involve upheaval and volatility.
An accelerated mopping up of excess global liquidity. The pandemic triggered global use of central bank balance sheets to drive down real yields on a vast scale relative to economic activity. The end of fragility sets up a risk that excessively loose financial conditions could trigger a re-leveraging cycle by the private sector. We expect central banks to accelerate the normalization of their balance sheets, given this rising risk. It is difficult for financial conditions to become tight until that happens. The result will be accommodative liquidity conditions along with yields that rise very slowly for many years; a tug of war between structural drivers that have induced excess liquidity; and a positive turn in the growth and inflation landscape.
Emerging market economies struggle to break free from stagnation. After a decade of China’s structural slowdown, an unwind of the commodity supercycle, and a lack of structural reforms, will EMs experience a rejuvenation of growth? We don’t see it. While the end of fragility in DMs will have positive spillover effects in EMs, we see several ongoing headwinds. China’s trajectory will be an ongoing challenge, particularly for EMs in its orbit. Reshoring and supply chain restructuring may benefit a small number of EMs, such as India and Mexico, but the majority will not benefit through the FDI channel, given the rise in automation. The lack of forceful policy support during the pandemic leaves most EMs worse off and susceptible to more scarring. And finally, decarbonization is likely to be a bigger tax on growth for EMs than for DMs.
Acceleration of decarbonization. Although COP26 was largely categorized as a disappointment, we see the glass as half full. Further commitments were made, and the development of a global carbon market will be an important addition to financial markets. But perhaps most importantly, the frequency of such forums looks set to rise, with annual events likely to maintain pressure on governments to continue adding new commitments and executing on existing ones. The current state of being should lead to a sizable rise in investment activity at a global level, making this an important tailwind for growth and job creation over our forecast horizon, particularly in years three to five; the annual investment gap to meet net-zero is estimated at US$2.9 trillion. That said, recent spikes in energy prices provide a glimpse of the difficulty in assessing and managing the knock-on effects of these policies, and commodity prices may prove an important de facto determinant of the “speed limit” of these initiatives. Higher macro volatility may be part of the cost.
Capital Market Line Endnotes
The Capital Market Line (CML) is based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. It is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indexes, compared across the capital markets. The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team for each asset class, which, when combined with current pricing, results in our annualized return forecasts for each class over the next five years. The expected return for each asset class, together with our view of the risk for each asset class as defined by volatility, forms our CML. Certain statements contained herein may constitute “projections,” “forecasts,” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying a set of assumptions to certain financial information. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. There can be no assurance that the expected returns will be achieved over any particular time horizon. Any views represent the opinion of the investment manager and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.
About the Capital Market Line
The Capital Market Line (CML) is a tool developed and maintained by the Global Multi-Asset Team. It has served as the team’s key decision support tool in the management of our multi-asset products. In recent years, it has also been introduced to provide a common language for discussion across asset classes as part of our Investment Strategy Insights meeting. It is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indexes compared across the capital markets.
The CML quantifies several key fundamental judgments made by the Global Multi-Asset Team after dialogue with the specialists across the asset classes. We believe that top-down judgments regarding the fundamentals will be the largest determinants of returns over time driving the CML construction. While top-down judgments are the responsibility of the Multi-Asset Team, these judgments are influenced by the interactions and debates with our bottom-up asset class specialists, thus benefiting from PineBridge’s multi-asset class, multi-geographic platform. The models themselves are intentionally simple to focus attention and facilitate a transparent and inclusive debate on the key drivers for each asset class. These discussions result in 19 interviews focused on determining five year forecasts for over 100 fundamental metrics. When modelled and combined with current pricing, this results in our annualized expected return forecast for each asset class over the next five years. The expected return for each asset class, together with our view of forward-looking risk for each asset class as defined by volatility, forms our CML.
The slope of the CML indicates the risk/return profile of the capital markets based on how the five-year view is currently priced. In most instances, the CML slopes upward and to the right, indicating a positive expected relationship between return and risk. However, our CML has, at times, become inverted (as it did in 2007), sloping downward from the upper left to the lower right, indicating risk-seeking capital markets that were not adequately compensating investors for risk. We believe that the asset classes that lie near the line are close to fair value. Asset classes well above the line are deemed attractive (over an intermediate-term perspective) and those well below the line are deemed unattractive.
We have been utilizing this approach for over a decade and have learned that, if our judgments are reasonably accurate, asset classes will converge most of the way toward fair value in much sooner than five years. Usually, most of this convergence happens over one to three years. This matches up well with our preferred intermediate-term perspective in making multi-asset decisions.