August 4, 2022 |
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INFLECTION POINT: RISKS AND OPPORTUNITIES IN A CHANGING GLOBAL ECONOMIC ORDER
August 4, 2022 | 14 Minute Read
Maria Vassalou, PhD
Co-Chief Investment Officer, Multi-Asset Solutions
Maria Vassalou, PhD
Key Takeaways
- Macroeconomic conditions are changing: Interest rates and inflation are rising. Attractively priced assets are scarce. And growing geopolitical unrest is making the world less stable.
- Navigating this new reality, defined in part by deglobalization, will create risks and opportunities and calls for an active investment approach that combines public and private assets.
- Investors should prepare to lean into long-term economic transformation, embrace regional diversity and play defense creatively.
The last several decades have been good ones for most investors. Robust economic growth, relative geopolitical stability, persistently low inflation and interest rates, and supportive global central banks have translated to strong portfolio performance with relatively low volatility.
Today, the world is at an inflection point. The COVID-19 pandemic accelerated digitization across many industries, disrupted supply chains, and helped spark demographic shifts as remote work became the norm for many professionals. Interest rates are rising to combat persistent inflation while economies look to secure supply chains and reverse decades of globalization. Elevated sensitivity to climate issues is spurring investment in decarbonization and sustainability, while geopolitical instability has roiled energy markets and increased overall uncertainty. These issues are creating market conditions and demanding policy prescriptions that many of today’s market participants—managers, traders and even most policymakers—have little experience with, and are provoking questions about what the world will look like in the decades to come.
While supply disruptions should ease as COVID-19-related restrictions and shortages fade out and the war in Ukraine ultimately reaches resolution, these pressures of digitization, deglobalization, demographic shifts, decarbonization, and geopolitical destabilization are likely to endure for some period of time, leading to a rise in dispersion across various dimensions and changing the outlook for investors. In this new environment, the portfolio construction playbook that worked so well in recent decades may be less effective going forward, forcing a re-think in approach. We believe active management and a dynamic approach to portfolio construction that combines public and private assets may help provide improved performance resilience as markets face these disruptions that are likely to have profound effects on the world economy.
Time to Adapt
In our view, the following important structural developments will spark profound changes to the global economy with the potential to alter the trajectory of countries, companies and the way we invest. Some are likely to keep prices higher than they have been in recent decades whereas others will have deflationary effects. All will generate uncertainty and have the potential to contribute to an elevated level of market volatility.
Deglobalization: A partial shift away from a world in which goods, people, capital and ideas flow freely across borders began before the pandemic hit, with populist movements from both sides of the political spectrum rising and countries turning inward, embracing inflationary policies such as tariffs over free trade and restrictions on immigration. The U.S. and Europe have in recent years sought to restrict foreign investments, particularly from China, that target the acquisition of technology companies deemed important to national security. The pandemic accelerated some of these trends and started new ones. For example, supply disruptions are beginning to encourage companies to source materials locally when possible and governments are looking for ways to support production of more goods domestically to improve their country’s economic resilience. It may sometimes be possible to divert production locally at a similar cost. Other times, it will not.
Digitization: While flows of goods, capital and people have slowed, trade in digital services is still on the rise, a trend that may counter any inflationary pressures resulting from the deglobalization process. Exports of computers and communication services have risen significantly since the early 1990s, and cross-border internet bandwidth has grown 115 times larger since 2008. As our colleagues at Goldman Sachs Global Investment Research put it recently, globalization may be slowing in tangible areas but accelerating in intangibles.1 In the U.S., remote working has saved workers time that would otherwise have been spent commuting but can now be channeled into more productive activities that can elongate the natural economic cycle and lead to a decreasing inflation environment. Other developments that may contribute to lower inflation going forward are the advance of telemedicine and other digitalized healthcare, as well as digital commerce and the rise of financial technology. Widespread digitization of business, the rise of e-commerce and the automation of factories, are likely to serve as deflationary forces in the long run, with benefits accruing to firms able to adopt and adapt quickly to the new paradigm.
"Whereas globalization tended to reduce prices for goods and labor as capital flowed to the lowest-cost producers, a partial unwind would likely increase them, leading to potentially higher medium-term inflation than pre-2020."
Explosive Growth of Cross-Border Data Flows; Global Digital Platforms
Source: Telegeography, McKinsey, SensorTower, Goldman Sachs Global Investment Research. The user shares are as of March 2022 for all services except for Google (June-August 2018 data).
Decarbonization: The move toward green energy is important for the health of the planet, and we expect efforts to move away from fossil fuels to accelerate. But the process may also lead to higher inflation—at least in the short run. Sustainable energy production still only represents a fraction of total demand, and bringing additional sources online will take time and significant amounts of increasingly expensive metals and minerals. Of course, the need to invest in green energy infrastructure should also be good for future economic growth and may present attractive investment opportunities. The shift to more sustainable forms of energy will also take time to play out. Europe, for instance, has a strong incentive to accelerate construction of renewable power sources, including wind, solar and even green hydrogen, but the transition will not happen overnight. And it may run into geopolitical roadblocks. For instance, a shift to more electric power will significantly alter the commodity landscape and increase the importance of a handful of countries rich in copper, nickel and lithium. Some of the critical minerals for electric vehicles and electric vehicle batteries are concentrated in countries with unstable political regimes and suspect human rights records.
Destabilization of the geopolitical order: Economic and political alliances rarely changed much in the era of globalization. They look like they are changing now. A world that divides into blocs—for example, the U.S., Europe, Japan and other developed countries on one side and Russia, China, India and major oil producers on the other—is likely to be one in which inflation runs hotter than it has in the past. Examples already exist: the war in Ukraine and sweeping sanctions on Russia by the countries in one bloc have reduced the supply of energy and other commodities, including metals, salts, food, and fertilizer, potentially leading to food shortages in developing countries. Taking commodity supplies out of the market over prolonged periods of time suggest that some of the temporary components of inflation will become more persistent. New alliances may also create a more uncertain environment that weighs on consumer and corporate confidence and possibly changes governments’ fiscal spending priorities. Examples may include increases in defense spending or more support for domestic industries. This might result in higher taxes and more government borrowing, potentially swelling government debt levels in some countries and pushing interest rates higher.
Demographics: Labor force participation rates have been declining in developed countries for some time as their populations age, but the trend picked up steam during the pandemic as layoffs rose and many workers chose not to return to the labor force as emergency stimulus payments temporarily supported their earnings and health and childcare concerns made the return to work more challenging. The evolving demographics and the increased ability to work remotely may change consumption patterns with more people moving to more affordable second-tier towns and away from high priced and overpopulated big cities. The importance of Millennial consumers—the majority of whom live in emerging-market economies—is also affecting consumption patterns, with more of it moving online.
Implications and the New Investment Playbook
Any of these inflection points and the uncertainty they bring could lead to a structural repricing of risk across asset classes. For now, corporate earnings expectations are holding up. But as inflation continues to run high and real wages struggle to keep pace, some companies are already struggling to pass on cost increases to consumers, which may result in a reset of corporate profitability with negative implications for equity prices.
Elevated inflation uncertainty due to the drivers outlined above leads to elevated monetary policy uncertainty, and possibly once again to reduced potency of central bank policy as it relates to achieving their inflation targeting and anchoring inflation expectations around 2%. The Federal Reserve and other central banks were able to support risk assets since the 2008 Global Financial Crisis by providing ample liquidity and engineering financial repression on the back of an inflation rate that nevertheless continued to run persistently below the 2% target rate. Their task now is far more complicated as some of the forces that keep inflation elevated today—supply disruptions and soaring energy and other commodity prices—are beyond policymakers’ control. Yet their credibility depends on their ability to re-anchor inflation expectations, and doing that with aggressive monetary tightening runs the risk of plunging the economy into recession and reducing the attractiveness of risk assets.
Inflation Likely to Stay Elevated in 2022
Source: Multi Asset Solutions Goldman Sachs, Global Investment Research Goldman Sachs, and Bloomberg. As of July 7, 2022. The economic and market forecasts presented herein have been generated by Goldman Sachs Asset Management for informational purposes as of the date of this publication. They are based on proprietary models and there can be no assurance that the forecasts will be achieved.
Leaning into the Silver Linings
As the environment and conditions around us change, we need to change our investment approach with them. What is important in this process is also to recognize that where there is change and upheaval, there are opportunities.
"Deglobalization, for instance, will likely widen the gap between winners and losers, which can create opportunities for active investment managers. Every cloud comes with a silver lining, and we can certainly see several in the current environment."
Free Trade or Optimal Trade?: A hallmark of globalization in recent decades has been the embrace of unfettered free trade. It is, however, now widely accepted that globalization has not spread its benefits equally when it comes to individuals or economies. Side effects have included rising income and wealth inequality, a hollowing out of the middle class and the compartmentalization of production and global supply chains resulting in reduced levels of productivity and innovation. A side effect of this process has been the increased specialization of economies which in turn made them less resilient to economic shocks. Overconcentration in one industry can hurt a country’s industrial diversity, making it less able to withstand external shocks and weather recessions. During the Global Financial Crisis, the U.S. bounced back more quickly than the euro area, thanks in large part to a more diversified economy. If a partial rollback of globalization helps shift the focus from unfettered free trade to optimal trade, we believe we may see some long-term benefits, as more economic and industrial diversity may contribute to more robust economic growth and stability over time. When the next shock comes, more economically diverse countries should be in a better position to absorb it.2
Deglobalizing the Supply Chain: Globalization has also created an increasingly global supply chain, often with each individual component of a good produced in different countries around the world. A shift toward greater domestic production and more localized supply chains may well raise prices in the short to medium run, not least because it would take time for countries that previously relied on low-cost countries for key parts of the production process to build their own cost-efficient production capabilities to replace them. But this process may also bring out synergies as a shared pool of labor and technology can foster further innovation. For instance, skilled labor with technological expertise in one industry may be able to apply its knowledge to another industry within the same economy. Such boosts in innovation and productivity are hard to achieve when production is spread out across the globe. Technological innovation may also spill over into other industries, something that is less common in highly specialized economies. Another potential benefit may be a partial rollback in the level of global income inequality that has grown with globalization. While automated labor will not disappear, a less globalized supply chain would likely raise demand for domestic labor, particularly in developed countries that have relied heavily on lower-cost emerging market labor. In the short term, this too would put upward pressure on prices. In the longer run, it may help to raise living standards more broadly, with a corresponding increase in economic growth. Even the supply chain for microchips and semiconductors—crucial components of key technologies for nations around the world—may eventually see some supply chain diversification, though this process may be lengthy and substitutions may in some cases turn out to be imperfect.
The Rise of Tier 2 Cities: Even before the pandemic began, businesses were actively relocating to Tier 2 cities with lower taxes, more affordable real estate and, for employees, the opportunity to strike a better work-life balance. Today, with part- or full-time remote work becoming mainstream, many of these cities are likely to thrive, which may lead to investment opportunities in real estate, including new multi- and single-family dwellings and infrastructure.
A Public-Private Approach
Investors may be able to capitalize on trends like these by embracing a holistic strategic view that looks for opportunities across markets, matches resources and goals and, when appropriate, uses a thematic rather than an asset class-specific lens. We believe some of the trends that markets face, such as a partial pullback from globalization and a shift toward green energy, may best be accessed through private alternatives, such as private equity, infrastructure and real estate—both residential and commercial. Others, such as the growth of the financial technology industry, the digitization of healthcare and other sectors and the growing corporate and investor focus on sustainability suggest opportunities for public equity strategies that look beyond benchmarks to find companies in tune with key secular growth trends. Combining private and public assets can also allow investors to take potential advantage of differentials in valuation, growth opportunities and access. Blending the two tends to create complementary exposures and may give investors more opportunities to add value by exploiting short-term pricing dislocations.
We believe it may be helpful to think about portfolio construction in the context of a few broad investment themes and their associated risks, as specific asset allocation decisions will vary widely, depending on investment goals, resources, organizational restrictions and other factors. In our view, thinking in themes rather than asset classes may help guide investors' optimal blend of exposures needed to better achieve their return and risk objectives.
Lean into Long-Term Economic Transformation: Companies—both public and private—that focus on new and transformative technologies, research and industries may help to forever change the path of economic growth and how it is distributed. They may also afford investors opportunities to gain exposure to a potential “new economy” and a more diversified stream of returns, including through early-stage and venture capital investments.
Embrace Regional Diversification: A changing global economy will affect different countries and regions in different ways. The U.S., for example, has been a major beneficiary of globalization, with U.S. assets outperforming in recent years. That outperformance may well persist. But a sustained reversal of globalization would create segmentation across capital markets and likely increase the benefits of regional diversification. Some regional distinctions may be harder to tease out, especially in emerging markets, underscoring the importance of partnering with diverse managers that have a presence on the ground in multiple locations around the world and a strong understanding of how regional politics and markets work.
Factor in Structural Limitations and Resource Constraints: Every investor is different. A large corporate pension fund’s asset allocation process will differ materially from that of a foundation, insurance company or venture capital firm. For organizations with a lengthy and complex process, acting quickly is not always possible. For these investors, creating a dedicated “opportunistic” sleeve in their overall allocation may help them act more quickly when markets are volatile and opportunities short-lived. Others may want to revisit some aspects of the overall approval process. For those that cannot execute their own opportunistic trades, it may make sense to outsource that function.
Play Defense Creatively: It may be time to reimagine the way we think about the defensive component of overall asset allocation. The need to dedicate a portion of any portfolio to defensive assets or strategies won’t change. But in today’s changing and challenging investment environment, where low inflation, falling interest rates, unfettered free trade and geopolitical stability are no longer the norm, the type of assets or strategies investors use to play defense might. Defensive sectors today, for example, may be categorized as domestic-facing and relatively more insulated from global supply chain disruptions as well as cost input and labor inflation.
We believe doing these things effectively amid a changing investment landscape and the repricing of investment risk will require an active investment strategy as well as a holistic approach that sees public and private assets as complementary components in a well-diversified portfolio. We believe this approach affords investors the best opportunity to capitalize on innovation, increase risk-adjusted return potential and navigate portfolios through future storms.
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