December 15, 2022 | 14 Minute Read
Co-Chief Investment Officer, Multi-Asset Solutions
The world as we know it is changing. The shape of the global economy and the policy prescriptions necessary to address post-pandemic challenges are likely to be different than they were in decades past. In the last issue of Asset Management Perspectives, we examined the world at an inflection point and identified five key structural developments that we believe will spark profound change: Deglobalization, Digitization, Decarbonization, Destabilization, and Demographics.
The unrelenting rise in energy and food prices and a reordering of economic and political alliances have accelerated some of these trends. Geopolitical shifts are putting issues such as supply chain resilience and greater economic self-sufficiency in particularly sharp focus and will likely accelerate a process of partial deglobalization. Destabilization is underway, changing bilateral relationships, and the rise of conflict is likely to shake up trade patterns and reorder alliances. We believe these developments will also affect the speed and scope of decarbonization efforts, while demographics and increased digitization will continue to influence the ways in which policymakers tackle key economic challenges, including inflation. But these three Ds are likely to take longer to play out.
Even so, the changes we’re starting to see make for an unfamiliar investment environment. The decade of low inflation, low interest rates and minimal market volatility appears to be over. Today, risk management is increasingly important while pattern recognition may be of limited value. We don’t yet know the precise impact this will have on industrial policy, trade, or monetary and fiscal policy, but we believe a changing world order will affect regions differently. For investors, we believe seizing the opportunities these changes may create while bolstering portfolios against market turbulence calls for a new approach rooted in a more holistic view of asset allocation with increased attention to risk.
COVID-19 revealed a few things about globalization. First, it showed just how highly interdependent countries have become as a result of unfettered free trade. The economic specialization and globalized supply chains were deflationary, but the regional specialization that came with them also made countries more vulnerable to economic shocks. When the pandemic shut down global production and trade in 2020, whole economies were nearly paralyzed. Basic goods were missing from shelves and showrooms as supply-chain disruptions created shortages across industries, including automobiles, semiconductors, and apparel, to name a few. At the same time, policymakers sought to ease the impact of economic shutdowns by injecting massive monetary and fiscal stimuli into the system, causing inflation to surge. The outbreak of war between Ukraine and Russia, a key supplier of oil and natural gas to Europe, added fuel to the fire.
At the same time, strained relations between the United States and China appear to have encouraged both to strive for more self-sufficiency in key industries. This is likely, in our view, to lead to more centralized economic policies where state intervention plays an important role, either directly or indirectly, through incentives and disincentives to decision makers and businesses.
In the US, the Biden Administration has passed major bills on infrastructure, semiconductors and the environment in which the state is poised to play a central role. This involves using tax incentives and subsidies to support domestic industries, notably the companies that produce the microchips necessary for advanced semiconductor technology, and restricting exports of advanced computing and semiconductors to China. The embrace of a more muscular industrial policy marks a stark shift from decades past, when US politicians and business leaders were often among the most vocal supporters of laissez-faire capitalism and globalization.
China, too, has signaled its intent to accelerate changes to a development model that for many years cast it as the world’s factory. In the 20th Party Congress Report, President Xi Jinping stressed the need to prioritize “high-quality development” to modernize the economy. Perhaps recognizing the perils of over-specialization, such as the reliance on low-valued-added exports to the US and Europe, China’s leadership said it also intends to continue redirecting strategic economic policy away from generic manufacturing and toward new development with a focus on technological innovation, food and energy self-sufficiency, and supply chain security.
Add to that the US move to ban the transfer of advanced semiconductor technology to China, which may prompt Chinese leaders to ramp up state-directed investment in domestic chip producers and bolster onshore manufacturing. Such a move could intensify the race between the two countries for dominance in the tech sector.
Europe saw more specialization than other parts of the world following the introduction of the euro two decades ago. The common currency and open borders facilitated a perfect flow of goods and services, capital and labor. But the lack of a common fiscal policy has created problems, as illustrated by divergent growth rates within the euro area and the developing energy crisis. During the European debt crisis a decade ago, the epicenter was firmly located in the south. The current energy crisis is having a more severe effect on the industrialized—and colder—northern countries. Germany and others that are heavily dependent on Russian oil and gas imports favor a common European Union response to support them as they struggle with soaring energy costs. Others with warmer climates and less dependence on imported energy, including France and Italy, do not. Time will tell if the current external shocks lead to a closer fiscal integration of the currency area or more divergence.
Source: Eurostat, Goldman Sachs Asset Management.
As prices have continued to rise in much of the world and external shocks threatened to destabilize economic dynamics, there is also a case to be made for increased coordination between fiscal and monetary policies to better affect outcomes. At times like these, fiscal and monetary policy can be complementary; using both can potentially be more effective while helping to limit unintended consequences. This is especially so in Europe, where the European Central Bank (ECB) must set an appropriate interest rate policy for 19 different countries despite vast national differences in the structures of member states’ respective economies, budget deficits, economic growth rates and debt-to-GDP ratios. For instance, Italy, the third largest economy in the euro zone, has a debt-to-GDP ratio of 150% and significant amount of debt coming due in the years ahead, making it particularly vulnerable to higher interest rates.
Some degree of targeted coordination between fiscal and monetary policy may also be relevant in the US, where a downward shift in inflation is dependent on the state of the labor market. So far, the Federal Reserve (Fed) is leading the charge against inflation with an aggressive tightening campaign. But monetary policy is a fairly blunt tool, and fiscal measures may have more influence over specific segments of the market. Without some policy coordination, the Fed’s monetary tightening process could inadvertently inflict damage on parts of the labor market, worsening income inequalities and regional growth disparities. Careful fiscal policies may help to temper such undesirable outcomes.
A byproduct of a world that is becoming more regionalized and increasingly polarized may turn out to be a new wave of re-industrialization in which fiscal policy and government interventions provide incentives to invest in certain sectors. This may act as a silver lining for countries that had swung too far toward specialization, a process that created country-specific and regional economic vulnerabilities and amplified income inequalities. Developed countries in particular have experienced a massive shift from manufacturing to services in recent decades, and we suspect today’s geopolitical developments and external shocks are likely to rekindle the argument for producing closer to the consumer, as technology, automation and robotics reduce the cost of labor and its contribution to the production process. This is likely to weaken companies’ incentive to outsource. A shift of this type—from unfettered free trade to what might be described as strategically optimal trade—may be more in line with the changing geopolitical landscape and can have important economic implications.
A key one is making economies more resilient to external shocks. Overconcentration in one industry can hurt a country’s industrial diversity, making it less able to withstand external shocks and weather recessions. This became evident during the Global Financial Crisis (GFC) from 2007-2009, especially in certain European countries. By contrast, the US was able to bounce back from the financial crisis faster, due to its largely diversified economy and limited dependence on external trade.
When we measure countries by their Economic Complexity Index (ECI)—an indicator developed by MIT and Harvard economists that captures industrial composition and information about export diversity—we see that improvements in a country’s complexity tend to correlate with higher GDP per capita. As an example, China’s GDP per capita and its ECI more than doubled between 2000 and 2020.1 It’s possible that a gradual shift from free to strategically optimal trade in the decades ahead may yield similar benefits for countries that diversify their economic structures, leading them to see increased resilience to external shocks and, eventually, reduced income disparities due to more broad-based growth, increased fiscal transfer or a combination of both.
Increased geopolitical tensions are also partly behind deglobalization, and they are accelerating destabilization of the geopolitical order. In many cases, we expect them to change trade patterns and alliances. In particular, we believe that control of commodities beyond energy will be an important determinant of political alliances and a source of economic and geopolitical influence. As the war in Ukraine has demonstrated, many of the countries that did not vocally criticize Russia for invading its neighbor exercise significant control over the global supply of important commodities. Saudi Arabia, like Russia, is a dominant global supplier of oil but has typically been a US ally. That did not stop it from joining with Russia in late 2022 to lead the OPEC+ oil cartel to cut production by two million barrels. US officials responded by pledging to reevaluate the country’s relationship with Saudi Arabia.
China also plays an outsized role when it comes to key commodities. It is the world’s top producer of aluminum, a key commodity necessary for the production of goods ranging from cars to iPhones. Any disruptions to aluminum supply would have repercussions for the supply of copper and other metals, which can lead to increased global uncertainty about inflation, trade and economic growth. China and Russia together are also key sources of copper, zinc and nickel—minerals necessary for the eventual transition to green energy. Wind power generation, for example, requires six times more of these commodities than a coal-fired power plant and 13 times more than a gas plant. Russia is also a major producer of wheat and, along with China, a top exporter of fertilizers.2
Other governments around the world—especially those in major developed countries—are likely to attempt to diversify their commodity suppliers for energy sources, metals, minerals, and grains. In the US, the Biden Administration has moved to expand domestic mining of many of the key minerals needed for green energy and invested in refining key battery materials such as lithium, cobalt and nickel.3 Such investment is welcome, but it is not, in our view, likely to enable the world to wean itself off fossil fuels completely and quickly. Countries may lack the ability to store green energy at sufficient scale for some time to come and will likely need to strike a balance between fossil fuels and alternative energy sources for the foreseeable future. Nuclear power may resurface as a clean energy supply option as well, though the risks associated with it may act as an impediment in some countries.
Over the long run, the trend toward green energy is likely to continue largely in line with the de-carbonization theme we highlighted in the past. Battery storage, which is crucial to solving the intermittency issues associated with wind and solar power, is becoming more competitive, and we expect investment in that space to continue the trend. But nearer term, geopolitical developments may delay the transition. Some of the delay can be chalked up to years of structural underinvestment in oil and gas production that left the US and Europe without a clear and reliable transition policy from fossil fuel to green energy. The war in Ukraine has since forced many countries to shift gears and ensure access to energy in the short run, irrespective of source or type, to meet immediate needs. China has invested heavily over the last year in electricity-generating coal capacity that will amount to three times more than the rest of the world combined.4 These developments are likely to keep energy prices elevated in the short- to medium-term.
Oil and other commodities, of course, tend to be denominated in dollars, which puts additional pressure on the budgets of countries that have seen their currencies depreciate sharply against US currency. An increasing dearth of safe-haven assets that are sufficiently liquid to address global needs presents further challenges. US Treasuries continue to be the asset investors primarily turn to for relative safety and risk reduction, and this also sustains the global demand for US dollars. At the same time, the Fed’s aggressive monetary tightening makes it more difficult for countries, such as Argentina and Turkey, that have significant USD-denominated debt to service.
Source: Institute of International Finance; as of Q2 2022
Dollar strength is a challenge for developed markets as well. Should the euro, yen and pound sterling continue to weaken significantly from here, central banks may have to intervene by selling dollars to restore exchange rate stability and help them counter inflation. Japan’s limited recent interventions in 2022 have had minimal effect in stabilizing the yen. A further depreciation may conceivably lead the Bank of Japan (BOJ) to abandon its Yield Curve Control policy, especially if inflation significantly overshoots the BOJ’s 2% target. That could result in a sudden selloff in dollars with possible repercussions for global financial markets.
If some or all of these risks play out, a financial crisis could become more likely. Reduced liquidity in the financial system—partly the result of higher capital requirements for banks that were put in place after the GFC—could amplify the severity of any crisis, particularly for financial firms that operate outside the traditional banking system. A surge in Gilt yields after the UK government announced unfunded tax cuts earlier this year sparked a liquidity squeeze among UK pension funds that required emergency bond purchases by the Bank of England to restore stability. And a rapid rise in US Treasury yields would have broader implications, given the dollar’s global role.
This underscores the need for risk management, which many investors were able to de-emphasize over the last decade when rates and volatility were low and liquidity was plentiful. It’s also important to note that interest rates are higher today than they were when the GFC hit and are still rising, suggesting it may take less to generate stress.
The era of low-to-zero interest rates required significant portfolio leverage to generate target returns. That is less necessary today; even high-quality government bonds are offering attractive yields for the first time in decades. We expect return potential across asset classes to remain elevated as rates settle at a higher equilibrium level, which reduces the need to employ high degrees of leverage. Those with sufficient dry powder may find opportunities to buy quality assets at attractive valuations when over-leveraged investors are forced to sell.
For investors who can adapt and remain flexible, today’s challenges and change bring potential opportunity across sectors and regions. Geopolitical unrest, tighter financial conditions, more centralized economic policy—all will likely provoke more dispersion across asset classes sectors and regions and between developed-world and emerging-market assets. For instance, the volatility of broad equity indices masks the vast dispersion of outcomes within them, providing a ripe environment for stock selection in public markets as volatility subsides. These opportunities may transcend the usual categorizations of value and growth or particular industries and instead be rooted in companies with effective operations and healthy balance sheets, regardless of sector or style. Adding private market allocations to the mix can provide even greater diversification, as ownership structures and deal terms typically give investors the ability to take a more active role in operations.
These are challenging times in the markets. But the tectonic shifts that are altering the shape and structure of the global economy are also creating a new and vibrant investment landscape. As risk reprices, we believe careful and informed investors will have unique opportunities to reshape their portfolios and capitalize on new opportunities.
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