Regime Change: Investing in the New Era – Switzerland
The post-Covid reopening of economies triggered a phenomenon investors have not seen in decades. Strong demand met limited supply, leading to a sharp rise in inflation. Central banks were slow to respond, blaming temporary spikes in energy and agricultural prices on temporary factors such as the war in Ukraine. However, healthy economies and low unemployment meant that these shocks led to higher domestic inflation and central banks had no choice but to catch up.
Higher interest rates are the most noticeable result – and they’re likely to continue – but they’re just one facet of the top five macro trends we anticipate over the coming years as we move into a new economic regime.
Central banks will prioritize controlling inflation over growth
Since the global financial crisis, central banks have supported the real economy and financial markets at the first sign of a downturn. Cutting interest rates to record lows, even below zero in some countries, and trillions of dollars worth of quantitative easing were all deemed necessary to combat the risk of deflation.
Now that inflation is at its highest level in about 40 years, political pressures have mounted and central banks have changed their response and are now actively trying to slow growth in order to bring inflation down – even if that means recessions trigger.
No Longer Ephemeral: How Central Banks Responded to Inflation
The magnitude of inflation means that interest rates must continue to rise in the short term and remain high for longer, with central banks unlikely to ease monetary policy to support growth for some time.
The likelihood of this scenario is reflected in “real” policy rates (post-inflation), as shown below. These have turned very negative in recent years and contributed to higher inflation, but are now rising again for most countries.
Further increase: Real interest rates remain at levels last seen in the 1970s
Governments will respond with more active fiscal policies
As central bank actions will impact growth, we expect governments to become more active in their tax and spending decisions. They will try to prop up households and businesses through the economic downturn. These fiscal measures could clash with central bank actions and lead to increased uncertainty.
Government balance sheets have yet to recover from the costs of the pandemic, and rising interest rates are putting pressure on governments to implement austerity measures. However, populist political movements, which are strong in many countries (see chart below), are largely opposed to austerity measures and are rallying their support to higher-spending platforms.
The rise of populism in Europe
Governments could employ redistributive policies, imposing higher taxes on wealthy individuals or corporations seen as beneficiaries of the current circumstances in order to maintain or increase certain spending. But any fiscal stimulus risks fueling inflation and counteracting central bank actions.
Conflicts of precisely this nature emerged in the UK’s disastrous financial announcement of September 23, 2022, when newly installed Prime Minister Liz Truss proposed naked tax cuts while the Bank of England hiked interest rates. This political conflict and the resulting market turmoil resulted in Truss being ousted after just 44 days in office.
Elsewhere, there is scope for similar disorder as governments, central banks, and financial markets clash over policy direction. The independent role of central banks, whose aim is not to provide governments with cheap finance, is already being challenged. Central banks could come under further fire as politicians become more sensitive to higher interest rates.
The new world order will challenge globalization
Relations between China and the West have been strained for several years, particularly on trade and technology issues. The pandemic brought a new, physical dimension to these existing political risks, as strict Chinese lockdowns caused widespread blockages. This has contributed to inflation.
Independently of this, but with corresponding consequences, the war in Ukraine has widened the geopolitical fault lines that are now reshaping the global energy landscape. These threaten greater divergence between China and the West, potentially leading to more protectionism on both sides.
Stuck in transit: traffic jam in Chinese shipping
In response to the disruption and these broader developments, companies are planning to diversify their production – and move it closer to home. Our analysis of the text of US corporate earnings reports (see below) highlights a notable increase in corporate talk of “reshoring”.
On the Retreat: Increased talk of bringing production home
This means that one of the major deflationary forces of recent decades, the growth of cheap manufacturing in China (see the expanding pink dataset below), is weakening and may have run its course. Globalization can still play a role in reducing costs as production moves to new countries, but the easy gains are over as companies place increasing emphasis on security of supply.
Globalization has kept inflation low for decades: is it over?
Businesses will respond by investing in technology
Companies not only face rising production costs due to higher raw material prices, but also higher personnel costs.
Labor shortages stemming from the demographic factors we previously described under our “inevitable truths,” as well as political causes such as stemming migration, have shifted power in wage negotiations back to the workforce. This allows workers to demand higher wage increases in response to the rising cost of living. As described above, offshoring as a way of limiting these costs is becoming less attractive.
Elsewhere, regulatory costs are rising, as is taxation. These factors will drive up costs and prices in the short term. Corporate share of overall economic growth is under threat, putting pressure on profit margins.
Higher wage growth will eat away at profits
To protect profit margins, companies have a clear path to increasing productivity: technology. This means investing and introducing increased use of robots and artificial intelligence wherever possible, rather than over-reliance on manpower.
In recent years, the use of robotics has increased significantly in Asia and Australia, but there is now momentum in Europe and the US to catch up. Likewise, some sectors, such as automobile manufacturing, have been major adopters, while others, such as agriculture, have lagged behind.
The response to climate change is accelerating
The long-term economic impacts of unchecked climate change would inevitably be huge. In the short term, measures to limit global warming are also proving disruptive. Governments are slow to coordinate and respond to the climate catastrophe, and so corporations have taken the lead.
The transition to renewable energy will structurally boost inflation in a number of ways. First, there is the cost of creating the required capacity. This is not a linear path due to the lack of rare earth elements and other key materials. Second is the higher initial cost of switching to a more expensive energy source. Third, there will be costs of regulation to force the switch as individual countries and blocs accelerate their policies.
Regulatory measures include carbon pricing (where environmental damage is reflected in the prices consumers pay) and carbon border adjustments. The latter – in which imported goods are “taxed” based on the emissions or other harms associated with their production – serves as a form of protectionist policy. There is a risk that this could be used as a cover for other political goals, as mentioned earlier.
The threat of climate change is likely to prompt greater investment in technological solutions which, if successful, could help reduce the inflationary impact and improve the outcome for economies worldwide.
The top five regime change trends: what they mean for investors
Johanna Kyrklund:
Regime change brings with it the need for a fresh perspective on the investment landscape. After a 40-year deflationary cycle, many investors will be in unfamiliar territory as they brace for a time when higher levels of inflation will persist.
Such an environment means that in the coming period we need to change how we look at fixed income, for example. With tighter monetary policy come higher bond yields, and the case for owning bonds is now based on the yield they offer rather than their diversification benefits.
How we value assets will change. When it comes to country or company selection, investors need to be proactive and critical when identifying winners and losers.
Countries that are less reliant on external funding and have demonstrated political discipline can be rewarded, while others can be penalized. We expect increasing divergence in interest rate cycles across countries and regions.
Likewise, companies that have survived on low borrowing costs may soon be struggling with higher interest rates.
Assessing which companies can pass higher costs on to their consumers will be crucial: those unable to do so will find themselves squeezed on margins.
Price-to-earnings multiples are likely to be lower and investors will focus more than ever on the earnings portion of this coupling.
Elsewhere, commodities should once again become a very helpful source of diversification after falling by the wayside during the ‘easy money’ era of quantitative easing.
Regime change is about more than just inflation and interest rates. A wave of investments in technology and structural changes in supply chains and energy policies will create opportunities for a new wave of companies. Some of the investment themes that have emerged in recent years will only intensify – and new ones will emerge.
Meanwhile, an increase in populist policies and political volatility call for a greater focus on risk and its associated rewards.
In this new era, it’s clear that a lot will change for investors: how to value assets, where to find the best opportunities, how to manage risk. But the ingredients for success remain the same. We need teamwork, thorough analysis, open-mindedness, flexibility and above all an active approach: plus ça change, plus c’est la même choose.