BNY Mellon Investment Management: Embracing volatility

Higher interest rates are here to stay but that is not necessarily a bad thing, according to BNY Mellon Investment Management chief economist Shamik Dhar. In fact, investors should embrace resulting volatility as it is likely to create asset allocation opportunities, he says.

The global economy is going through a profound transition to a world of higher interest rates and inflation, according to BNY Mellon Investment Management chief economist Shamik Dhar. This will create heightened levels of market and economic volatility, but it also means a more rational world for asset allocation, he adds.

Dhar says his short-term outlook on the global economy is gloomy. He thinks recession in some of the major western economies is more likely than not in the next 12 months, with the risks to GDP skewed to the downside.

He expects inflation to stay high, meaning a bumpy path for central banks over the next few years as they target a 2% rate. As such, Dhar thinks interest rates will stay high to help generate the economic slack required to pull inflation back down.

A more rational world

“Economic volatility means market volatility,” says Dhar and, as such, he foresees a choppy outlook for markets in the short to medium term. He thinks risk assets could take a leg down at some point following a good first six months of 2023.

When it comes to fixed income, he says sovereign and investment grade bonds seem to be the place to be in the short to medium term because they have the potential to offer income. Additionally, he says bonds could be supported should rates start to come down and they will probably act as a better hedge against equity exposure in a way they were not able to during 2022. But Dhar suspects high yield to be more volatile, like equities.

“Ultimately, we are transitioning into a more rational world for investors and asset allocators,” says Dhar. “A world in which bond yields consistently offer 2-3% is a more sensible world in which to do asset allocation. It is also a world in which equities must outperform on the basis of their fundamental profit performance, not just because interest rates are low.”

Global forces

Aside from inflation, Dhar says there are other forces at play affecting the outlook on interest rates and asset prices. One is ageing demographics. For several countries the dependency ratio (the ratio of people aged over 65 to people of prime working age) is rising quickly. Dhar notes older people tend to run down their assets quickly and this depletion of savings could put upward pressure on interest rates, though rising longevity works in the opposite direction. Dhar thinks this pressure could be exacerbated as the control of global GDP shifts, broadly speaking, from older people living in rich countries to younger people in poorer countries who will have to provide the goods and services older people need.

Another factor is deglobalisation, says Dhar. “We are emerging from a hyper globalised world to one in which, essentially, there are two blocs: US-aligned western countries and China-aligned eastern countries,” he explains. Dhar notes how allegiance to these two blocs is currently split evenly on a country and population basis, but the western bloc generates roughly two-thirds of global GDP.

“That balance of power will remain in place for a while but clearly the geopolitical situation is going to become choppier and that may contribute to economic and market volatility more frequently,” says Dhar.

Elsewhere, Dhar notes how investment opportunities could arise from the US$100 trillion of investment required between now and 2050 to reach net zero[1], a sum that represents about 3% of global GDP. He notes energy, utilities and airlines are the sectors most at risk of policy change that will affect their transition rate. Meanwhile, about two thirds of that global investment must come from emerging economies.

AI and productivity

Dhar notes that productivity performance has been poor ever since the Global Financial Crisis, noting UK average hourly productivity levelled off at around 1% annually after 2008, having previously been at about 2% a year.

However, he is more optimistic about the future, thanks to the growth in Artificial Intelligence (AI) which Dhar describes as a general-purpose technology, akin to the internal combustion engine or steam power. He says AI will change industries and technologies and has the potential to revolutionise the way we work in unpredictable ways.

One impact of AI could be job losses. Dhar says, hypothetically, as many as 40 million jobs in the US could be lost over the next 30 years as the levels of employment, labour force and wages as a share of national income fall, while the working age population and overall populations rise. “That is why policy makers are going to have to get involved and that could have implications for asset prices across the board,” says Dhar.

But the widespread adoption of machines could boost productivity growth to perhaps 5% a year on average, adds Dhar. If that is the case, he thinks it would be necessary to “tax or nationalise the robots” to compensate those who lose out. “We would need to see an income transfer of about US$7 trillion from the robots back to us which could finance a universal basic income per head of US$15,000,” he says. 

Overall, Dhar thinks lot of these global trends point towards higher real interest rates which he thinks is the key economic and market transition we need to get used to. “Higher rates are here to stay; embrace the idea because it will be a better world for asset allocation,” he concludes.

Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

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