18 Apr 2023
For many years the dominant secular themes were disinflationary. Investors always need to contend with the interplay and overlap between secular and cyclical forces. Arguably these have now changed, and investors should be thinking about a 7D world if looking for longer term secular trends (perhaps the move from 3 to 7 is an indicator in itself of higher inflation!). The 7 are Deglobalisation, Decarbonisation, Digital revolution, Defence, Disease, Debt and Demographics. Within this there are forces that are both inflationary and disinflationary, so there may be periods of inflationary waves, depending which has the most influence on the macro factors driving the global economy. However, on balance, the demand and supply side effects which imparted secular disinflationary forces on the global economy for much of the post GFC period have dissipated to a significant degree.
Defence is now a higher priority for government spending due to heightened geopolitical tensions. Economist Roger Bootle had described an era starting in the nineties as ‘the death of inflation’ with one of the factors behind this being the benefits of the peace dividend or lack of wars. He argued in the post World War II era that inflationary impulses had been driven by wars in Korea and Vietnam and the absence of these was a major positive in terms of lower levels of inflation. Deteriorating geopolitics had already raised costs of doing business with the US. Imposing tariffs on Chinese exports during the Trump administration and heightened trade tensions, together with the Russia/Ukraine conflict, has resulted in companies looking to bring supply chains closer to home and diversifying rather than having sole reliance on China. Even prior to this there was some degree of backlash against globalisation. Free trade is an overall positive and was taken as an inequality driver, particularly in Western countries, but it masks at the individual level when it comes to both winners and losers. Both higher defence spending and de-globalisation are inflationary factors, as is decarbonisation with the full costs of the green revolution becoming more apparent with the passage of time. With shortages of many inputs like electric vehicle batteries, the costs of moving to a greener future have been underestimated, not just by investors, but also by consumers, and is likely to put further pressure on disposable incomes with renewable energy still more expensive than conventional methods of electricity generation.
The Covid-19 pandemic has been another driver of higher costs. In every pandemic since the Black Death, wages have risen and the pandemic does seem to have resulted in a reduction of labour supply in most developed world economies which, together with supply chain disruptions, seems to have resulted in a permanent move upward in many price levels which ties in with negative demographics. Falling working age populations was once seen as a disinflationary impulse but is now being blamed for higher prices as the number of available workers falls in many developed countries and this situation is only going to worsen over the next few decades.
So, there are now five potentially inflationary influences on the global economy that will be offset to some degree by two of the original 3D’s; debt and the digital revolution. The former is likely to suppress demand going forward, while the latter continues to have scope for higher levels of productivity together with lower costs of production of both goods and services.
This all argues for a world of instability and a very different one from which investors have become accustomed to. Looking at economic forecasts we can see that conventional models are struggling to adapt to the new environment. The US labour market, which was expected to come under pressure during the fourth quarter of 2022 remained robust and for the first time ever at a time of rising interest rates, employment in the construction sector has continued to rise.
Asia and the Emerging World have not been immune to the volatility in equity markets caused by concerns over the banking sector. In the main emerging country, banks remain better capitalised and on a different growth path to their developed market counterparts. Markets have also seen volatility over the quarter caused by fluctuations in the US currency and historically a weaker dollar has coincided with better returns from emerging market equities. A strengthening US currency over part of the first quarter (February/March) was a temporary headwind to emerging markets as some countries are financed with US$ debt and imports of energy, materials and food are all effectively priced in the US currency. There were also some geo-political concerns after the balloon saga. The Indian market suffered some fallout from the ongoing Adani scandal. As tensions in the banking sector have receded, the US currency has once again weakened, and it is highly likely that 2022 saw a peak in the value of the dollar. Emerging markets are also further into their monetary tightening phase than Western counterparts with China at a different stage of its economic cycle as policy is being eased. Economic prospects for China as a recovery story and India and Mexico look positive.
China has now exited its Zero Covid Policy and has indicated support for the areas of the economy hardest hit including the property market and has increased fiscal and monetary stimulus. Within urban areas 80% of job creation comes from the private sector and SOEs alone cannot revitalise the economy. Tensions within the internet sector have eased with more gaming approvals and clear indications of less regulatory interference in these companies. The rebound from the economic slowdown in China is not likely to be rapid, with many Chinese consumers taking a more cautious stance to re-opening. International air travel has been slow to rebound which is a factor behind weakness in the oil price. China has set a growth target of 5% this year, its lowest in decades, but as the economy slowly recovers, it's a realistic target.
Post the SARS outbreak in 2003, consumers in China took time to recover their confidence. While the property market is stabilising, a rapid rebound in prices would not be consistent with the common prosperity framework shaping Chinese economic development and there are signs that the manufacturing sector is suffering from the global economic slowdown. On a positive note, China’s services activity is now expanding at its fastest rate in 12 years and the government remains committed to increasing fiscal support for the economy and reducing taxes on small companies.
India continues to offer investors an excellent long-term investment opportunity. It’s home to a fifth of the world’s population and is the world’s largest democracy with strong rule of law. This remains a market with very high-quality businesses overall compared to others in the developing world. India is now investing heavily in its infrastructure with strong levels of new road construction and private sector investment improving airports, gas and power distribution, renewable energy, and the railway system. The government has encouraged investment in local manufacturing through attractive tax and labour reforms and there remains scope for continued productivity improvements. A large domestic market, improving infrastructure, and the increasing need for multinationals to diversify global supply chains add to the long-term positive case for manufacturing in India. India had been beset with its own banking crisis in the post GFC period, but the introduction of new insolvency and bankruptcy rules have helped the write-off of non-performing loans and the private sector banks remain well placed to capitalise on the growth of the economy.
Brazil has multiple well-run companies although there are some concerns in the market about the future economic policies of the Lula administration which during its second term was beset by corruption issues. The market is waiting to see whether the current administration will look to copy the first Lula term or the second one, although in the long term, if properly managed, the country should benefit from its abundance of certain resource assets including oil, iron ore and a favourable environment for soft commodities production.
Mexico remains well placed to attract inward investment as manufacturers look to expand their non-Asian supply chains with companies such as BMW, Tesla, Foxconn and Advantech all expanding their operations in the country. Some countries in the Middle East, including the UAE, are continuing to benefit from the inflows of foreign investor money due to their increasing popularity as safe-haven states in the emerging world in the post Ukraine conflict era. The UAE is seeing a property boom aided by low corporation tax rates.
Overall, emerging markets are benefitting from a favourable longer-term story and should be supported by their relatively low valuations compared to developed markets and ones which sit towards the bottom of their range in absolute terms. With the monetary tightening cycle further advanced in these countries, which were not beneficiaries of QE or zero interest rates, the long-term investment case for the region remains intact. Levels of economic growth relative to the developed world should be a lot stronger over the next five years compared to the previous five as inflation is less elevated than in the West and there remains abundant sources of relatively cheap supplies of labour, especially in non-China Asian countries such as India, Indonesia, and Vietnam.
The Opec+ group shocked global markets by announcing a surprise production cut of more than 1m barrels per day - a move which boosted the oil price but also upset some western nations.
Its largest members Saudi Arabia and Russia both want to support and if possible, boost the oil price. It also emphasised the strained relationship between the Biden administration and Saudi Crown Prince MBS. A higher oil price is damaging to western economies and negative for inflation, especially in Europe, which has been a major beneficiary of lower-than-expected energy costs over the winter months, helping to avoid recession. A general economic slowdown and recession if it occurs would take some of the benefits of the production cut away. If oil does reach $100 again and inflation accelerates, central banks may decide to act due to the negative ramifications for the global economy and stock markets. With China still trying to engineer an economic recovery, a higher oil price is not likely to be welcomed so time will tell how this all plays out, but the news is certainly not positive.
This remains an environment where it would be easy for investors to end up making binary bets which will either be very right or very wrong and it is clear that the US Federal Reserve has no definitive view on how soon inflation will peak, or when it will return to target levels. Central banks may be forced to choose between maintaining respectable levels of economic growth or instigating a severe economic downturn to hit inflation targets which might be politically unacceptable and eventually lead to questioning of the relevance of central bank independence. Even before the problems in the banking sector, commentary from banks suggested that credit standards were already tightening and subsequent events will only reduce the availability of credit on the ground, especially to individuals and smaller businesses. The pace and timing of the economic slowdown or recession may well have been brought forward, but on the positive side, inflation could fall quicker and therefore interest rate rises pause earlier than expected.
An economic slowdown would negatively affect corporate profits, but markets may be once again prepared to look further forward across the valley to the next economic upswing, something we’ve seen occur in previous mini cycles in recent years. In this environment, it is hard to be resolute or confident about the outlook, but in the shorter term, whether inflation is heading back to a 2% level may not matter that much, as investors will not want to be left on the side lines during a rally when rates are seen to be peaking. Definitive evidence of a peak in the US rate cycle would likely see the US currency weaken further which could re-ignite the rally in emerging market equities.
The economic outlook often throws up surprises to forecasters but there are an unusually large number of moving parts just now. The typical lagged effects of monetary policy may be even longer due to the build up of cash during the pandemic adding to the difficulty of forecasting. With levels of uncertainty high, investors should look to build portfolios with resilience, especially as the possibility of a further deterioration in geopolitical conditions remains.
It is clear though that there are both inflationary and deflationary forces at work at the same time, which is in complete contrast to the decade following the GFC and over the medium term is likely to result in stubbornly higher inflation than investors have been used to and will put a cap on the levels to which bond yields can fall and equity market valuations can rise. Investors are facing into a different macro-economic regime than during the decade following the Financial Crisis. The prospects for risk assets over the remainder of the year remain tilted to the upside as investors will be looking for the end of the tightening cycle but, in light of the valuation constraints imposed by higher interest rates, it may take a number of years of earnings growth for some equity markets to regain previous peak levels.
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