There are five global megatrends that will guide financial advisers and their investor clients in optimising asset allocations through 2023. In its Crystal Ball 2023 Investment Outlook presentation, global investment manager Schroders mentioned ‘regime shifts’ in fiscal and monetary policy responses to inflation as likely key influencers of market returns this year. As expected, the outlook for inflation and interest rates in the Eurozone, United Kingdom (UK) and United States (US) dominated the discussion.
After 15-years of record lows, interest rates are rising fast world while inflation is spiralling out of control, contributing to a cost-of-living crisis in many developed economies. In addition, the ongoing energy crisis and fears over deglobalisation are contributing to doubts over financial market performances. “We are approaching a turning point in the world economy as far as growth and inflation are concerned,” said Keith Wade, Chief Economist at Schroders, before predicting recession in the Eurozone, UK and US during 2023. He warned that this year may deliver the slowest global economic growth since the 2008-9 global financial crisis (GFC).
Wade set the stage for Azad Zangana, Senior European Economist and Strategist at Schroders to introduce the five megatrends in a presentation titled ‘Regime shift: investing into the new era’. Although these trends will be developed and expanded upon throughout the year, they contain useful insights for investment professionals who must optimise clients’ portfolio allocations to bonds, cash, equities and property over the coming 12-months.
Trend 1: Central banks will prioritise inflation ahead of growth
The lower-for-longer interest rate policy pursued by developed market central banks for the better part of 15-years is over. “Central banks are [finally] ready to prioritise fighting inflation over supporting growth,” said Zangana. He added that until recently, the Bank of England and US Federal Reserve had responded to any sign of slowdowns in economic activity by cutting interest rates, adding additional liquidity to the point where interest rates reached near zero in the US and below zero in Europe and Japan.
These interest rate cuts coincided with trillions of dollars in quantitative easing injected into Western economies immediately following the GFC and, again, during the two-year-long COVID-19 pandemic. “We are seeing a big regime change in monetary policy … investors have to understand that the old central bank ‘put’ is over for now,” he said. “Central banks are responding to high inflation and are focused on that part of their mandate, at least in the near term”.
Trend 2: Fiscal policy likely to be more active
Wikipedia.org offers a simple definition of fiscal policy as “the use of government revenue collection and expenditure to influence a country’s economy”. In a South African context, government’s decision to implement a ZAR350,00 per month Social Relief of Distress (SRD) grant during pandemic is just one example of the myriad fiscal policy interventions that take place on an ongoing basis. More recently, we have seen fiscal policy in action through European governments’ responses to the cost-of-living crisis brought about by soaring energy prices. “We are likely to see more fiscal policy interventions going forward, given that central banks are stuck fighting high inflation; the risk is that governments are [already] highly indebted after the impact of the pandemic on their public finances,” noted Zangana. He warned that populist responses to such crises often led to outcomes that were less desirable for financial markets. Just ask the UK’s shortest-serving prime minister, Liz Truss.
Trend 3: A new world order will challenge globalisation
The Russia-Ukraine war, underway since February 2022, has placed tremendous strain on relationships between NATO-aligned countries and Russia and its supporters. According to Schroders, the war has impacted energy and food policy throughout the region while forcing countries to rethink their allegiances. “Even before the pandemic and war there were problems with the trade relationship between China and the US,” said Zangana, who added that the unbundling of the 30-year-long production ‘shift’ from the West to the East was contributing to structural inflation in the West. As a result, many Europe- and US-based companies are reconsidering their supply chains and diversifying away from simply relying on China and other parts of Asia and Latin America, with the consequent rise in input costs coupled with slower economic growth potentially causing stagflation.
Trend 4: Labour shortages to drive investment in technology
Both private sector firms and public services entities are finding it increasingly difficult to fill vacancies, let alone meet the rising wage demands of those currently employed. By way of example, consider the crisis facing the UK-based National Health Service (NHS) where the system has been virtually brough to its knees by a combination of strikes for better wages and almost 50 000 nursing staff vacancies. Data published by NHS Digital in December 2022 showed 133 400 unfilled jobs across the NHS in England! “Companies, faced with higher costs on the back of labour shortages are having to take a different approach,” said Zangana. He expected labour shortages to accelerate investment into technologies aimed at improving productivity, including artificial intelligence (AI) and robotics.
Trend 5: Response to climate change is accelerating
The global response to climate change remains top of mind among investment managers who are keen to lock in any return dividend as the world migrates from fossil fuels to green energy. Unfortunately, the infrastructure investments required to facilitate this transition will prove inflationary over the short- to medium-term. “The energy transition process requires greater investment in new technologies and new forms of energy which are more expensive than traditional fossil fuels; governments are also going to have to introduce more legislation and increase taxes in order to encourage individuals and companies to shift away from fossil fuels,” Zangana said. Shortages of the key raw materials required to build green energy infrastructure could cause the cost of the energy transition to rise exponentially.
Conclusions and macroeconomic outcomes
Asset managers and financial advisers must consider the impact of each of the aforementioned trends on the various asset classes they invest in. The first observation is that high inflation is likely to persist for longer than initially anticipated. As such, investors can expect tighter monetary policy through higher interest rates in addition to reduced liquidity and quantitative tightening. Put another way, central banks are going to prioritise lower inflation rather than supporting economic growth, while governments will push ahead with fiscal initiatives in spite of record debt levels.
Schroders warned about increased volatility, both in a macroeconomic sense and also in financial markets, as populism continues to rise. They predicted a ‘full reshaping’ of global supply chains and energy policy during 2023. “Investors really need to think about what happens to supply chains and be nimble in thinking about past relationships and how they will change going forward,” Zangana said. “And finally, we can expect more investments in technology to support profitability … substituting away from the cheap labour that we enjoyed for many decades now”.
Recession seems a certainty…
Tougher monetary policy looks certain to overlap with recession in much of Europe and the US. “We expect to be hitting recession signals in the second quarter of 2023, which suggests that there is a bit more work to do in terms of [a fall in] equity prices before we can turn bullish,” noted Johanna Kyrklund, Co-head of Investment and Group CIO at Schroders. This bullishness would likely coincide with the start of the recession, with the caveat that emerging desynchronised economic models will create equity opportunities in different regions.
As for bonds: “We have upgraded our view on fixed income markets and have been taking advantage of the yield spread in credit and emerging market debt; we think there is a significant cushion in [these classes] after the declines of 2022,” she concluded.