Strategic Asset Allocation in a Changing Economic Landscape: Insights and Implications
Three overarching forces are poised to shape the investment landscape for the foreseeable future, with profound implications for macroeconomic conditions and portfolio strategies. These forces—climate change, demographic shifts, and deglobalization—are individually significant, but their convergence could dramatically reshape financial outcomes, presenting investors with a new set of challenges.
Macro Forces and Their Influence on Economic Growth
Primarily, these mega-forces are expected to contribute to a lower baseline level of economic growth. Below is a brief examination of each force and its potential impact on growth prospects.
Demographics: The global workforce has reached its zenith and is anticipated to decline in the coming decades. While increasing labor participation could mitigate this decline, the proportion of individuals capable of extended careers is limited. Efforts to raise retirement ages have met with controversy. Additionally, the escalating demand for long-term care may impede productivity by diverting resources away from research, development, and infrastructure. Artificial intelligence (AI) holds promise in enhancing productivity, offering a potential counterbalance to demographic challenges.
Climate Change: Assessing the growth implications of climate change is complex due to a multitude of variables, including rising temperatures, migration patterns, and resource conflicts. Focusing solely on temperature rise suggests a potential dampening effect on growth, albeit with significant disparities across regions and countries. Poor nations are particularly vulnerable to adverse impacts. However, investments in energy transition, supported by government spending, could partially offset these negative effects. Yet, the overall impact is expected to be modest and contingent on sustained global capital investments.
Deglobalization: The ongoing retreat from globalization, fueled by domestic discontent in developed economies and strained relations between major global players like the US and China, is likely to persist. This trend is anticipated to exert downward pressure on growth rates and corporate margins. Deglobalization manifests through reduced trade, fragmentation of the global workforce, and limited capital mobility, potentially leading to political instability and geopolitical tensions. Although some countries may form trade blocs, overall, deglobalization casts a shadow over the growth outlook.
We frequently receive inquiries about whether the advent of AI could enhance productivity sufficiently to counterbalance these macroeconomic forces. While it's a possibility, any such impact would need to be at the upper end of historical improvements seen under various economic conditions. Thus, incorporating such expectations would represent a significant shift.
Expectations of Higher Inflation over a Strategic Horizon
From our perspective, all three mega-forces have direct implications for inflation, with both inflationary and deflationary pressures exerting influence over strategic timeframes. The impact of demographics is subject to vigorous debate, often exemplified by Japan's experience of rapid and sustained aging followed by deflation. However, this example is relatively isolated; in the coming decades, nearly all regions are expected to undergo similar demographic shifts.
Deglobalization is anticipated to increase labor bargaining power and emphasize the social aspect of ESG, implying a trajectory of higher wages. Furthermore, it may boost inflation by curtailing firms' ability to exploit labor-cost differentials and by unraveling aspects of the supply chain infrastructure established in recent decades, thereby increasing input costs.
Climate change could drive inflation upward through increased energy input costs and the necessity to finance the global energy transition, although this impact might diminish over time. Once renewable energy infrastructure is established, economies could become less dependent on commodity prices.
While AI introduces potentially deflationary pressures, we maintain our view that equilibrium inflation will remain above pre-pandemic levels, considering the influence of other significant macro forces pointing toward higher inflation.
The Link between Government Debt Burden and Mega-Forces
In addition to the mega-forces outlined, the question arises of whether governments will attempt to monetize their debt. Although this pertains to future policy decisions and is somewhat distinct from other forces impacting inflation, there exists a connection.
Thus far, the substantial accumulation of public-sector debt in developed economies has not posed significant issues, as favorable demographics and deglobalization have contributed to lowering debt costs. However, with rising debt costs, sustainability could become a pressing concern.
Macro Volatility Likely to Increase
The pre-pandemic period witnessed an unusually sharp decline in macroeconomic volatility, particularly regarding inflation. If part of this decline was due to globalization cushioning against inflationary shocks, we anticipate a return to a somewhat higher level of inflation volatility. GDP volatility has been more sporadic but generally below pre-pandemic averages.
The forces we've discussed suggest a tendency toward higher macroeconomic volatility. This is partly due to the anticipated increased role of governments in post-pandemic economies, heightened political uncertainty from migration, and the heightened risk of extreme weather events. Additionally, the demise of the post-WWII US-led order implies greater economic risk.
Declining Margins... with More Impact on the US
Corporate profitability, especially in the US, has been notably high. While there's a cyclical aspect to this trend, there likely exists a structural component as well. Over the long term, we see no compelling societal rationale for maintaining the elevated margins of recent years, though AI could potentially delay the process of mean reversion.
Key factors likely to influence this trend include increased bargaining power among labor, a rise in effective corporate tax rates, reduced efficiency and knowledge transfer due to declining global trade, and a diminishing impact of mega-cap efficiency on cap-weighted corporate margins. Consequently, we anticipate a decline in the after-tax profit share in the US, reverting back to its long-term average. While other regions and countries have not experienced the same sustained increase in profit share, suggesting a weaker case for downward mean reversion elsewhere, the US stands to lose more in terms of profit share.
Expectations for Real Interest Rates
Given our outlook of lower economic growth, real interest rates, which reflect expectations of future economic performance, are likely to remain very low. While the retirement and savings drawdown of Baby Boomers could potentially exert upward pressure on rates, this may be offset by factors such as the younger cohorts' greater need to save and wealth accumulation in Asia, particularly in China, which has historically pushed yields down. While there may be significant cyclical fluctuations in real rates, the collective forces at play suggest that investors should not anticipate a secular rise in real yields. Overall, our view is that real interest rates will likely remain very low.
Implications for Strategic Asset Allocation
An environment characterized by higher, albeit anchored, inflation, lower economic growth, and reduced margins necessitates a strategic response in asset allocation. For investors with known nominal liabilities, the recent yield increase presents an opportunity to reduce risk. However, investors seeking to safeguard the purchasing power of their liabilities may need to assume more risk.
In a baseline scenario, equities are expected to deliver a positive real return, despite lower real growth and margins. Higher inflation underscores the importance of diversifying into other real assets, such as inflation-protected bonds, commodities, infrastructure, and real estate. Consequently, equities should remain a core holding for investors aiming to preserve the purchasing power of their portfolio. Diversification and exposure to alternative return sources, such as private assets, can complement equity positions.
In a favorable outcome, returns may be dampened compared to the pre-pandemic era, but equities are still expected to provide positive returns, albeit with lower growth and constraints on risk premium compression. Conversely, the worst-case scenario entails stagflation, where inflation rises, real growth declines, and risk premia increase, resulting in neither equities nor nominal bonds enhancing portfolio returns. In such circumstances, a more aggressive shift into physical real assets, gold, and inflation-protected bonds may be warranted. Additionally, factor strategies, such as free-cash-flow yield, should be considered.
It's important to note that the views expressed here do not constitute research, investment advice, or trade recommendations, and they may be subject to revision over time.
Click here to know more about AB’s approach to responsibility.
Macro Forces and Their Influence on Economic Growth
Primarily, these mega-forces are expected to contribute to a lower baseline level of economic growth. Below is a brief examination of each force and its potential impact on growth prospects.
Demographics: The global workforce has reached its zenith and is anticipated to decline in the coming decades. While increasing labor participation could mitigate this decline, the proportion of individuals capable of extended careers is limited. Efforts to raise retirement ages have met with controversy. Additionally, the escalating demand for long-term care may impede productivity by diverting resources away from research, development, and infrastructure. Artificial intelligence (AI) holds promise in enhancing productivity, offering a potential counterbalance to demographic challenges.
Climate Change: Assessing the growth implications of climate change is complex due to a multitude of variables, including rising temperatures, migration patterns, and resource conflicts. Focusing solely on temperature rise suggests a potential dampening effect on growth, albeit with significant disparities across regions and countries. Poor nations are particularly vulnerable to adverse impacts. However, investments in energy transition, supported by government spending, could partially offset these negative effects. Yet, the overall impact is expected to be modest and contingent on sustained global capital investments.
Deglobalization: The ongoing retreat from globalization, fueled by domestic discontent in developed economies and strained relations between major global players like the US and China, is likely to persist. This trend is anticipated to exert downward pressure on growth rates and corporate margins. Deglobalization manifests through reduced trade, fragmentation of the global workforce, and limited capital mobility, potentially leading to political instability and geopolitical tensions. Although some countries may form trade blocs, overall, deglobalization casts a shadow over the growth outlook.
We frequently receive inquiries about whether the advent of AI could enhance productivity sufficiently to counterbalance these macroeconomic forces. While it's a possibility, any such impact would need to be at the upper end of historical improvements seen under various economic conditions. Thus, incorporating such expectations would represent a significant shift.
Expectations of Higher Inflation over a Strategic Horizon
From our perspective, all three mega-forces have direct implications for inflation, with both inflationary and deflationary pressures exerting influence over strategic timeframes. The impact of demographics is subject to vigorous debate, often exemplified by Japan's experience of rapid and sustained aging followed by deflation. However, this example is relatively isolated; in the coming decades, nearly all regions are expected to undergo similar demographic shifts.
Deglobalization is anticipated to increase labor bargaining power and emphasize the social aspect of ESG, implying a trajectory of higher wages. Furthermore, it may boost inflation by curtailing firms' ability to exploit labor-cost differentials and by unraveling aspects of the supply chain infrastructure established in recent decades, thereby increasing input costs.
Climate change could drive inflation upward through increased energy input costs and the necessity to finance the global energy transition, although this impact might diminish over time. Once renewable energy infrastructure is established, economies could become less dependent on commodity prices.
While AI introduces potentially deflationary pressures, we maintain our view that equilibrium inflation will remain above pre-pandemic levels, considering the influence of other significant macro forces pointing toward higher inflation.
The Link between Government Debt Burden and Mega-Forces
In addition to the mega-forces outlined, the question arises of whether governments will attempt to monetize their debt. Although this pertains to future policy decisions and is somewhat distinct from other forces impacting inflation, there exists a connection.
Thus far, the substantial accumulation of public-sector debt in developed economies has not posed significant issues, as favorable demographics and deglobalization have contributed to lowering debt costs. However, with rising debt costs, sustainability could become a pressing concern.
Macro Volatility Likely to Increase
The pre-pandemic period witnessed an unusually sharp decline in macroeconomic volatility, particularly regarding inflation. If part of this decline was due to globalization cushioning against inflationary shocks, we anticipate a return to a somewhat higher level of inflation volatility. GDP volatility has been more sporadic but generally below pre-pandemic averages.
The forces we've discussed suggest a tendency toward higher macroeconomic volatility. This is partly due to the anticipated increased role of governments in post-pandemic economies, heightened political uncertainty from migration, and the heightened risk of extreme weather events. Additionally, the demise of the post-WWII US-led order implies greater economic risk.
Declining Margins... with More Impact on the US
Corporate profitability, especially in the US, has been notably high. While there's a cyclical aspect to this trend, there likely exists a structural component as well. Over the long term, we see no compelling societal rationale for maintaining the elevated margins of recent years, though AI could potentially delay the process of mean reversion.
Key factors likely to influence this trend include increased bargaining power among labor, a rise in effective corporate tax rates, reduced efficiency and knowledge transfer due to declining global trade, and a diminishing impact of mega-cap efficiency on cap-weighted corporate margins. Consequently, we anticipate a decline in the after-tax profit share in the US, reverting back to its long-term average. While other regions and countries have not experienced the same sustained increase in profit share, suggesting a weaker case for downward mean reversion elsewhere, the US stands to lose more in terms of profit share.
Expectations for Real Interest Rates
Given our outlook of lower economic growth, real interest rates, which reflect expectations of future economic performance, are likely to remain very low. While the retirement and savings drawdown of Baby Boomers could potentially exert upward pressure on rates, this may be offset by factors such as the younger cohorts' greater need to save and wealth accumulation in Asia, particularly in China, which has historically pushed yields down. While there may be significant cyclical fluctuations in real rates, the collective forces at play suggest that investors should not anticipate a secular rise in real yields. Overall, our view is that real interest rates will likely remain very low.
Implications for Strategic Asset Allocation
An environment characterized by higher, albeit anchored, inflation, lower economic growth, and reduced margins necessitates a strategic response in asset allocation. For investors with known nominal liabilities, the recent yield increase presents an opportunity to reduce risk. However, investors seeking to safeguard the purchasing power of their liabilities may need to assume more risk.
In a baseline scenario, equities are expected to deliver a positive real return, despite lower real growth and margins. Higher inflation underscores the importance of diversifying into other real assets, such as inflation-protected bonds, commodities, infrastructure, and real estate. Consequently, equities should remain a core holding for investors aiming to preserve the purchasing power of their portfolio. Diversification and exposure to alternative return sources, such as private assets, can complement equity positions.
In a favorable outcome, returns may be dampened compared to the pre-pandemic era, but equities are still expected to provide positive returns, albeit with lower growth and constraints on risk premium compression. Conversely, the worst-case scenario entails stagflation, where inflation rises, real growth declines, and risk premia increase, resulting in neither equities nor nominal bonds enhancing portfolio returns. In such circumstances, a more aggressive shift into physical real assets, gold, and inflation-protected bonds may be warranted. Additionally, factor strategies, such as free-cash-flow yield, should be considered.
It's important to note that the views expressed here do not constitute research, investment advice, or trade recommendations, and they may be subject to revision over time.
Click here to know more about AB’s approach to responsibility.
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