Pictet Group
A changed landscape
In the space of no more than three years, we have gone through a series of unprecedented changes that will shape economies and financial markets for a long time to come.
In early 2020, the authorities in major economies pushed through massive fiscal and monetary support to counter the huge upheaval caused by the covid pandemic. After re-opening caused a huge surge in demand (helped by these same massive support packages), central bankers belatedly realised that the economic environment prevailing before the pandemic no longer existed and that inflation was again becoming a major issue. Because the central banks in the US and Europe started late, we have seen since last year the steepest and most rapid tightening of interest rates in history.
On the political side, the Russian invasion of Ukraine in 2022 has modified the geopolitical equilibrium and brought forward the realignment of countries around different visions of the world. Both the pandemic and the war in Ukraine have placed a question mark over the supplies of commodities and products that we previously took for granted. In short, the economic and political framework of the past 10 years is gone. As we look ahead, this implies that any asset allocation based on this framework is doomed to perform badly. Since we do not expect a return to pre-2020 conditions, investors will have to adapt and redefine their allocations.
We see four main factors defining the way forward: households’ excess savings; governments’ large fiscal deficits; the size of central banks’ balance sheets; and disturbing geopolitical tensions.
Our expectation is that high household savings will combine with strong growth in wages (due to labour shortages) to sustain household spending and thereby make it hard to bring inflation back down to its previous level. At the same time, we expect the dire state of public finances to encourage governments to seek new sources of revenues, especially as central banks move to shrink their balance sheets by selling their government bond holdings or letting them mature without reinvesting. Lastly, geopolitical tensions are creating a less integrated world, forcing corporations to rethink and reshape intricate supply and production networks.
Fraught international relations mean that control over the means of production and security of supply have become top priorities for corporate executives, as well as for governments that can no longer rely on former allies. For many observers, recent developments look like a return to a Cold War mentality. But whereas the Cold War involved tensions between blocs centred around two global superpowers – the us and the Soviet Union – today is more complicated, with rivalry between a variety of economic and political blocs in a more multipolar world.
The top priorities today for governments are promoting industrial resilience and energy independence, and building defence capabilities and key new infrastructure. Countries currently lacking in these areas will need to adapt rapidly, implying many years of strong public investment.
Against this backdrop, fiscal incentives are increasingly being used as part of a strategic goal to keep key companies and industries closer to home. Competition between countries to secure and control access to cutting-edge technologies is only likely to increase in the years ahead. From an investment point of view, countries that try to regain industrial prowess when there is already tension in the labour market could increase inflationary pressure unless technology (including artificial intelligence) triggers large productivity gains. For corporations, the costs associated with the reshaping of supply and production networks imply lower profitability and the redirection of cash flows towards new capital expenditure –probably at the expense of equity holders who in previous years were beneficiaries of companies’ profitability through share buybacks and dividends. As well as capital spending, how to attract a dwindling pool of workers could be higher on corporates’ agendas than rewarding shareholders.
The fast rise in interest rates since 2022 will also impact equity investing. This is because the discount rate (the rate central banks charge commercial banks for short-term loans) impacts the present value of any future cashflow. The rise in the discount rate means structurally lower equity valuations going forward. In some countries, the rise in short-term rates since 2022 means that cash instruments look like credible investments again. Meanwhile, a more fragmented geopolitical scene could lead to a reshaping of the monetary order, with the us dollar’s supremacy increasingly being challenged. Investors may see further changes on this front in the coming decade as countries question the us currency’s dominant role in trade and forex reserves.
While equity investing will be challenged by this new environment, the picture is also changing for fixed-income investments. Faced with ever lower nominal yields, investors have in recent years increasingly pushed into riskier fixed-income assets to find attractive yields. But now, the rise in inflation and the resultant rate hikes have made high-quality fixed income attractive again. With inflation and interest rates set to stay higher than in the past, quality investment-grade corporate and government bonds should account for a structurally larger part of both asset allocations and returns without increasing portfolios’ risk parameters. Promising once again decent returns and a degree of portfolio protection, the return of fixed income should be good news for typical 60/40 allocations.
To conclude, the trends identified in last year’s edition of Horizon have accelerated even more, leading to a very different investment landscape that calls for a changed approach to asset allocation. It is only by looking at the long-term changes that we outline and understanding their implications that investors will able to make the best of our forecasts for asset-class returns over the coming 10 years.
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