Introduction
We have been struck by the number of clients who want to engage in a debate about strategic return forecasts. These discussions go beyond merely questioning return assumptions, frequently touching on changes needed to the methodology of forming those assumptions. We assert that the post-pandemic world constitutes a new economic and investment regime, implying that the structure of strategic forecasts should change. Huge macro changes at work are likely to determine the investment landscape in coming decades: deglobalization, a shrinking global workforce and climate change. This note attempts to sketch out a provisional language for the combined effect these forces will have on capital markets, return streams and strategic asset allocation.
Return forecasts have changed over the last 18 months. That is not controversial: after a 200 basis point increase in real interest rates and a 15% fall in equities, forecasts should have changed. But the intriguing (and more intellectually interesting) observation is that many investors recognize the need to change the structure of the underlying models.
Adjustments to model structure should always be done with caution,1 but we think there is good evidence that the economic and financial regime has changed. We spelled out this case in our recent black books, Are We Human or Are We Dancer? and A Painful Epiphany. If that case holds true, it demands a rethinking of underlying assumptions for capital market forecasts and the resulting strategic asset allocation decisions.
In this note, we focus specifically on the triumvirate of macro mega-forces: climate change, demographics and deglobalization. Each is significant in its own right and subject to varying degrees of controversy in terms of their impact on capital markets.
However, where they are likely to interact in a directionally similar way, their power to shape financial outcomes is sizable. We think this is particularly the case for inflation, growth, macro volatility and margins.
None of these forces were caused by the COVID-19 pandemic—they were set in motion before that. Nevertheless, we suspect that history may well treat the pandemic as the marker for a regime break. The after-effects of the pandemic have had significant implications for many of the macro transmission mechanisms we identify that relate to these macro forces, including shocks to supply chains and labor participation. However, the excess liquidity and its subsequent withdrawal—features of the pandemic response—have so far masked the longer-term implications for these variables.
Here's a brief overview of the mega-forces we will discuss in this note:
Demographics: The global population of working-age people has peaked, excluding Africa and South East Asia (although the latter is forecast to peak later). The number of workers is set to decline in the coming decades, and to do so even faster in China than in the West. A decline in the number of workers implies a decline in real growth, unless there is a sustained increase in productivity. This mega-force also shifts the balance of power between labor and capital (subject to the level of automation that can be achieved), which will be inflationary.
Climate Change: Climate change, in addition to its other effects, also plausibly reduces growth rates. However, its more tangible impact will be increasing the heterogeneity of growth outcomes among regions, which has implications for migration and other second-order effects through its impact on politics. It will also likely be a significant force in directing capital investment. The cost of the energy transition will likely be inflationary in the medium term, though in the long run could plausibly be deflationary. Government spending on the energy transition could boost growth and offer one of the few offsets to the downward growth forces we will highlight in this note.
Deglobalization: This mega-force will likely continue, because two mutually reinforcing pressures point in the same direction: 1) dissatisfaction with globalization in the internal politics of developed economies and 2) hardening relations between the US and China. This process is likely to be inflationary, fragmenting the global labor supply and forcing a rethinking of supply chains.
Deglobalization also puts downward pressure on growth rates and margins, and plausibly puts upward pressure on risk premia.
All this implies that long-term equilibrium assumptions for inflation, growth and margins should change, which in turn implies a need to change strategic asset allocation. The nature of that change depends very much on the nature of liabilities, but for investors who must maintain purchasing power and generate a real return, it demands higher risk levels. What makes this task even trickier is that the macro forces we describe here imply an elevated equilibrium level of macro uncertainty and a dampened ability for bonds to diversify equity risk. This logically sets up an inevitable clash between risk defined as the volatility of a portfolio and a definition of risk rooted in the possibility of a hardship outcome for beneficiaries, such as individuals saving to meet the cost of retirement—a cost set in the real economy.
The strategic asset allocation implications are that inflation protection will remain important, not merely a cyclical need. Despite falling growth rates and margins, there is still evidence that equities can deliver positive real returns and be a key anchor for many portfolios. Accompanying that equity position should be a selection of assets that deliver an attractive trade-off between real return and diversification, including private assets and factor strategies.
The net effect of these mega-forces on real yields is ambiguous. At the very least, we do not expect real yields to be higher over strategic horizons, making inflation-protected bonds a part of this allocation. A possible exception: if sovereign risk starts to be repriced significantly.
Beyond the issue of portfolio allocation, these forces raise profound questions around the nature of retirement and the best way to try and preserve it in a very different economic regime. There are also questions about the nature of capitalism. The so-called “late-stage capitalism” of recent decades has been typified by three characteristics: high returns on financial assets versus real assets, a preponderance of capital over labor when it comes to bargaining power, and an unprecedented gain in the power of corporations versus governments. Whatever we call the next regime, we think all three of these defining characteristics will be overturned by the triumvirate of macro forces laid out in this note.
