Expect more inflation, more debt, slower growth and higher rates to define the new regime.
Adapted from a guest lecture at Stockholm School of Economics-Riga, delivered 11.28.22.
We think the trend in globalization peaked in 2008, at least the most recent push in this direction. We also believe this foreshadowed the climax and now end to an investing regime that we have seen crumble over the last year or so. At the same time as trade barriers were coming down between countries over the last decades, we saw the march toward centralization of economic control progressing strongly inside countries and trading blocks. The Treaty of Lisbon (EU), Xi's consolidation of power to leader for life (China) and continued expansion of federal rules of control and influence in the United States, all conspired to create less free internal structures in these zones, quite possibly in partial reaction to the effects of the global trade free-for-all punctuated by the China WTO entrance in 2001. Or maybe it was the shock of the Global Financial Crisis, where the interconnected global system's fragility was first laid bare. The zenith of this globalization trend has generally left the world more leveled out economically but with greater inequality of income inside the biggest economies. The world also finds itself with debilitating levels of debt across nearly all geographies, the residual of two crises in the last 20 years and the acceptance of the orthodoxy of credit and spending as the primary tool to run economies and solve all sorts of societal ills.
In critical areas such as advanced semiconductor devices (chips) and energy, reaction among the governing circles has been to put up incremental fences and aggressively spend with line of sight to building regions independent from sources of supply that have now been deemed unreliable, unsavory or both. The war in Ukraine has brought this to the forefront in Europe, especially with regard to energy but advanced semiconductor manufacturing as well. At the same time, the "one world" crowd pushes back, still trying to use or make up crises in order to justify a centralized, extra-national view on how problems should be solved. For every problem that arises in the EU, the default position in Brussels is more centralized control, not less. In all, we think the old regime in which investors operated over the past 4 decades, with its more extreme manifestations in the last 20 years, is fading fast into the rear view mirror. To say that an entire generation of senior investment managers have come of age with the Fed put, no inflation, near friction-less global trade and an obsession with China's pull on the global economy makes them ill-prepared for the likely environment going forward, is an understatement. Before the current equity bear market is done we expect the permanent optimism of equity players needs to be broken. We do not believe this has happened yet.
Make no mistake, our interpretation is that we are in the midst of a point of departure in the overall regime in which investors must operate. To contextualize our views on the future, it is best to first describe the past and where it has left us.
Where Have We Been? The Secular is Cyclical
How to define globalization? We think one good way is reflected in the chart below, tracking exports as a % of GDP for the world. This is as good as any measure to show the degree of trade friction present between countries. The chart below takes the last 110 years or so and shows us a couple things. First, the trend in export volumes has not always been positively sloping, the first half of the 20th century was the story of markets closing off, war and experiments with non-market economies on a grand scale. The second half of the century saw a great re-opening of trade with the dissolution of the Soviet bloc and the opening of the great population center of China. Post the WTO entrance of that country at the turn of the century, the trend went nearly vertical, coming to a halt at the Global Financial Crisis.
The by-product of the free-trade environment was an economic growth environment that was overall positive but varied substantially by country and region. Multinationals based in developed markets saw profits boom with increased access to large and growing new markets, along with profit expanding manufacturing shifts. Developed market aggregate economies saw much slower relative growth. The pressure on labor inside these countries has been building for decades, really starting in the 1970's as the Asian powerhouse economies began asserting themselves with their cost and quality advantages. The addition of China as a manufacturing hub with its WTO entrance in 2001 provided one last push with wages' share of national income in the US taking another leg down. This should make it unsurprising that labor will assert itself for more compensation, especially with the stimulus-induced inflation driving real wages negative at a rate not seen for 40 years.
Where Are We? Leveraged, Financialized and Integrated
So where has all this free trade and manufacturing repositioning left the world? It is true numerous countries have benefited as a source of inexpensive labor to feed a debt fueled consumption engine in developed markets, along the way bringing their workforce up and to the right in terms of economic station. That said, what has been the cost to the consuming nations from which relatively expensive labor was hollowed out?
Look to the chart below to see the pressure on manufacturing employment in the US over time. This goes hand in glove with the pressure on overall wages as a share of the national income and shows how the economy has become more financialized and less production oriented. It also shows that the days of holding the wage inflation ball underwater are nearing their end.
To fuel economies the apparent tool of choice has been to accumulate debt to levels not seen before. Additionally, the liquidity released into the economy has fueled financial asset inflation well before it fed the breakout in CPI inflation through the stimulus packages of the last several years. These stimulus packages were particularly inflationary as the Federal Reserve literally lost control of the money supply as payments were made directly to citizens, with a complete end around of the commercial fractional banking system. What sort of misallocation of capital has played out with financing rates held artificially low and free money will be hard to know. The following series of charts show the expansion of US debt financing to international creditors, a US and global debt position ridiculously bloated and equity markets that have been supported by liquidity and stimulus spending, not earnings potential or attractive starting valuations. Our interpretation of this level of debt is it decreases degrees of freedom in the economy in the aggregate and just as in an individual company, necessarily serves as an overhang on growth as the call on capital is overwhelmingly to those senior in the capital structure. Further, the central bank as buyer pushes such an expansion of the monetary base with its debt purchases that the inflationary impulse is nearly inevitable as we have seen recently.
Economies over the last several decades have become more integrated across the world. What had previously been substantially less correlated economic performance had offered some diversification benefits of owning positively returning yet lowly correlated assets. If we believe there is a link to the performance of a given country's economy to its investable equity market, we could posit an increase in correlation among international equity indices to the US market. In fact, in work published by the CAIA in 2021, correlations of the US to Europe and Asia ex Japan indices steadily increased from the 1990's and peaked at the GFC in 2008. So, while they are off their highs, correlations remain measurably higher than in the 1990's. To the extent this has made garnering index level diversification benefits more difficult due to this increased correlation, we wonder whether a lower synchronization of economics due to regionalization and trade barrier construction will change this math. Lower synchronization could actually provide opportunities to more robustly select positively returning yet low correlated markets to improve risk/return inside a global weighting in equities.
The last graphic we show to orient ourselves is related to the increasing internal restriction of commercial freedom through more rules and regulations to which corporate actors must adhere. While this rule setting varies somewhat by administration, the overall direction of cumulative significant rules is higher and has been for some time. We show statistics for the US, we suspect it would be similar for the EU.
Where Are We Going? Forecast Direction not Destination
If this is indeed a point of true lasting change in an investing regime, not just a bear market, what new set of operating rules might investors face as they deploy assets? The factors we list will not only have an influence on cross asset returns over time but will likely affect the volatility structure inside many of these markets. The points we raise are long term in nature but we believe powerful and in most respects, different than what we have faced over the last four decades. We find it interesting but not that helpful that for many forecasters of equity returns, these long-term issues and their effects on returns seem to be ignored. This makes no sense as equities and specifically technology stocks, the drivers of the overall index for some time now, are by definition long duration assets where what we pay for them is deeply informed by our views on events many years into the future.
Looking Ahead at the High Probability Outcomes that Change the Regime
Slowing secular growth as major economies face a shortage of people. Birth rates have been declining for some time and we will see absolute declines in working age populations from now onward. Japan is already experiencing this. Qualified technical labor is already the major resource constraint for regions in creating self sufficient technology ecosystems.
Politics of internationalism will be increasingly challenged by individual and sovereign forces-conflicts with the global “south” remain likely. Look no further than energy/climate transition negotiations to see this dynamic at play on global issues. We expect this remains a part of the state of play going forward.
The “carrot” of China has been replaced by a “stick” and technology, food and natural resources have become security issues. Look no further to the current American administration's technology trade restrictions to see one stick responding to the other's poke.
Economic refugee migration will constitute security, political and cultural risks. In reality, this is already an issue across numerous developed markets, we think it does not resolve itself and remains a source of political volatility.
The great 40-year bull market in US rates and equities will give way to lower return outcomes across risk assets and bonds over time, fading moral hazard. For asset allocators focused on time frames greater than the popular media talking point of one year, forward compound return expectations should be tempered. Consider the valuation starting point for risk assets currently remains high, the forward macroeconomic outlook is subdued, more government meddling in trade is likely to cause sustained higher inflation and debt levels are high. Coming off of several decades of over-stimulative monetary and fiscal policies is not necessarily the time to over-allocate to risk assets.
Governments will increasingly look to industrial policy solutions to politically unappealing societal outcomes. As governments globally have gradually asserted intended control in management of their economies and we would argue, cultures, issues such as access to technology, income inequality and other societal challenges will be necessarily met by more government, not less. This trend toward central government socialization of societal problems is ultimately a growth inhibitor due to the central tendency of governments to misdirect capital and manage through friction-creating regulations.
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