Mid-2022 Global Economic Outlook

The new macro mega themes: deglobalisation, inflation and volatility

John Butler, Macro Strategist
Arancha Cano, Portfolio Manager

The world looks very different today than it has for the past 20 years. In our view, the new environment of deglobalisation, higher inflation, greater global cyclicality and consistent volatility will disrupt and drive markets for years to come. Here, we outline these key trends and the resulting investment implications.

The end of globalisation as we know it

After decades of global markets interconnecting, we believe globalisation has peaked and in many ways is now substantively reversing. Developed market incentives are changing as policymakers shift their focus to income inequality and other domestic issues. Moreover, politicians in developed markets are blaming domestic instability and market shocks on various forms of “contagion” (e.g., financial, health and energy), which they attribute to globalisation.

This trend has been evolving since the global financial crisis (GFC) nearly 15 years ago and has been accelerated by the Russia/Ukraine conflict, the COVID-19 pandemic and rising tensions with China. The impacts of deglobalisation are far-reaching, including shifting labor market dynamics, evolving supply chains and financial deglobalisation’s effect on liquidity, savings and wealth transferability across borders. Importantly, as deglobalisation accelerates, we also believe fiscal policy is likely to become increasingly dominant over monetary policy.

Rising (and volatile) inflation

Developed market inflation reached 7.4% in May 2022, the highest rate since June 1982. Crucially, we think this new inflation era is likely to persist. Over the past 10 years, inflation across the developed world has averaged 1% – 1.5%. Looking ahead, we think it is likely to average 2.5% – 3% over the next decade. That may appear to be a small increase, but it adds up.

In addition, although we believe inflation is at or near peak in many countries — as some bottlenecks ease and growth slows — inflation cycles are likely to be more volatile and frequent. It wouldn’t be surprising to see inflation swing up and down in a range from below zero to more than 5%. We also think there is likely to be much greater dispersion in inflation rates at the country level. All of this could drive significant market volatility in the years ahead.

Increased cyclicality

We believe global cycles are likely to be more frequent and violent as there is now an increasingly explicit trade-off between growth and inflation. This environment means central banks are no longer able to be a consistent savior that drives growth. In fact, they will likely lag turning points, meaning they could at times become sources of volatility rather than compressors of volatility.

Since the GFC, slower growth has generally been a signal to buy risk assets, as it usually triggered central bank liquidity. This is less likely going forward, with central banks needing to be very confident they are able to sufficiently control inflation before they act.

In addition, though the cycle is currently turning over, central banks cannot react as they must carry on tightening because of heightened inflation. In this environment, the market must price a higher and higher probability of recession. At some point, the central banks will likely blink, and when they do, it could turn the tide abruptly.

Tallying the investment implications

As investors digest this new reality, they may be underestimating the impact on risk premia. The world of higher inflation, higher cyclicality and much lower cross-border transference of savings signals that risk premia are likely to rise not just a little bit but substantially over the course of the next few years. In addition, localised and idiosyncratic stories will become more important and relative country stories are going to drive opportunities. In our view, this will matter much more than it has over the last 10 years.

In terms of market dynamics, investors have become used to an environment where equities and bonds have a negative correlation, while central banks fuel new gains at every sign of a downturn. But that era is over, in our view. Instead, we think the equity market is going back to pricing cycles and profits. Many companies are facing supply-chain issues, rising costs and the inability to grow revenues. Moreover, we are starting to see price cycles and price correlations breaking down by sectors. Historically, investors have often looked at the S&P 500 Index as one unit, but we are now witnessing different companies and sectors reacting distinctly. Some appear to be significantly pricing in a recession while others are not at all.

In addition, equities are likely to remain very volatile as two key tail risks — potential recessions and rising interest rates — drive markets. However, the return of risk premia and of substantial volatility creates significant opportunities for the active management of equities, in our view. Take European equities, for example, where many investors are currently hesitant to invest. In contrast, we believe Europe has several sectors that are poised to benefit from this kind of nominal world and high inflation.

Bottom line on today’s investment landscape

The world’s markets are rapidly evolving, and many historical relationships are breaking down. As deglobalisation, inflation, cyclicality and volatility drive markets, we believe it is critical to adapt investments to the new reality. In our view, the key trends impacting today’s environment create substantial opportunities for active managers to add value across asset classes.