- Fixed Income Portfolio Manager
Asia ex-Japan, Institutional
Change
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One of the key questions that markets are currently trying to answer is whether central banks will be able to engineer a soft landing for the global economy. While an important consideration, I think investors should not overlook the broader structural shifts that are reshaping the investment landscape in this new economic era. Take for instance the dramatic pickup in all types of corporate capital spending we are witnessing in the US. If sustained, this trend could, in my view, trigger a new industrial revolution in the US and beyond, with major implications for fixed income investing.
A potentially structural story
I think today’s significant increases in capital spending are not a temporary phenomenon but, instead, are being driven by long-term factors such as:
- Rapid developments in AI, which are driving exponential increases in corporate capital expenditure (capex) far above consensus estimates.
- Deglobalization, prompted by escalating geopolitical rivalry — especially between China and the US — and concerns about the fragility of global supply lines.
- Growing demand for power, which is amplified by both energy-intensive AI and reshoring of manufacturing.
- Electrification of the grid combined with a continued drive to invest in alternative sources of energy generation.
- “Revenge” spending on physical assets after a prolonged period of underinvestment where markets favored asset-light business models with a focus on R&D and intellectual property investments.
Impetus for higher economic growth
In combination, the size of these additional private nonresidential investment flows (Figure 1) is such that they could materially alter the course of the US economy. Typically, investment in physical assets tend to have much larger positive multiplier effects on economic growth than the asset-light business models that until now have dominated the market.
Figure 1
It is too early to tell whether this new industrial revolution will materialize, given the long history of false starts in US industrial renaissance and the risk that heightened geopolitical turmoil could derail the global economy. Nevertheless, I see several reasons why, for now, data has been surprising on the upside relative to surveys, including:
- The nature of the capex — The amounts announced already exceed the money spent during the last capex pickup, when shale gas production was ramped up. Based on the amounts committed alone, we can expect an above-inflation growth rate in private nonresidential structure and equipment spending for several years to come. Importantly, some of the mega-caps are able to finance their capex without external funding, thus sidestepping public credit markets as these have become less willing to fund capital-intensive infrastructure projects with long payback periods.
- Productivity gains resulting from AI capex — AI is already delivering productivity gains, with companies reporting return on their investment (ROI) at a much faster rate than was the case for previous technology breakthroughs. This acceleration in ROI, in turn, further reduces the need for external funding.
- The urgency and scale of the investments needed — After a prolonged period of underinvestment, there is an urgent need for physical investments to upgrade aging US infrastructure.
- The resilience of the US consumer — A weakening US consumer would undo much of the additional growth momentum generated by this incipient industrial revolution given how crucial consumer spending is to the overall economy and I am therefore monitoring this risk closely. However, despite some signs of increased vulnerability, consumers — even at the lower income spectrum — appear to be more resilient than markets assume. Consumer balance sheets remain robust, though excess savings are now largely spent, and while AI may eventually lead to job losses, workers’ bargaining power has increased for now, at least. Many consumers also still benefit from the wealth effect of increased house prices, while real incomes are continuing to rise thanks to the drop in inflation.
On balance, therefore, I think the US economy is structurally positioned to deliver higher-than-anticipated growth and that even if a recession were to materialize, it would likely be shallow.
Important implications for monetary policy
This structural growth momentum coincides with still extraordinarily loose fiscal policy and growing public debt levels across much of the developed world. And while central banks have started an easing cycle to support economic growth, inflation remains in many cases above their target and is likely to pick up again. I therefore believe that the yield curve will eventually steepen and that rates will remain at higher levels than markets currently price in as a combination of stubborn inflation and the need for additional government deficit funding will curtail the ability of the Federal Reserve and other developed central banks to cut rates. The eventual adjustment to this reality of what our macro strategists call “the new economic era” — with higher and more volatile inflation and shorter and more pronounced economic cycles — will inevitably entail more volatility.
Portfolio positioning for this new reality
How can investors position for the significant risks and opportunities this new environment brings? There is clearly no uniform answer but one potentially attractive avenue, in my opinion, is to adopt a total return approach that enables dynamic pivots across a wide opportunity set.
Specifically, at this unpredictable stage of the cycle, I think such an approach allows investors to:
- Avoid taking on excessive credit or duration risk while still achieving attractive yields, by taking positions at the shorter end of the curve and away from those segments of the credit market where I think spreads have become exceedingly tight.
- Avoid having to make an “all-or-nothing” call on whether we will see a continuation of growth surprises or move into recession.
- Lean into either scenario. While I am bullish that the growth scenario will prevail, I think such a positioning also offers investors the potential to take advantage of the associated volatility when other market participants may be forced sellers. Such flexibility could be particularly advantageous if we are truly entering a new era of industrialization with the US as its epicenter.
