- Head of Multi-Asset Strategy
Switzerland, Institutional
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In his recent Top of Mind publication, Multi-Asset Strategist Adam Berger contemplated a series of potential macro and market outcomes, on topics ranging from inflation to an equity bear market to regulatory risk in China.
One what-if scenario — a Russian invasion of Ukraine — has of course already unfolded before us. Adam believes geopolitics will be a meaningful source of volatility in the near term, but the bigger risk of the conflict — for markets — may be that the inflationary impact of rising energy prices and the growth impact of sanctions will make it harder for the Federal Reserve and other central banks to navigate policy and engineer a “soft landing” in the economy. He remains optimistic that policymakers can adjust both policy and rhetoric to slow inflation without cutting off growth, but there is undoubtedly more risk than there was in late 2021. For more insights on the Ukraine situation, visit our collection of content, which we’re updating regularly
Below, Adam follows up with quick takes on 10 additional topics asset allocators have asked about, including labor shortages, cryptocurrencies, the IPO market, and long-term capital market assumptions.
1. What if we continue to see a lack of participation in the labor force?
I see this as a real risk in the near term, although I think it will abate in time. Weak US labor supply could come from a combination of baby boomers who may have used COVID as a reason to retire earlier than planned; younger workers who use their stimulus checks to take some “time off”; and perhaps others who adjust the nature of their work after an extended “hybrid” or “work from home” COVID experience. In addition, my colleague Macro Strategist Mike Medeiros has noted that along with these COVID-related/cyclical factors, there are some structural factors at work, including an immigration shortfall of about 3.2 million workers over the past five years.
This combination of factors may drive wage inflation in the near term, but in the longer term, I suspect there is a deep pool of “shadow” workers (including, perhaps, some “retired” baby boomers) who will reenter the labor force if wages rise or their cost-of-living increases (or both).
2. What if we reach the satiation/”pain” point for the end-consumer on goods inflation?
I think we have some room here, given US wage pressures and household savings from last year’s stimulus payments. I am also optimistic that consumers will view inflation as relatively transitory and linked to COVID-induced supply challenges and (if we see more inflation in 2022) a post-COVID excess of demand for services (dining, travel, entertainment) that people postponed during lockdown. Higher energy prices in the wake of Russia’s invasion of Ukraine may compound this risk, but I believe this will also be seen as a one-off event rather than part of a broader pattern.
The risk is that consumers start to incorporate persistent, long-term inflation of 3% or more into their plans, in which case behavior might change and the risk of a wage-price spiral would increase. But I think we could survive episodic high inflation prints of even 5% or more through 2022 without that worst case coming to pass. I’m more worried that overly easy monetary and especially fiscal conditions could keep inflation going into 2023 or beyond. There is also a risk that consumers with lower incomes (and others who needed to use any stimulus benefits received during COVID) will be more vulnerable to near-term inflation.
3. What if a developed economy integrates cryptocurrency-based payments into the broader economy?
I think this represents an opportunity for blockchain technology and innovative companies in the payments sector, as I believe this would only happen with cryptocurrencies that are in some way sponsored/endorsed/issued by a domestic central bank. That type of shift would unlock a realm of efficiencies in the financial services sector. If a non-government-linked cryptocurrency (e.g., bitcoin) takes hold, there may also be opportunities, but I would be worried about the risks, both technological (hacking of an instrument that has no guarantor or sponsor) and financial (volatility relative to other assets or stores of value). Some of my colleagues have somewhat more bullish views. For example, Ranjit Ramachandran, whose views on cryptocurrencies can be found here, is more bullish on the role “open source” cryptocurrencies could play.
4. What if emerging markets continue to lag developed markets when it comes to COVID reopening?
I worry about COVID’s impact on emerging markets, especially in China, where it’s not clear the “zero COVID” policy can hold — and even if it does, the economic fallout in 2022 could be substantial. My colleague Santiago Millán notes that, to date, there may have been some benefit from China’s policy, as the manufacturing supply chain has held up well and China has gained market share in global manufacturing during the pandemic. The question is whether China delays its exit from the zero COVID policy too long (and these benefits reverse) or perhaps whether the exit itself creates a bad economic and/or public health outcome.
I also worry about the challenges the emerging world faces in catching up on vaccinations. The bull case (maybe becoming more of the base case) is that Omicron levels the playing field and allows economies to reopen fully because of herd immunity (although this assumes we don’t see another significant variant after Omicron.) This could be really bullish for emerging markets and could lead to greater economic growth and strong market performance. But if emerging markets end up lagging the developed world in reopening, their markets (debt and equity) might underperform for a year or two while the risk premium investors demand remains elevated.
5. What if the massive flow of capital to private equity continues?
This would not shock me at all, given that asset owners are in need of high returns and, based on my conversations, remain very focused on private equity as a potential source of those returns. But the question in my mind is whether the massive flow of capital might ultimately dampen those returns, with too much money chasing too few opportunities. I think the key message is to be selective. As I discussed in a recent Top of Mind paper, there may be a case for preferring “niche-y” areas in the private market. This could mean seeking out managers who are doing something unique in pursuit of a liquidity risk premium, for example.
6. What if the buoyant IPO market meets a prolonged period of skepticism?
We’ve certainly seen IPOs go in and out of favor, but when the IPO market shuts, it generally doesn’t shut for long or completely. Volume may decline, but strong companies still go public. Overall, I don’t think some slowing in IPO activity would necessarily be a crisis for markets. It’s worth remembering that an active IPO market is typically a source of selling pressure: People are selling something else to buy a new IPO. So absent new capital coming into the market, fewer IPOs means somewhat less downward pressure on markets. A slower period for IPOs would also force companies to stay private longer, and they would need more private capital to continue growing — creating an opportunity for investors.
7. What if Republicans take back the US House and Senate in 2022?
This scenario seems very likely based on all the polling data and research I’ve seen. I think the most notable outcome is that it would probably cap the degree of fiscal stimulus still to come. We saw that a divided government was able to come up with ample stimulus during the COVID crisis, but I don’t think we’d see much more, especially if it’s in the midst of an economic rebound. That, in turn, would probably put a lid on one major source of potential inflation risk. So, in that sense, I’m very sympathetic to the view that a divided government would not necessarily be a bad thing for markets and for equity owners in particular.
8. What if China moves aggressively on Taiwan?
Wellington Geopolitical Strategist Thomas Mucha thinks the prospect of an invasion is remote at this point, although, as discussed in his 2022 outlook, he does see a “low but real risk of accidental military conflict” amid elevated tensions in and around the Taiwan Strait. Thomas does not think the recent Russia/Ukraine conflict has increased the likelihood of an aggressive move. He is much more concerned about slowly escalating long-term tensions between the US and China as rival powers. I think global markets would react very poorly to an aggressive move by China, akin to the response to Iraq’s invasion of Kuwait in 1991 — although in this case, I’m not sure the situation would resolve itself as quickly.
9. What if long-term capital market assumptions (CMAs) remain far lower than historical averages?
This is an important question that many asset owners are asking. Our Investment Strategy Team publishes long-term CMAs across two horizons: 10 years and 30 – 40 years. We build these by estimating income (for equities, dividend yield), fundamental growth (for equities, EPS growth), and changes in valuation. Given the variation we have seen historically in 10-year returns, we should not be surprised to see the 10-year forecast below the long-term history, especially when valuations are high relative to history, as they are today. Given our methodology, the 30 – 40 year forecasts are more likely to correspond with long-term historical averages, but even here our expectations of future earnings growth (which may not match the remarkable run in the US from 1920 to 2020) and dividend yield (which is far lower today than the long-term average) can push these forecasts below the long-term history. (As our team explains in a new paper, we also expect climate risks to dampen return expectations for some asset classes going forward.) Of course, the question for asset owners is how to close this gap, a topic I’ll be addressing in an upcoming Top of Mind webcast.
10. What if the long-term impact of federal government borrowing is a greater risk than the market expects?
There is plenty of debate about this question, but at the margin, I think the “solution” to managing our way out of massive government debt is likely to include some degree of future inflation, albeit hopefully not a return to 1970s-style price growth. This thinking factors into my 10-year expectation of 2% – 3% inflation (versus 1% – 2% for the past decade or more) and makes me worry a bit about the possibility of a tail risk that could be worse. Having said that, there’s a plausible argument that if economic growth is higher than the interest rate on government borrowing, debt to GDP can shrink even amid substantial government borrowing — and perhaps that is an alternate approach to reducing our debt burden. (Of course, that scenario assumes we can maintain very low interest rates without sparking inflation.)
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