Welcome to the new (retro) era
So, what are the 1970s, and to a lesser extent, the 1980s telling us? They suggest that we are returning to a world characterised by much more frequent and shorter cycles, with inflation that is structurally higher and more volatile. I see the likely road map for the next 10 years following a similar trajectory for two key reasons:
- Deglobalisation caused by geopolitical rivalry, concerns about the fragility of supply chains and the accelerating physical impact of climate change; and
- Bigger labour share of income given governments’ intentions to address growing income disparity.
Both developments imply that inflation is here to stay. As well as being structurally higher, inflation may also be more volatile than in the recent past, meaning that policymakers now face a tricky trade-off between growth and inflation. When growth slows, inflation may, at times, still be high and hard to dislodge without painful adjustments. Central banks will therefore need to make a decision about what outcome they fear the least. The message from all central banks over the last six months is that they want to avoid an unnecessary recession due to overtightening, rather than sticky inflation, thereby increasing the likelihood that inflation is going to remain entrenched in the system for longer.
This new paradigm has unsettling implications for asset prices and the correlation between assets. In particular, with cycles becoming shorter and more volatile, the correlation between equities and bonds is likely to fluctuate, thus reducing bonds’ reliability as a hedging asset in multi-asset portfolios. Asset prices also will have to adapt, and I foresee much more differentiation between countries and even sectors and companies. In my opinion, markets haven't yet accepted the regime transition as they still want to sing from the hymn sheet that they have been using for the last two decades. This behavioural bias implies that investors should brace for potentially disruptive adjustments as markets reprice for the new reality. More broadly, while this new epoch may have a distinctly retro feel, it is unlikely to be a carbon copy of those earlier decades, as demographic change, geopolitical rivalry, climate change and technology are all likely to add further uncertainty and volatility.