Capital Market Line: The Pendulums Are Swinging

A reset of inflationary forces brought about by a mild recession will be front and center in 2023, triggered by 1) the erosion of fiscal demand props, 2) the gradual reversal of Modern Monetary Theory (MMT)-inspired “free money” to pay for the demand props, and 3) receding goods-oriented supply-side constraints. Recall that it was fiscal and monetary props to private sector demand that spiked pricing power, profits, and return on equity (ROE) in 2021 and 2022. This year’s reset involves profitability and inflation. There is a much higher likelihood of a profit recession than an actual economic recession – especially given China’s rapid reopening. For most markets, it’s the growth (or decline) in cash flows that matters, not GDP.

Post-2023, the new balance is unlikely to swing the pendulum all the way back toward the post-financial crisis “Stall Speed” regime or even to the last 40 years of disinflationary forces. If not balanced, the new regime is more likely to lean toward insufficient supply teamed with resilient demand and moderately restrictive monetary policies, as opposed to yesteryear’s powerful supply-led forces and insufficient demand teamed with negative real interest rates and quantitative easing (QE) forever, which we believe will be looked back on as policy errors – perhaps even by market participants who benefitted disproportionately from excessive monetary accommodation.

Supply scarcity is unfamiliar after 40 years of disinflation, led by Volckerism to tamp down the entitled demand of the 1970s in the midst of a then-unproductive world. From there, disinflation forces were driven by a new generation of leaders, such as Deng, Thatcher, and Reagan, intent on leading societies away from socialism back toward more market-oriented policies. The fall of the Berlin Wall opened up the possibility of one global economy, with greater specialization facilitating faster supply-led growth and greater efficiency. China’s entry into the World Trade Organization (WTO) amplified the new era’s technology transfers and labor arbitrage. More of the world’s countries and populations were brought into this new global trading order, greatly alleviating global poverty. Yet demand had a tough time keeping up as a result of income concentration toward best-of-breed companies and countries, ushering in disinflation and expanding margins and return on investment capital (ROIC). While this form of globalism decreased inequality between countries, it simultaneously increased it within many countries, notably the US and China.

While markets are impatiently focused on rapid transitory disinflation, central banks are among those worried about the medium- to longer-term inflationary consequences of many of the longer-term pendulums that are now reversing. These include Russia’s “if you can’t beat them, disrupt them” policies, the escalating US-China rivalry in what could herald a reversal of globalism, and societal shifts resulting from heightened inequality, the pandemic, and demographic trends. A result of these multiple pendulum swings is movement away from income maximization and toward quality of life. To date, lower labor participation and productivity have, unfortunately, been one offshoot. Collectively, these represent supply obstacles that are likely to outlast and outweigh any drop-off in demand after the pandemic stimulus packages and supply-side constraints fully wear off.

Then, there is China. Despite 2023’s dramatic policy reversals, in 2024 and beyond we see China’s geopolitical and economic stances tacking back toward less market-driven principles. We suspect that the desire for common prosperity hasn’t diminished; its path has merely been delayed until the country is on firmer economic footing. Decoupling of US-China technology, supply chains, and currency blocks looks poised to continue. In what could turn into a new Berlin Wall, the economic and market impact would be a stepped-up investment cycle in the medium term, along with longer-term stagflation consequences with lower ROIC.

With regard to decarbonization, Europe is set to accelerate its plans in order to reduce its reliance on Russian energy, with Germany pulling forward its net-zero plans by 15 years. Renewable energy is now a matter of national security as well as climate change. This should lead to a sizeable rise in investment activity at a global level, making this an important tailwind for growth and job creation over our five-year forecast horizon. The annual investment gap to meet net-zero is estimated at $2.9 trillion.

That said, recent spikes in energy prices give a glimpse of the difficulty in assessing and managing the knock-on effects of these policies, and commodity prices may prove to be an important de facto determinant of the “speed limit” of these initiatives. Higher macro volatility may be part of the cost. While ESG is receiving pushback from 2022’s events, ESG 1.0 – which prioritizes excluding offending industries in total, in attempt to cut them off from capital – no doubt contributed to the global misallocation of capital that led to today’s structurally short energy posture.

We see the lesson from 2022 as opening the door for ESG 2.0 to advance, with its new and improved emphasis on a company or industry’s improvements in ESG, rather than merely its current status, as the primary consideration for investment. The difference provides an incentive for improvers, many of which are in industries with prodigious cash flows to invest in cleaner sources of energy amid a nearly $3 trillion investment gap.

With poorer demographics than when the term “secular stagnation” was coined, today’s robust and resilient consumer suggests that post-financial-crisis mortgage paydowns (not secular stagnation), along with chronic fiscal drags, were primarily responsible for last decade’s lethargic demand. Despite a decade’s worth of hangover, it was not secular. The new post-2023 regime looks to be characterized by rebooted demand into pendulum-induced medium- to longer-term supply constraints, teamed with ongoing withdrawals of excess liquidity to mop up the decade of monetary excess.

Our Capital Market Line has flattened out since last quarter, with the left side of our CML rising relative to the right. Fixed income is competitive again, although the regime ahead likely sustains the weakened hedging benefits of risk-free bonds to equities. Within equities, defensive flight-to-safety equities in the US (especially after China’s reopening) will also find renewed competition from other growth assets beyond this year’s profit reset. A return to more traditional monetary practices is likely to frustrate those hoping for the return to high returns amplified by extreme policies. From here it’s up to cash flow growth to drive performance – nothing more.

Capital Market Line as of 31 December 2022 (Local Currency)

Capital Market Line as of 31 December 2022 (USD View, Unhedged)

Please see Capital Market Line Endnotes. Note that the CML’s shape and positioning were determined based on the larger categories and do not reflect the subset categories of select asset classes, which are shown relative to other asset classes only.

Insights From Today’s CML

A flattening Capital Market Line (CML) with a high level of dispersion. The slope of our CML continued to flatten during the quarter. We previously incorporated most of the forward-looking impacts of the new regime on our fundamental forecasts, so the flattening since last quarter has been primarily from price changes. Nonetheless, the persistent withdrawal of liquidity will be an enduring, if moderating, headwind for valuations on a broad basis. Dispersion has also continued to increase after such an unsettling year, making asset class selection all the more important.

Developed market (DM) government bonds are becoming more attractive. As yields have risen to levels not seen for a decade, the relative value of DM government bonds has improved significantly. The fundamental insights from our CML process point to inflation settling in at 2%-3%, higher than after the financial crisis as a result of a tighter labor market and a splitting of global supply chains as companies address rising geopolitical tensions – not the best environment for fixed-rate safety assets. Yet current yields finally provide a positive real yield, and a fading of inflation from current (high) levels will create a more attractive risk/reward profile; this is probably just for 2023 as recession sets in, before the asset class becomes very middling for some time beyond, with real returns post-recession barely above inflation and not providing much hedging benefit.

China’s zero-Covid pivot is expected to support both domestic and global growth. Following a series of protests in opposition to the party’s stringent zero-Covid policies, and amid a new dose of pragmatism acknowledging the economy needed help, the central government has rapidly accelerated reopenings. Despite near-term volatility driven by soaring Covid cases, China’s reopening will support domestic growth and benefit its equity sectors. Looking beyond the next nine to 18 months, however, fundamentals for Chinese equities are likely to be under pressure as policies pivot away from maximizing profits.

Credit assets have become more attractive relative to equities. Credit spreads have widened somewhat, and along with higher yields, they now compete in risk-adjusted terms with many equity markets. This is an improvement versus the previous cycle, when credit spreads remained stapled to the floor. US high yield stands out in this regard, supported by much better credit quality and lower default risk. Asian investment grade bonds also appear attractive, having widened in sympathy with broader credit markets while maintaining one of the most robust fundamental profiles. On the other hand, there is significantly more risk in the leveraged loans and private credit markets.

Equities are challenged by less-generous capitalization rates. The main challenge to equities is an average risk premium today and the likelihood of a higher equity risk premium tomorrow, as excess liquidity is mopped up and profitability resets downward. This repricing drag significantly offsets the contribution of growth to returns. Our ongoing lukewarm outlook for emerging market (EM) growth over the next five years, dragged down by China and deglobalization trends, leaves EM equities looking relatively unattractive still. Commodity producers within EM may be an exception, but ESG considerations mean that a highly selective approach is needed to identify those taking steps to meaningfully improve their ESG profiles.

‘Green commodities’ are structurally attractive. Developments over recent quarters have added incremental demand for commodities in the years ahead. Higher military spending, decarbonization investments, and the rebuilding of Europe’s energy infrastructure are all drivers. Beyond 2023, we see the resumption of slowing demand growth from China – the single largest consumer of commodities – though this in all likelihood this can be offset by the $2.9 trillion investment gap to achieve net-zero. Meanwhile commodity prices remain well supported by the lack of supply growth, as global producers remain very disciplined about adding capacity for financial and ESG reasons. Key metal enablers for the energy transition, such as aluminum and lithium, are particularly well-placed to benefit from secularly growing demand colliding with supply constraints.

The Fundamentals Driving Our CML

A reflationary, more volatile macro regime. The next year will feature a reset of fundamentals triggered by recession, yet this will not swing the pendulum back toward the prior regime. The current cycle will be spent mostly above target on inflation and will challenge monetary policy to walk the tightrope of tightening conditions to bring inflation down to target without causing recession. Such regimes are inherently more volatile. The result may be shorter cycles with longer recessions and less forthcoming policy support due to persistent inflation, and thus potentially deeper drawdowns as well.

Restructuring of supply chains will accelerate. When Covid hit, companies began contemplating diversifying their supply chains, although not much happened at first. After the Russia invasion many companies were forced to write off two decades of investment, and they are now actively seeking to diversify their supply chains away from China toward countries that are closer to end markets and more aligned geopolitically. This restructuring will contribute to a shift in growth rates, particularly within emerging markets, and will have implications for inflation. Labor costs in many EMs are now lower than in China, yet all-in costs may still prove to be higher. Yet decoupling of China from DM economies across strategic sectors is well underway, and while it’s too early to pin down the impact with any accuracy, this could reverse the declining asset intensity and rising ROICs in DMs so evident since the fall of the Berlin Wall. India and Indonesia may well be two beneficiaries of this wave.

From demand deficiency to supply scarcity. Beyond the transitory supply bottlenecks, which are rapidly healing now, other long-lasting supply constraints persist around labor, energy, and geopolitical concerns. These require more redundant but less efficient systems, often in sharp contrast to those of the past few decades. Weaker labor market participation will, if it continues, provide a stubborn floor for service-based inflation. Demand, on the other hand, continues to show resilience that may surprise those in the secular stagnation camp, even despite burgeoning fiscal drags and tightening of financial conditions. This combination will continue to withdraw excess liquidity, challenging most financial assets.

Energy supply will drive the geopolitical calculus and contribute to inflation. Prior to Russia’s invasion of Ukraine, a quiet geopolitical period lulled politicians into taking energy supply for granted, particularly in Europe. Moreover, the noble drive to combat climate change was mismanaged. ESG 1.0 attempted to cut off capital to all constituents within cashflow- generating hydrocarbon industries, even those that were committed to shifting the reinvestment of those huge cash flows toward cleaner sources of energy. A narrow group of opinion leaders, focused too little on the speed of transition paths and the massive capital required, led to dramatic shutdowns of nuclear and coal-fired power before most of that power could be replaced by cleaner sources. Given the extent of today’s disruption, we expect the rebuilding of energy networks to take several years, with Europe incurring substantially higher energy costs and slower growth in the interim.

Acceleration of decarbonization. For the eurozone, decarbonization has become as much a matter of national security as a climate change imperative. Europe is therefore set to accelerate its decarbonization plans to reduce its reliance on Russian energy, with Germany pulling forward its net-zero plans by an impressive 15 years. That said, recent spikes in energy prices give a glimpse of the difficulty in assessing and managing the knock-on effects of these policies, and commodity prices may prove to be an important de facto determinant of the “speed limit” of these initiatives. Higher macro volatility may be part of the cost. ESG 2.0 – which focuses on improvement in ESG – should help to avoid exacerbating the energy crisis.

China will likely pivot back to strategic priorities beyond the immediate growth revival. After pivoting away from zero- Covid policies, policymakers are currently focused on reopening the economy and removing the drags from the real estate and internet sectors. Yet after the economy returns to sustainable growth, we wouldn’t be surprised to witness a pivot back toward the strategic priorities outlined by the party under Xi Jinping: more centralization of control, a larger role for state-owned enterprises (SOEs), and a focus on “common prosperity.” The decisive factor determining China’s growth path is the impact of these dynamics on private sector incentives and confidence, which have been severely dented in the past two years. Internationalization of the renminbi and deepening of ties with Russia and other trading blocs are strategic initiatives that China will pursue more urgently in the coming years.