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2022 has catapulted the global economy and financial markets into a new constellation. It’s a constellation characterised by a level of complexity rarely witnessed in the post-WWII era. The complexity plays out across a fragilisation of the geopolitical power balance, a changing capital-labour dynamic and a digital acceleration impacting public and private business models. We briefly lift the veil on each to comment on their impact on financial markets. The manifestation and visibility of this triptych explains the aggressive correction across asset classes ex-central bank support over 2022. Sustained high implied and realized volatility is a side-effect.
Over the past 5 years, the trade tensions between the US and China have accelerated and now linger on at a higher level than before. The Chinese Belt and Road, global infrastructure initiative, got countered by ill-defined G7 initiatives advanced mainly by the US. However, both initiatives that would restore and provide a globalisation impulse are waning. Given pending recessionary conditions in the US and a growing loss of control over the real estate crisis developing in China, a distinct inward reflex on economic policy becomes visible. Protectionist behaviour is broadening from the base. Cheap labour and cheap goods that resulted from this once mutually reinforcing partnership of the mind is crumbling. A similar picture folds out in the EU through Brexit and a complete break-up with Russia as the energy supplier of choice. Cheap energy has exited over the medium term. The impact lag is long for financial markets but requires a persistent higher risk premium across equity and fixed income markets. Over 2022, we crystallised part of this reality. The persistence of a renewed ‘cold war’ dynamic does not rhyme with inclusive growth objectives called upon by international bodies like to UN, IMF or Worldbank. Expect supply frictions to abate but also to resurface as certain political power balances get disturbed again.
Economic output flows to owners of capital in the form of profits, dividends and rents or to labour, as wages, salaries and extra-financial benefits. Maybe this comes as a surprise, but over the past 100 years, the share of labour versus capital as a % of GDP has been stable, allowing for a certain corridor around both but have been evolving at 70% for labour and 30% for capital. Wage setting dynamics are working against capital. At the same time, capital is obstructed from obtaining an optimal combination of production factors given geopolitical constraints. On the back of a tight labour market, the bargaining power of labour is strong. Salary demands are built on three factors. The starting point for current negotiations is driven by the previous contract and preceding rate of wage growth. Second, the behaviour of headline inflation in the recent past has been extrapolated by the candidate. Third, inflation expectations over the short-term (i.e., 1 year) impact wage expectations. Not necessarily long-term inflation expectations. The combination of the above factors explains persistent wage inflation visible across the economies at 5%+ year-over-year levels. The second-round wage inflation spiral is gaining traction. Only a harsh economic recession can steer towards a reversal. A sudden, unexpected slowdown in employment and a subsequent rise in unemployment can achieve such outcomes. The US non-farm payroll figures on October 7, early November, December and early 2023 will determine the level of terminal FED fund policy rates as well as the time that the US central bank will hold the status quo. Fiscal profligacy is a recipe for disruption and panic as we witnessed in the UK over the past week. UK institutional investors lick their wounds. We give this erratic policy making the idiosyncratic stamp, a one-off, a real experiment that should prevent other governments from making similar choices that fan inflation and cement stagflation.
A successful transition towards a digitally-enabled business model is an essential ingredient in becoming a purpose driven, sustainable and inclusive public organisation or private enterprise. A growing share of new value created in the economy will be based on platform-based business models across financial and non-financial sectors. Embracing a digital transformation will become a differentiator as companies that innovate, keep up with change and become highly resilient will prevail. Such companies might also attract the required talent, provide for a flexible set of working conditions and reach the required scale that protects profit margins. Market beta exposure as a main driver of investment performance will be replaced by security selection. Identification and selection of companies, across equity and credit will define investment success. Country selection and constructing a well-diversified, sustainable government bond portfolio becomes an attractive value proposition.
This triptych of changes has collided over 2022. Result: the performance of the S&P 500 till end September has only been worse in about three instances over almost 100 years. The small and mid-cap Russel 2000 index at -25.7% YtD is tracking 2008 to potentially become the worst year since the index was launched in the late 70s. Within fixed income, the Global Aggregate USD 56 trillion Bond index sits at -19.89% in USD terms. Unseen. The reset that is bestowed on market participants is historic. The silver lining, not easing the current pain, is that longer-term expected bond returns have normalised. The 10-year US Treasury rate averaged 3.92% over the past 30 years…If we extend the lookback horizon by 10 years, we arrive at an average level of 5.22%. Such an outcome would require UK-style policy mistakes. Jay Powell and Janet Yellen know their economic history far too well to succumb to such errors.