A handful of major long-term trends have reached a tipping point: economic policy and globalisation; inflation; demographics; productivity; global power relations.
Economic policy and globalisation
Globalisation took off following the fall of the Berlin Wall, China’s admission to the WTO, the rise of container transport and the lowering of import tariffs. These changes allowed western businesses to produce cheaply in Asia and Eastern Europe, and competition in western labour markets increased, keeping wage increases at low levels.
It did not lead to lower consumption. On the contrary, downward pressure on inflation has enabled central banks to lower interest rates and encourage consumers and governments to step up borrowing and consumption. This was a golden period for corporate earnings. Profits rose considerably because wage costs went up less rapidly than productivity growth, and interest charges declined.
Monetary policy became the policy of choice to boost growth in times of negative shocks or low growth. The challenge today is that central banks have already cut nominal interest rates to 0% (or lower), making further cuts increasingly detrimental to economies. Central banks could step up quantitative easing. Based on recent years however, it is doubtful whether this alone will be enough to boost economic growth to any great extent.
As a result, the focus has shifted to fiscal stimulus when it comes to boosting growth. It has a number of consequences:
Governments generally respond more slowly than central banks.
Central banks have a stable inflation target of roughly 2% and – in the case of the Fed – maximum employment. They fine-tuned monetary policy to meet this target, irrespective of who benefits the most. Although different governments have different and changing objectives, they typically aim to increase employees’ wages and benefits, even at the expense of earnings. If their competitive position deteriorates too much because of rising wages, governments can step up protectionism.
Fiscal policy may change after each election, which increases uncertainty surrounding long-term investments.
Not all countries are as efficient. It means more variation between countries in terms of the extent and duration of fiscal stimulus. This will trigger more variation in growth expectations, and more fluctuations in the currency and stock markets.
The growing importance of fiscal policy is particularly challenging for the Eurozone. Without fiscal union, fiscal dominance will lead to greater divergences between the euro countries and ultimately to more tensions.
In this scenario, the role of monetary policy will change into a facilitating role. This means that real interest rates will have to be kept negative and interventions will be required if nominal long-term interest rates rise too sharply. This could be in the form of stepping up bond-buying programmes or announcing yield curve control policies.
Inflation has declined on balance since the 1980s. Increasing monetary stimulus has mainly prevented deflation, and failed to trigger higher inflation for different reasons:
A decline in the velocity of circulation.
International competition sparked by globalisation.
Monetary stimulus funds largely flowed to property and stock markets. Prices of these assets rose rapidly, so did related debts. As a result, a more limited proportion of the monetary stimulus flowed to the real economy.
The shift from monetary to fiscal dominance will change this. For governments, the advantages of boosting wages and benefits far outweigh higher asset prices. In addition, governments will be reluctant to allow fiscal policy to lead to a deteriorating competitive position via higher wages. If this happens, the stimulus largely leaks abroad via higher imports. Consequently, the transition to fiscal dominance will ultimately lead to deglobalisation, more protectionism and less competition in the labour market. We also expect central banks and governments to work together to stimulate the economy via higher investment activity. Here, governments guarantee (part of) the loans to businesses, while central banks ensure that there is enough money to supply credit at low interest rates.
Fiscal dominance and associated political uncertainty could also make it far more difficult for businesses to plan adequately. This could lead to more supply bottlenecks. We also assume that low commodity prices have led to too little investment in new production capacity, putting commodity prices under upward pressure. This, combined with higher wage costs, will create more upward pressure on inflation.
In the coming years, many baby boomers will retire. This means the number of workers compared to the number of non-workers will decline. A contraction of the workforce means that – ceteris paribus – potential growth will be lower. This could lead to more downward pressure on inflation and an even greater urge to step up fiscal stimulus.
Moreover, an ageing population leads to a gradual de-saving process. Over time, this could put downward pressure on asset prices and upward pressure on long-term interest rates.
Higher productivity would be able to help sustain growth amid high debt, ageing populations and deglobalisation. Alas, productivity growth has not been very encouraging in recent years and longer-term growth expectations are lower than the growth achieved in recent years. This will probably require far higher public deficits.
However, some developments could boost productivity growth.
There is considerable progress in the field of robotisation, automated driving and artificial intelligence which will lead to massive productivity growth in the event of large-scale adoption.
Central banks will keep capital costs low, which makes investment in productivity-boosting elements appealing.
The rivalry between China and the US could lead to economic blocks that reduce economies of scale, but it could also lead to a technology war with more innovations.
All in all, it is difficult to have clear expectations in terms of future productivity growth.
Global power relations
For the past decades, the US has been the undisputed world leader, promoting free world trade and the importance of multinational institutions. However, China is increasingly challenging the US on the global stage. According to many political analysts, the question is not whether but when China will assume the leading position in the world. In the past, a change in world leadership almost never happened without conflict. A direct armed conflict between the US and China does not seem likely to us, but it would make an economic or technological war more possible. This will speed up the process of deglobalisation and could affect companies doing business both in China and the US.
Consequences for financial markets
It is these trends that we believe could lead to a different economic and investment climate in the decades ahead. Rising inflation and persistent high public deficits are negative for government bonds. We expect government bond prices in the US and Europe to decline over the next couple of years to decades.
Lower economic growth, where a greater proportion of the economy goes to wages and less goes to earnings, is negative for equities in the longer-term; we expect a prolonged bear market in real terms. This is also in line with the very high valuations for equities at the time of writing, which, from a historical perspective, suggests very low return expectations for the next ten years.
Assets that benefit from increased government expenditure and investment and provide protection against increased political uncertainty and inflation have the best prospects: commodities, gold, inflation-linked bonds, and property. In addition, dollar assets have a relatively large share in global stock and bond indices at this point. The chances are that this will increasingly shift towards a larger share of yuan assets and that the relative performance of yuan bonds and stocks will outperform these dollar assets.
Finally, Europe will face major challenges. If the EMU fails to become a fiscal union, a period of fiscal dominance will lead to greater economic differences and rising tensions. It will be increasingly difficult for the ECB to ease these tensions via a looser monetary policy, especially in times of rising inflation. In this scenario, the collapse of the Eurozone will only be a matter of time, resulting in considerable underperformance of many European assets.