The global economy saw one of its quickest economic recoveries on record in 2021, bouncing back from the devastating effects of the Covid-19 pandemic that began the year prior. This was due in large part to strong monetary and fiscal policy responses around the world, which helped prevent similar levels of economic scarring that persisted long after the global financial crisis (GFC) of
2008 to 2009.
Unfortunately, this recovery has been hamstrung by an increasing lack of geopolitical stability, upon which the global economy thrives. Pictet Wealth Management, the wealth management arm of Geneva-based Pictet Group, says in its 2022 edition of Horizon that its 10-year view on economies is that higher inflation and moderate growth are “on the menu”, with the macro shocks experienced this year setting the foundation for higher structural inflation.
According to Pictet, 2020 marked the end of a 40-year period of low inflation and disinflation stretching back to the early 1980s, following the oil shocks of the 1970s. This period saw the global economy experience the “Great Moderation” from the early 1980s to 2000, followed by a period of disinflation as it recovered from the GFC.
Pictet believes the global economy has now entered a regime of sustained structural inflation spurred on by the pandemic, which is most visible in the US and UK — countries which also happen to have large current-account deficits.
“In terms of long-term inflation for major economies, compared to the actual average inflation that we experienced in the decade between 2010 and 2019, we are expecting inflation to be higher for most economies — and for some of these economies, the change will be quite significant,” says Dong Chen, Pictet’s head of Asia macroeconomics, at a recent briefing.
He expects average inflation for the US, UK and Euro area to rise to 3.0%, 3.0% and 2.2%, respectively — from 1.8%, 2.2% and 1.4% in the decade prior. China’s inflation is expected to rise 0.3% points to 2.9%, while Japan’s is expected to nearly double from 0.5% to 0.9%.
‘Regime’ of higher structural inflation
Chen, who is responsible for researching the macro-economic outlook and government policies of the Asia-Pacific-Japan region, believes that the global economy is unlikely to return to the “low inflation dynamics” seen before the Covid-19 pandemic. He estimates structural inflation to reach a long-term annual average of 2.8% in the US, compared to 1.8% in the pre-Covid period; and for the Euro area, 1.9%, compared to 1.4% pre-Covid.
He attributes this “regime change” of structural inflation to five drivers: the fading disinflationary effects of the current innovation waves, demographic shifts, the trend towards deglobalisation, the return of “big government” to combat negative externalities, and finally, the energy transition.
Most governments are “determined” to switch from traditional fossil fuels to renewable energies. “This will require a huge amount of investments in the foreseeable future to produce renewables that tend to be more costly than fossil fuels,” says Chen, noting that the “vast” amounts of investments will be a driver of inflation as the world transitions towards greener energy sources.
The global economy also faces the threat of structural increments to the direct cost of energy as well as to indirect costs, such as carbon pricing and other government incentives to reduce dependence on fossil fuels. US-driven trade tariffs since 2018, particularly focused on imports from China; the global repercussions of the war in Ukraine; and high global transport costs could enhance the trend towards reshoring to limit the vulnerability of these supply chains.
“Overall, we think that the world economy is probably moving towards a higher inflationary environment,” says Chen, who adds that a consequence of higher inflation is a “long-overdue” change in monetary policy direction towards “normalisation”.
He believes that since the GFC, central banks, especially in developed countries, have been expanding their balance sheets through quantitative easing, pushing policy rates lower as seen most recently during the height of the Covid-19 pandemic.
“There have been discussions of the so-called normalisation of monetary policies for the past several years, but this did not really happen. In some countries, the US for example, it happened for a short period of time before being interrupted by the pandemic,” says Chen. “But we think that with higher structural inflation going forward, this normalisation of monetary policy will probably finally start.”
However, Chen adds the caveat that he believes the process will be “very slow and gradual”, and says that he does not believe interest rates decreasing to levels seen prior to the GFC is a “likely scenario”.
Over the coming decade, Chen expects underlying GDP growth to average 2.0% in the US and 1.6% in the Euro area.
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The “common prosperity” political and economic policies under President Xi Jinping, which have dominated — and slowed — China’s economy and businesses for the past couple of years, are anticipated to continue their momentum. The once red-hot growth of the real estate and Internet sectors will continue, but at a more sustainable pace over the long run, says Chen, who has lowered his average GDP growth estimate for the coming five years to an average of 4.8% a year from 5.1%.
‘Space’ for alternatives
Frederik Ducrozet, Pictet’s head of macroeconomic research, advises that this “regime shift” towards higher structural inflation will have “long-lasting implications” for asset-class dynamics and strategic asset allocation in the next decade. He forecasts average returns for the vast majority of asset classes to be lower, with “safe-haven assets” facing severe erosion of as much as a fifth of asset value while low expected returns leave extra space for alternatives.
Ducrozet warns that investors relying on sources of fixed income could be hit especially hard. “Higher long-term inflation would have consequences for monetary policy. It could also put financial stability at risk, since higher inflation tends to increase the volatility of both macroeconomic data and of the policy response,” he says.
He cautions that returns will be particularly low for so-called “safe-haven” asset classes like cash and core sovereign bonds. Higher structural inflation should also lead to a starker contrast between the expectations for real and nominal returns. “Investors who choose to stay strategically invested in safe-haven assets will have to bear a particularly severe erosion of capital — possibly by as much as a fifth of these assets’ initial value,” adds Ducrozet.
The difference between nominal returns — what investors would expect in terms of the actual money in their portfolios every year — and the real returns — what to expect in terms of purchasing power after inflation is subtracted — is “larger and rising” from previous years, Ducrozet explains.
He expects US cash to deliver average nominal returns of only 1.9% and euro cash only 1.2% in the next 10 years. In real terms, cash could lose more than 1% of its capital value each year, equating to a rate of over 10% erosion in a decade.
To account for this “new environment”, Ducrozet believes that investors will have to reconsider the traditional balanced portfolio of 60% equities and 40% fixed income. This long-held approach has been able to generate almost 10% returns per year but going forward, returns are likely to drop to just 4% to 5%. Investors need to also buffer “room” for policy mistakes amid higher market volatility.
Ducrozet expects developed-market equities to deliver an average annual return of 5% to 6% in nominal terms compared to over 9% in the previous four decades, while corporate bonds are a partial exception as widening spreads should ensure credit
Meanwhile, real assets and private equity — which has historically posted a 15% annual return — should continue to deliver superior returns. However, due to steeper valuations, increasing funding costs and private equity moving towards becoming an “overcrowded” asset class, returns might dip to just 9.2% a year in the coming decade, says Ducrozet.
However, he also notes that a number of real asset classes are still attractive as alternatives to bonds, including real estate, and expects annual average returns of 5.6% from core real estate and 5.9% from core infrastructure, with the bulk of returns generated by yield.
Chinese equities: high risk, above-average reward
To Ducrozet, Chinese equities “stand out” as one of the “riskiest but also best investments” within the overall equities sector. Following the deep corrections over the past couple of years, Chinese equities are now at a better entry point, with an average nominal return of 7.5% per year.
Although owning Chinese equities now comes with a significantly higher geopolitical risk premium as US-China relations remain chilly, Pictet’s view is that owning this asset class is “unavoidable” for investors of emerging markets, given the unparalleled size and depth of the Chinese market. China currently accounts for 30% of the MSCI EM market capitalisation, although onshore shares are only included at 20% of their actual value, he says.
Domestic onshore equity markets alone represent more than US$3 trillion ($4.19 trillion) of market capitalisation, which is roughly three times the size of the entire Indian stock market and 10% of the US market.
Beyond pure size, Ducrozet believes that Chinese equities also exhibit more diversity across sectors than other emerging countries, and given China’s increasing geopolitical sway, international investors will find it difficult to overlook Chinese assets.
Relative to the US and Europe, the potential for growth of the Chinese equities continues to be “attractive”, although investors will have to brace for occasional, but temporary, economic shocks. For investors willing to take on this risk, Chinese equities are a “no-brainer”, says Ducrozet.