Written by LGT Crestone Senior Asset Allocation Specialist Matthew Tan
There is no doubt that we are living in “interesting times”. The world around us appears to be changing rapidly and many of the norms and conventions that the global community has taken for granted are being challenged fundamentally. The Future Fund calls this the New Investment Order, and BlackRock has said that we are entering ’a new regime’ of greater macro-economic and market volatility.
In this Observations piece, we outline the key structural shifts in the investment environment that are most relevant to investors, we consider the implications for investment strategy and asset allocation, and outline some actions that investors can take to position their portfolios for a changing world.
Five fundamental forces have underpinned a stable global economy and strong financial market returns for most investors’ careers.
The environment that most investors have experienced since the 1980s (and in some respects, since the end of World War II) has been broadly underpinned by five core dynamics:
1. A unipolar geo-political order led by a pre-eminent hegemon (the United States) which has supported increasing globalisation by providing and enforcing a common framework for co-ordinating global commerce.
2. A conservative libertarian political and policy environment skewed towards laissez-faire policies that prioritised free markets, property rights, economic efficiency, and institutional independence over state intervention.
3. An epochal demographic dividend driven by the ‘Baby Boomer’ generation that supported significant growth in the global working age population.
4. Increasing use of economically efficient fossil fuels to power the global economy.
5. Ongoing technological innovation, including personal computers and the Internet.
The combination of these five forces led to a significant improvement in global economic output and living standards, while also underpinning a “great moderation” in macro-economic volatility and inflation outcomes since the 1980s. These have, in turn, supported tremendously positive returns for investors across a broad range of traditional asset classes.
These decades-long tailwinds are now shifting, creating significant uncertainty around the long-term outlook.
However, in the last decade (and particularly since 2016), these hitherto stable tailwinds have become more volatile as each appears to be transitioning to a new state, with significant uncertainty around where these forces might settle and how they might interact with each other.
The geo-political backdrop is becoming more multi-polar. The US hegemony faces challenges as it reckons with its own relative internal decline, an assertive China, a revanchist Russia, a more independent Europe, and the rise of India and the broader ‘Global South’.
Increased societal inequity, partially driven by the globalisation of the labour force, is driving a shift from laissez-faire policy settings towards those tilted more towards nationalist and/or populist settings.
Demographics (particularly in the developed world) are shifting from a tailwind to a headwind and aging populations may force fewer workers to support more retirees, likely through increased taxes.
Increasing awareness of climate change and humanity’s response to it is compelling us to ‘internalise’ the carbon emissions from our economic activity into our cost functions as we embark on one of the largest and most challenging energy transitions in our history.
The one bright spot remains the potential of technological innovation, including in areas such as green energy, bioengineering and artificial intelligence, though again increased geo-political tensions risk fragmenting efforts in research and development.
These changes are not all unprecedented, and an appreciation of our collective history can help provide a starting point for contextualising their economic and investment implications.
Individually, each of these structural shifts represents a significant challenge for investors to:
(i) understand and appreciate the context, key drivers, and potential future outcomes; and
(ii) think through the investment implications of these changes.
The fact that all these shifts are occurring at the same time is extraordinary, and the task of contextualising them into investment implications can seem overwhelming.
One way to approach this challenge is to consider analogous time periods in the human experience. While history doesn’t necessarily repeat, if we look carefully, we can find time periods that ‘rhyme’ enough to at least point us in the right direction in our thinking, as outlined in the table below.
Structural theme | Analogous period | Key characteristics |
Multipolar world | 1870 – 1914 | Broad balance between great powers as the unification of Germany challenged UK hegemony. Increased geo-political competition and uncertainty, but also ongoing global trade and innovation as great powers compete against one another. |
Populism / nationalism | 1930s | Governments adopt protectionism and policies that favour workers over companies, hurting returns to capital amidst significant political volatility. |
Demographics: working age population decline | No clear analogue | It is difficult to find a close analogue to today’s conditions, as we are (thankfully) living longer and healthier lives than at any other time in human history. That said, the fall in working age populations in the aftermath of wars and plagues has historically led to significant shifts in labour supply and demand, as well as encouraging innovation and investment in labour-saving technologies. |
Energy transition | 1800 (coal), 1900 (oil and gas) | Significant capital expenditure and economic activity as economies re-tooled to utilise new energy sources. |
Technology | 1870 – 1914, 1960s space race | Competing powers spend more on research and development, leading to significant innovation and productivity growth. |
Sources: Bank of England, BCA Research, IMF, LGT Crestone.
At a high level, we anticipate the following key characteristics of the investment environment going forward:
With this contextual appreciation, and understanding that it is not practical to capture every nuance and detail of these highly complex and interconnected forces, we can make some high-level (and humble) observations about the likely implications of this changing world for the global economy, financial markets, and investors.
More players and more drivers affecting economies and markets…
Simply put, there will be more ‘players’ in the economic game that investors will need to be aware of. In addition to the traditional actors, such as central bankers, these are likely to include increasingly self-directed geo-political blocs pursuing their own interests, more active and vocal populations putting political and societal pressures on policymakers, and others.
These new players will likely introduce new drivers to the economic equation. Strategic industrial and climate transition policies, policies intended to redistribute wealth and address societal inequities, not to mention the potential for geo-political and/or physical climate-related shocks to the economy.
More activity leading to higher nominal growth and inflation pressures….
As a consequence of having more players, we are likely to see more economic activity. In the first instance, we expect fiscal policy to be more active, as policymakers act to address the various priorities around national security, supply chain resilience, societal inequity, and the energy transition. Beyond this, we expect private corporations to also step up their research and capital expenditure programmes as they respond to the same drivers and, in some cases, take advantage of policy incentives. The US Inflation Reduction Act is a key example of this.
Not all this additional expenditure will be going to the most productive areas (in fact, improving supply chain resiliency necessarily requires building redundant systems). This additional demand for limited resources and labour will put further pressure on supply chains, so inflation pressures are likely to increase. As a result, we expect inflation outcomes to be higher on average compared to the post-GFC regime. However, it is important to note that inflationary pressures don’t always translate directly into inflation outcomes. If central banks choose to react by raising interest rates, these pressures may instead translate into higher real interest rates. This is an important distinction for investors to appreciate.
More volatility in economic, inflation and financial markets….
Another key effect of more players and more activity is increased volatility in economic, inflation, and financial market outcomes. As a first order effect, we are in the process of transitioning away from one of the most stable and investor-friendly states of the world—a unipolar geo-political regime coupled with a laissez-faire political paradigm. It is almost axiomatic that any other state of the world will be more unstable. In addition, transition periods often result in increased volatility as the various economic participants adjust to the new ‘rules of the game’.
More divergence across regions, sectors, and companies.
Finally, we can expect more divergence across regions, sectors and companies in this changing world. A multipolar geo-political backdrop will likely push different nations and regions down different trajectories, driven by their internal constraints and preferences. Some blocs, such as the US and European Union, may remain relatively aligned, whereas others, including a rising India and the broader Global South, are finding their voices and defining their own agendas and priorities.
There will also be significant winners and losers across economic sectors and industries. The risk of carbon-intensive assets becoming stranded as part of the energy transition is a clear example. Other national priorities, such as strategic industrial policy, may promote winners in sectors such as semi-conductors, critical minerals, and artificial intelligence.
We think the best way for investors to approach this environment is to:
The picture that we have painted above might seem disconcerting. It appears that we are heading into a more uncertain, more volatile world that will be less friendly for investors than at any other time in the past 40 years. It will be a particularly challenging environment for a set-and-forget investor who has failed to recognise these fundamental shifts in how the world, the economy and financial markets are likely to operate.
Thankfully, many investors are well aware of these risks—the key question going forward is what to do about them. We think there are four key actions that investors can take today to help position their portfolios for this challenging environment:
Get detailed: Understand the key thematics, get granular on asset allocation…
There is an old saying that you should learn something new every day, and in today’s world there is no shortage of topics for investors to get educated on—geo-politics, politics, national security, and climate change are just a few examples. We don’t think it is wise (or practical) to become a world-leading expert in each of these topics, but investors who are able to develop a detailed understanding of how these drivers might impact economies and financial markets will be much better equipped to navigate the various risks and opportunities that they will create.
Beyond the thematic, this action applies at the asset allocation level too. We think that investors will benefit from constructing and managing their asset allocation at a more granular level to better account for the increased regional and sectoral divergences that we expect.
Get active: The days of a set-and-forget portfolio are likely behind us…
We think it will be difficult for a set-and-forget 60/40 portfolio to achieve most investors’ required return objectives. Instead, we believe a more volatile and divergent investment environment will likely reward investors who manage their portfolios prudently and actively across all aspects of asset allocation, portfolio construction, and manager selection.
This could involve implementing a more prudent approach to adjusting portfolios as macro-economic conditions change and opportunities emerge. Portfolios should be constructed in a manner consistent with an investor’s outlook, and invest with high-quality managers that are able to harness the opportunities from this changing environment.
Get creative: The best opportunities may come from outside the box of traditional assets…
A corollary of being more active is thinking more creatively about designing portfolios and considering investment opportunities. This might involve investments beyond the traditional realm of stocks and bonds, such as hedge funds, infrastructure, private assets, and even direct investments in thematic opportunities. Ensuring that portfolios are underpinned by a well-designed ballast of diversifying and liquidity-providing assets (like government bonds and defensive alternatives) can enable investors to more readily pursue these opportunities.
Get constructive: Position for the upside, while prudently managing risk.
As the saying goes, in every crisis there is opportunity, and there should be just as many opportunities as risks in this new world. As such, we believe it will not pay to be too negative.
A clear case in point is the ongoing ramp-up in capital expenditure and incentives surrounding the energy transition. The sheer amount of money being committed to this endeavour is bound to create opportunities for the astute investor. In addition, we expect technological innovation to continue to provide support to global growth and productivity. Indeed, the twin backdrops of geo-political competition and the energy transition are likely to promote higher investment, more innovations, and potentially higher productivity growth.
Hence, while it is important to design portfolios to weather increased volatility and uncertainty, we would devote at least as much effort to understanding the upside opportunities. And bear in mind that over the long term, it seldom pays to bet against the ingenuity of humanity!
The winds of change are blowing strongly today, and it is likely that the investment environment we are entering will be very different from the one that we experienced over the last 40 years. We expect the confluence of shifting geo-political, political, demographic, climate and technological forces to lead to a macro backdrop that has more players and drivers, more activity, more volatility, and more divergence.
We believe that the best way for investors to navigate this changing and uncertain environment and deliver on their long-term objectives is to get more detailed, more active, more creative, and more constructive.
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