GAM Investments’ Niall Gallagher believes economies and markets are undergoing a regime change towards an environment of more volatile growth and durable inflation. The implications of such as shift would be complex and overlapping. Against such a backdrop, he believes consistent equity market alpha generation requires true flexibility and agility.
Multiple short-duration distortions from the pandemic-induced lockdowns have impacted a broad range of areas, including freight, semiconductors and labour markets. The consensus view appears to be that such distortions will be resolved soon. We are less convinced. We think resolutions to many of these issues may not occur until H1 2022, possibly even H1 2023. More importantly, we think the market rotation could be signalling something potentially far more significant. Conceivably, what we are witnessing may represent the beginnings of a regime change in economies and markets, away from a period of low but stable non-inflationary growth towards an environment of more volatile growth, combined with more persistent inflation. There are numerous, complex and overlapping drivers of this potential regime change.
The Covid-19 pandemic itself
Beyond the short- and medium-term dislocations, the pandemic and associated government actions may have induced societal changes with respect to citizens’ desires for government intervention and shifted the acceptable boundaries between the state and the individual. This is manifesting itself in greater demand for fiscal activism that goes beyond temporary support measures, such as furlough schemes, into longer-term interventions such as infrastructure investment, public sector renewal, changes in trade arrangements, greater redistribution and government support for higher wage claims for working class labour (especially in the UK). We can see this in the greater urgency given to plans for state-sponsored infrastructure investment, strongly overlapping with the need for investments in digitisation and decarbonisation, as well as rising taxes and rising wages.
In a fascinating book titled ‘The Great Demographic Reversal’1 , Professor Charles Goodhart (London School of Economics) and Manoj Pradhan (Talking Heads Macro, former Morgan Stanley) have written about the profound effects that demographics have on global labour markets, wages, inequality and economic growth. They write that over the last 40 years, starting in about 1980, the combined effects of the maturation and entry of the baby boomer generation into the work force, rising female participation, the opening of China and accession to the global trading system, and the fall of the Berlin Wall have more than doubled the effective size of the global labour market. This has particularly impacted those parts exposed to globally traded products and has heavily depressed wages in the advanced economies of Europe and the US. These dynamics particularly impacted people in many traditional working-class trades, fuelling inequality, but also acting to significantly reduce inflation by ending the wage-price spiral of the 1970s and ultimately driving disinflation into the new millennium through depressed and static wages.
Goodhart and Pradhan’s observations are that these demographic factors have now played out and are about to go into reverse. They believe this will increase the pricing power of those parts of the western labour market exposed to these trends, ending the period of downward pressure on wages exposed to globally traded goods. Rising wages and reduced wage inequality might be good news for societal stability if the gains are not inflated away but they will exert positive upward pressure on inflation. We can already see this occurring with for example shortages of heavy goods vehicle drivers in many countries and labour shortages in supply chains, retail industries and parts of the medical industries.
The energy transition
Policymakers have emphasised and articulated the positive economic outcomes of the necessary energy transition to net zero. Such benefits include the obvious avoidance of the adverse costs of climate change and the harnessing of low marginal cost energy sources from solar and wind generation. However, in our view, what they have failed to articulate or analyse is the full / true cost of creating a robust and resilient energy system with storage and back-up generation for when renewables are not providing sufficient energy. The true cost of a robust and resilient energy system – with battery technology and green hydrogen as back up and nuclear as base load – is likely to be much higher than currently budgeted for, particularly in certain countries. Moreover, it is likely that the costs of creating a robust and resilient system based on renewable energy will ultimately be borne by consumers and industries through higher energy costs.
Perhaps by 2040-2050 economies will be enjoying low marginal cost energy systems. However, at least during the long transition period, energy systems will likely become a lot more expensive to build and operate. In addition, the costs of abatement and reducing carbon emissions across a range of industrial activities such as steel, cement, chemicals and aviation are likely to be very high in the initial parts of the transition and will add significantly to costs. We are not in any way questioning the need for the transition to net zero but do believe that far greater analysis is required from policymakers as well as honesty with consumers and electorates about costs. The transition to net zero is also likely to be inflationary.
Related to our points on the energy transition, we see significantly higher energy costs across oil, gas and electricity. Capital investment into global oil and gas has declined by over 60% since 2014 despite the fact oil and gas demand is not yet declining and may not decline on a global basis for several years to come; potentially much longer in the case of gas. It is unlikely that integrated energy companies will invest in oil and gas capital expenditure in a serious way, particularly in new hydrocarbon exploration (and they are certainly being encouraged not to do so) but a combination of rising demand and falling supply will likely lead prices higher.
In our view, policymakers and commentators in the northern / western hemisphere should remember that energy demand growth now comes from non-Organisation for Economic Co-operation and Development (ie developing) countries who are far behind in their economic development (lower GDP per capita) than those in Europe, developed Asia and the US and they are unlikely to enjoy being lectured at. In addition, the energy transition is leading many nations to (rightly) phase out coal-fired power generation, but to replace it with gas-fired power generation as a back-up to intermittent wind and solar without properly thinking through where that gas will come from. Ultimately, we believe the solution should be robust and resilient energy systems combining renewable generation with energy storage solutions (batteries, green hydrogen, etc) but in the transition period the demand for gas is likely to increase given the lack of supply and rising demand. We believe it would be better to recognise this rather than saddle economies with avoidably high gas prices when there are no obvious short-term alternatives.
The economic and investment implications of the above points are numerous, complex and overlapping. While we do not have all the answers, we would tentatively suggest that developed economies are likely to be entering a period of much higher physical capital expenditure driven by the required energy transition, digitisation and greater fiscal activism by governments. Meanwhile, we expect inflation to be higher and more volatile as developed economies enter an era of higher wage growth, higher costs from ageing populations and rising energy prices. This has serious implications for investment portfolios with inflation eroding returns, potentially higher discount rates lowering valuations and different sectors / stocks outperforming given different economic drivers.
Key structural trends, such as the rise of the Asian middle class, digitisation, decarbonisation, the offline to online convergence and the shift from cash to digital payments, are likely to remain in place and potentially become more powerful. However, individual equity returns are likely to be more dispersed and skill will be required in discerning the true growth and disruptive stocks. The era of ever-lower bond yields pushing up valuations across the board for growth, quality and low volatility stocks may well be over. It would be easy to suggest that this new environment will shift outperformance from growth stocks to value stocks, but we believe this ignores the profound impacts of disruption and technological change that could render many so-called value stocks obsolete or send them into terminal decline. We believe the future is not growth or value – it is more nuanced and highly stock specific.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.