Alessandro Magnoli Bocchi
Key takeaway – Over the next five years, mega-trends will not support an acceleration of global growth. Consumption, investment and productivity will remain sluggish, inflation low. Macro fundamentals are weak: high debt and unemployment will constrain performance. Developed markets (DMs) will stagnate and emerging markets (EMs) will struggle. Flat real incomes and rising inequality are major political risks. Instability, populism and authoritarianism will rise. Political tensions, financial instability, lower oil prices, deflation and competitive devaluations are major economic risks. Fiscal and monetary policy will not support demand and investment. The over-reliance on central banks (CBs) will continue, leading to further financial repression. Regulatory tightening will force traditional banks to choose between lower profitability and sanction risks. Liquidity-driven markets will fuel asset inflation and remain jittery. Inevitably, the rising disconnect between fundamentals and valuations will bring about a bear market, if not a crash1. Unusual times call for unusual portfolios: investors should lower their return expectations, and increase exposure to alternatives.
Over the next five years, global growth will not pick up speed … Aging populations2 will lift savings and reduce consumption and investment3. The world economy will keep transforming: services will rise – as shares of: a) global output4; b) employment; and c) value added – but will contribute little to job creation, technological innovation and an already-sluggish productivity growth5. Secular stagnation will keep savings rising6, further depressing investment7, productivity8, and interest rates9. Economic migration will soar, but immigration-without-integration will become the norm10, boosting remittance flows.
… instability, populism and authoritarianism will rise. In a leaderless world and in absence of coordinated policy action11, economic interdependencies will increase – rather than diminish – uncertainty and fragility. Business cycles will become shorter and financial crises more recurrent. Joblessness12, stagnating real incomes13 and rising inequality14– combined with the lack of vision of political élites – will put pressure on welfare systems, lead to economic instability and foster populism15. The “one person, one vote” principle will bring about authoritarianism,challenging democratic values16. Nationalism and insularism will bring about protectionist policies17.
Macro fundamentals are weak: high debt and unemployment will constrain growth, inflation will remain low. At the global level, a self-reinforcing negative-feedback loop will keep growth low and real incomes flat. Large (public and private) debt overhangs, deflation pressures, low investments and stagnant wages will weaken aggregate demand. Structural reforms will either be lacking or ineffective. Global industrial activity will remain lackluster and trade weak18. Increased uncertainty will dampen consumer and business confidence. Excess oil supply will decline and prices will remain in the range of USD 50-60 per barrel (bbl), providing relief to oil producers19. The world’s economy will continue to move East, but will not decouple: DM and EM will be intertwined through synchronized business cycles and trade and financial flows. The US dollar (USD) will remain stronger than other currencies.
DMs will stagnate20: despite a reduction in potential growth, output gaps will close very gradually and actual growth will fare below-potential. The share of employment in manufacturing will not rise. Businesses will remain unwilling to hire, unemployment will stay elevated and consumers cautious. Labor slack – by putting downward pressure on wages and prices – and low commodity prices will keep inflation below target. In the Unites States (US), estimates of long-term growth-potential will be revised down. The European Union (EU) will delay tackling banking sector legacy-issues. Rich migrants will fuel demand for luxury goods. Political pressure to control immigration flows of unskilled workers will rise.
EMs will struggle with slowing growth21, structural bottlenecks, sluggish investment, a sizeable external debt22, liquidity outflows, vulnerability to sharp currency depreciation23, political fragility and policy uncertainties. Interest rates will remain low, largely driven by monetary policy in the US, EU, and Japan. Larger middle classes24 will spend more on discretionary items. China will steadily decelerate25, depressing the price of commodities and specialized manufacturing equipment, but will consolidate its role in world trade, invest heavily overseas – especially in the US and EU – and see its brands rise26. Lower commodity revenues will hamper commodity exporters. The Middle East and North Africa region (MENA) is unlikely to enact the fiscal consolidation needed to face structurally lower oil revenues27.
Risks: political tensions, financial instability, lower oil prices, deflation, competitive devaluations. At the global level, economic growth will be achieved only via the build-up of debt and asset bubbles. As macro-liquidity28 creates asset inflation but will not translate into consistent market-liquidity, financial stress will intensify. Risk aversion could bring about a tightening of financial conditions, rising volatility, financial market turbulence, and weaker consumer confidence, reducing global growth. Over time, monetary policy interventions will lose effectiveness. CBs risk making policy mistakes and, eventually, lose credibility. Geopolitical tensions29 might escalate and take a toll on the outlook, especially in MENA. Oil prices could drop to an average of 25USD/bbl, spurring dis-inflation and deflation.
In DMs, politics will hamper efforts to tackle long-standing structural issues, migration and the refugee challenge. In the US, where Clinton will win the 2016 US elections, key risks are a faster-than-expected Fed tightening cycle, a more than 20 percent USD appreciation, social tensions and the looming fiscal cliff; massive corporate bonds defaults in the energy sector look increasingly unlikely. In the EU, immigration flows and social tensions will compound the consequences of Brexit30, the eurozone crisis could see more countries leave, while persistently low inflation could develop into full-fledged deflation; unresolved legacy issues in the banking system, in particular in Italy and Portugal, could bring about bank distress. In Japan, the chronic lack of structural reforms will hamper the outlook.
EMs are fragile. China’s unceasing reliance on credit, investment and exports as growth drivers will lead to over-leveraging, financial bubbles and over-heating of the real estate sector, increasing the risk of a disruptive adjustment (i.e.: hard-landing); fast urbanization will increase income disparities. While India’s risks reside in slow reforms and the rural-urban divide, in Brazil low growth and high inflation could spur social tensions. In Russia, the middle-income trap, sanctions and low oil prices are major economic challenges. In MENA the negative spillover of the Syrian, Iraqi and Yemeni conflicts, increasing tensions between Saudi Arabia and Iran, lack of job creation and low oil prices are key risks. In Turkey, political instability might hamper economic resilience. In the GCC, if oil prices were to decline to 25USD/bbl, real estate prices could drop more than 30 percent. In Saudi Arabia and Kuwait, the budget deficit could grow larger than 20 percent; the Saudi Riyal (SAR) could de-peg from the USD and – along with the Kuwaiti Dinar (KWD) – could suffer a devaluation of more than 20 percent.
Fiscal policies unlikely to strengthen demand and investment, over-reliance on CBs to continue, financial repression. While measures to support short-term domestic demand are politically palatable but fiscally challenging, structural reforms to reinvigorate medium-term growth are fiscally palatable but politically challenging, and hence on hold. Governments consider public debt write-offs unacceptable (e.g.: Germany’s position on Greece) and private debt write-offs a political suicide (e.g.: Italy’s unwillingness to impose losses on holders of banks’ subordinated debt). As a result, financial repression31 will continue, via negative policy rates. Without inflation, the easier way to reduce debt is a slow process of sustained negative returns32 and – where possible – some orderly restructuring. In other words, a transfer from savers to borrowers (negative returns) and from creditors to debtors (debt restructuring) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system.
Fiscal policy unlikely to turn expansionary. The global economy needs growth-enhancing taxes and expenditures, but will not get them. Now contractionary in many major economies, fiscal policies are unlikely to support consumption and investment.
Monetary policy normalization to take longer than expected. The upcoming tightening cycle will be well below historical norms. Thee major CBs – the Bank of Japan, the European Central Bank and the People’s Bank of China – are likely to experiment with more easing, up to “helicopter money”. Eventually, however, over-reliance on CBs will make monetary policy ineffective.
Banking: traditional banks under pressure. Increasingly stringent regulations will aim at developing banking systems’ resilience to both uncertainty and turbulence. Yet, regulatory tightening will force traditional banks to choose between lower profitability and sanction risks, and shadow banking will inevitably grow. International banks will keep moving away from retail and selling loss-making franchises; as a result,local banks will prosper. Technology-driven innovation will boost non-traditional competitors: blockchains, biometric authentication for payment transactions, and new “digital” banks – as consumers will refrain from going to branches. In the long run, only banks able to remain customer-centric ‘trusted advisors’ (i.e.: aggregators of services driven by customer needs, such as personalized cash and wealth management, confidentiality and data protection) will prosper. In the EU, financial sector vulnerabilities will not be tackled head-on and – as much as in Japan – the negative-interest-rate policy will de facto tax banks that hold reserves, without encouraging bank lending.
Markets: disconnect between fundamentals and valuations, liquidity-driven markets to remain jittery. The disconnection33 between fragile fundamentals and buoyant markets is due to repeated CB intervention. Over the next five years, macro-liquidity will remain abundant, prices elevated and asset class correlations unusual and unstable. Additional liquidity injections will intensify asset inflation: corporate cash will keep supporting share buybacks and the quest for financial safety will create severe safe-asset shortages34. Inevitably, the financial system will reach an unstable equilibrium and a bear market (a drop of more than 20 percent from the 52-week high) – if not a full-fledged market crash (a more-than-40-percent plunge) – will ensue. As fundamentals will ultimately determine asset value, investment returns are likely to belower than in past years. With high volatility traders will perform better than fundamental investors.
Portfolio approach: lower expected returns, greater exposure to alternatives. Capital preservation via a defensive asset allocation is priority. Conservative investment strategies will need to be tactical, with high cash allocations, and accept lower expected returns in exchange for lower volatility (i.e.: a lower standard deviation of the expected returns). Yet, unusual, less liquid portfolios will perform better than conventional ones. As a result, only 55 percent of the assets should be liquid, and as much as 45 percent should be kept illiquid. In the liquid space, the allocation should privilege bonds (20 percent) over stocks (15) and cash (15) over commodities (5). In the illiquid space, alternative investments should be split between real estate (25) and private equity (20).
Stocks (15 percent) – Lacking viable alternatives, and given limits on cash holdings, equities will keep attracting investors, so far satisfied with the “buy on dips” strategy (as long as liquidity-driven markets keep achieving new highs). The whole allocation should go to DM large caps with cash flow. In particular, dividend-paying blue chips – better if multinational brands with exposure to EM domestic demand – are to be preferred. Volatility will remain elevated and small caps are better avoided, as much as EMs, where earnings growth will soften and currency risks will rise.
Bonds (20 percent) – The allocation should privilege corporate (15 percent, DM only) over sovereign (5 percent, EM only). In DMs, where the regulatory and institutional setting is stronger, overbought sovereign should be avoided35; the whole 15 percent should go to corporate, but only to high quality, high-yield blue chips, better if multinational brands. In EMs, corporate should receive no allocation, given currency risks and a weaker regulatory framework in case of insolvency; once country risk has been assessed, 5 percent should be allocated to sovereign bonds, only if USD denominated, investment grade and with above-inflation yields.
Commodities (5 percent) – Weak global demand and abundant inventories will keep commodity prices subdued. Low global inflation and USD strength will remain headwinds for performance. Price increases will only depend on supply shocks. The whole 5 percent should be allocated to precious metals, as an insurance against: a) currency debasement; b)sharp downturns; and c) periphery-to-core runs.
Cash (15 percent) – Cash is required as: a) seeding-capital to quickly size opportunities; b) insurance against sharp downturns; and c) protection against negative rates. The 15 percent allocation should be held in money market funds, cash ETFs and hard cash. Given depreciation pressures on EM currencies, in DMs the USD and CHF should be favored, while in EMs the SGD.
Alternative investments (45 percent) – The allocation should privilege real estate (RE, 25 percent) over private equity (PE, 20 percent). The 25 percent invested in RE should go to: a) undervalued “trophy” assets; and b)distressed properties in rapidly growing cities. As much as 20 percent should be allocated in DMs – as a fixed-income play, based on rental income. The remaining 5 percent should go to EMs – as a capital appreciation play, based on fundamentals36. The whole 20 percent PE allocation should go to DMs only, invested in undervalued firms with positive cash-flow, able to produce non-replicable or luxury products in high demand in EMs. No allocation should go to EMs: regulatory and currency risk are too elevated, despite fair fundamentals.
I thank Eduardo Eguren for his comments and suggestions. All errors are mine.
1 “Market correction”: a fall of more than 10 percent from the 52-week high, over a single week. “Bear market”: a fall of more than 20 percent from the 52-week high, over 300 days. “Market crash”: a fall of more than 10 percent in just one day, or 40 percent from the 52-week high over 150 days.
2 According to the demographic transition theory, as a country becomes wealthy and industrialized, fertility falls. Over the last 50 years, the global fertility rate decreased by almost-half, from 5.0 to 2.7 children per woman. Over the next 50 years, it is forecasted to drop to the replacement level of 2.1 children per women, according to the UN. The “replacement fertility rate” (2.1 children per woman) is the average number of children required to keep the population stable without help from immigration. In Europe, fertility rates have been below the replacement level for several decades. Eventually, below-replacement fertility rates bring about immigration.
3 The interaction of three factors will reduce consumption and investment: a) falling birth rates and a rising life expectancy are leading to aging populations, prone to saving (notwithstanding the looming pension crisis); b) as the pool of working-age (15 to 64 years old) individuals shrinks in both DMs and EMs, firms deploy less capital – because there are fewer workers to hire; and c) as a result, labor-force participation rates (the proportion of working-age individuals either employed or actively seeking work) decline and consumers refrain from spending. In 2016, for the first time since 1950, the working-age population will decline in DMs – where by 2050 it will shrink by 5 percent – and in key EMs, such as China and Russia. At the same time, the share population over 65 will rise steeply.
4 Over the next five years, internet use will rise in EMs; while China and India will drive growth, obstacles will persist in Latin America. Global shopping, cloud computing and the importance of social media will keep growing, as much as information overload and online crime.
5 Services (i.e.: tech and digital companies) need little investment. As a result, the productivity boost of the “new economy” – the post-manufacturing, service-based economic system – is lower than in past industrial revolutions. After the 2008 financial crisis, labor productivity growth fell across sectors in most OECD countries, where 45 million workers are jobless.
6 Savings will keep accumulating: first, as inequality rises, a higher share of income goes to richer individuals, with higher-propensity-to-save.Second, since 2008 EMs have accumulated massive foreign-exchange reserves and the world’s main Central Banks (CBs) nearly doubled – from USD 10.1tn to USD 18.2tn – their combined balance sheets. Third,corporations relentlessly accumulate retained earnings. Fourth, this rising supply of savings is rather unresponsive to interest rates cuts; hence, lower – even negative – CB policy-rates do not boost spending. As a result, and despite historically-low interest rates, economic growth stagnates, along with inflation.
7 Global net investment (gross investment minus depreciation, as a share of the total capital stock) is close to its lowest level since the Second World War.
8 Innovation is needed to significantly boost productivity. Lack of innovation and declining productivity trigger deindustrialization, and vice versa.
9 In many economies, with short-term interest rates close-to-zero anddeclining prices, achieving full employment becomes a real challenge. Negative real interest rates are needed to equate saving and investment with full employment. The ongoing low-interest-rate cycle – including negative real rates – is here to stay. The trend is not new: interest rates (short and long maturities) and inflation declined in most DMs since the 1980s. Lower rates were driven by the global (mostly China) “saving glut” and “secular stagnation”. The accommodative monetary policy brought about by the 2008-financial crisis put further downward pressure on interest rates, pushing more than 30 percent of the global economy into negative nominal policy interest rates.
10 The inability to assimilate minorities and the immigrants’ reluctance toconform to local norms result in discrimination, ethnic prejudice and xenophobia, eroding social cohesion. As inflows are likely to last decades, poor integration policies will led to cultural isolation.
11 Global problems – protectionism, low trade and growth, financial instability, inequality and migration – need coordinated global solutions. Yet, the G-20 (i.e.:, the group of leading industrialized nations) will remain ineffective, unable to provide the needed global public goods, such as transnational communication and transportation, technological change, cross-border welfare systems, peace-keeping and international security, and a comprehensive policy to address unemployment and communicable-diseases. After the 2008-crisis, the financial system was improved and it will remain a dominant force, but most of its damaging incentives are still there, and will create instability.
12 Both overqualified and inexperienced in the labor market and unable to constructively voice its discontent, the disaffected youth is at risk of becoming a lost generation.
13 Between 2005 and 2014, in 25 high-income economies between 65 and 70 per cent of households suffered from stagnant or falling real incomes. In the period between 1993 and 2005, only 2 per cent of households suffered from it. Prolonged real income stagnation disturbs citizens more than rising inequality and undermines political stability. Conversely, when everybody becomes better off, the positive-sum makes democracy easier to manage.
14 Low productivity, low growth and declining living standards will increase inequalities and discourage upward social mobility. The rise of the super-rich will create demand polarization: luxury (for the rich) versus value (for the poor). With climate change, temperatures will continue to rise, and food and water shortages will hit the poor first. Meat will become a luxury, prices will soar and importing countries will suffer the most. Urbanization will accelerate as city growth speeds up, especially in China and Indonesia; as the bulk of the new middle classes will be in megacities, income and demand will rise, but pressure on resources will increase, as well as pollution and social unrest.
15 Insecurity will provide political support to: a) the “defense” of national identities and interests; and b) the “closing” of societies by reducing immigration and lowering cooperation on trade and security. Citizens will feel threatened and resent sharing their wealth and privileges – including citizenship – with immigrants (see Brexit). Populism – by promising simple solutions to complicated problems and acting through the democratic process – will rely on the “tyranny of the majority” to marginalize (ethnic or religious) minority groups and challenge the separation of powers and the independence of the judicial system, the Central Bank and the press, further undermining the political debate.
16 Citizens will not feel represented by traditional parties and protest vote will rise, along with anti-establishment feelings and xenophobia. The resulting (incongruous) coalitions will lead to political impasse andparalysis, boosting far-right and national-socialist factions. Recent 2016 examples are the rise of Donald Trump in the US, Marine Le Pen in France, Brexit, Turkey’s failed coup, and the plunge in Merkel’s popularitydue of the attacks in Germany. In 2015, the Danish People’s Party in Denmark became part of the governing coalition, and introduced border controls and restrictions on asylum policy. After having won the parliamentary elections in Hungary (2014) and Poland (2015), the conservative-religious right has displayed ultra-nationalism,authoritarianism, xenophobia, illiberal attitudes and the tendency toundermine constitutional democracy. In 2014, Italy appointed its third unelected Prime Minister.
17 The gap between: a) the promises of globalization; and b) the daily life of average-citizens will grow larger. Without prosperity, immigration and religious divides will spur social tensions.
18 In 2015, global trade grew by 2.8 percent, versus a pre-crisis average of 6.5 percent.
19 This forecast relies on three key assumptions: a) a stable Middle East; b)oil producers aiming at maintaining their market share (i.e. OPEC – which accounts for about 30 percent of world’s crude production – not responding to low oil prices by reducing output); and c) a recovery in the performance of US oil producers. Over the long term, low oil prices will put pressure on the fiscal balances of OPEC countries, forcing OPEC to reduce output to increase the price. Source: International Energy Agency’sWorld Energy Outlook, 2016.
20 On average and in rounded figures, over the next five years the US economy will grow at about 2.5 percent per annum, Europe (and the UK) at 1.5, Japan at 0.5. Brexit will reduce growth: a) in the UK (shaving in average about -0.8 percent per annum); b) in the EU (-0.3 percent per annum); and c) at the global level (-0.1 per annum) and increase political uncertainty. Yet, the EU and UK will manage to avoid a large increase in economic barriers and a major financial market disruption. Trade arrangements will converge to the Swiss model (leaving everybody unhappy). A portion of UK financial services will gradually migrate to the Euro area.
21 On average and in rounded figures, over the next five years India’s economy will grow at about 6.5 percent per annum, China at 5.5, MENA at 3.0, Brazil, Russia and Saudi at 2.0.
22 Between 2009 and 2015, taking advantage of low interest rates in DMs,EM governments, banks and firms borrowed in USD at unprecedented levels. If a market-event – a US Federal Reserve (Fed) interest rates hike, a surging USD, a drop in commodity prices, a conflict – were to cause EM currencies to slide against the USD, the debt burden in local currency would rise even more: some borrowers would become unable to service their foreign currency debts and start missing interest payments; others could become unable to roll over principal and corporate defaults would ensue.
23 US-denominated debt would, in sequence: a) become a bigger burdenwhen measured in local currency; b) push international lenders to demand new collateral or loan repayment; c) impair local borrowers (governments, banks and firms)’s access to credit; and d) force these to allocate to debt servicing a larger share of their local-currency revenues. The higher demand for USD will foster further exchange-rate depreciation and further reductions in the USD value of the collateral.
25 Amidst international economic headwinds and domestic financial bubbles, the rebalancing of the economy will be slow: local consumption will rise slower than expected and infrastructure spending will keep growing.
26 Chinese brands will threaten the monopoly of Western brands. Examples abound: Alibaba (retail), ICBC (banking), and Tencent, Baidu, Huawei, and Lenovo (technology).
27 Many countries in the region are still plagued by conflict. Rising political risks and lower oil prices will result in low growth.
28 “Macro-liquidity”: broad money supply. “Market-liquidity” (i.e. trading liquidity): ability to buy and sell financial assets with minimal transaction costs.
30 Britain’s global influence will decline. Reduced trade ties – e.g.: post-Brexit trade arrangements could even revert to World Trade Organization (WTO) norms – will transform the UK into an isolated medium-sized economy. The UK could also become a regulatory and tax heaven.
31 Policies implemented to help debtors benefit from capital that, in a deregulated environment, would be invested elsewhere bring about “financial repression” and include measures aimed at: a) creating a captive domestic market for government debt via: i) explicit or implicit ceilings on interest rates; ii) high reserve (or liquidity) requirements combined with the issuance of nonmarketable – i.e.: to be held until maturity – government debt; iii) prohibition of gold purchases and securities transaction taxes; and iv) cross-border capital controls; and b)aligning local banks to government goals via: i) barriers to entry into the financial sector; ii) public control of financial institutions; and iii) directed lending to government entities by captive domestic audiences (i.e., domestic banks, pension funds).
32 Financial repression occurs when interest rates (the returns earned by savers) are held below inflation. When accompanied by inflation, it becomes a form of debt reduction. In today’s low-inflation or deflationary environment, CBs need negative policy rates to produce negative real rates. By transferring benefits from savers (the lenders) to borrowers via negative real interest rates, financial repression works as a tax on savers and bondholders, which helps liquidate the (public and private) debt overhang and eases the burden of servicing that debt.
33 Supported by CB liquidity, financial markets have ignored structural economic and political developments at the global level. Despite chronically below-potential growth, Brexit, fragile Italian banks, populism and terrorism feeding each other and Turkey’s failed coup, US equity and bond markets set record high prices. In other words, by providing liquidity, CBs strengthened investors’ confidence in market resilience.
34 In bond markets, regulators – by forcing institutional investors to invest in triple-A assets, while the supply of these assets has declined by 50 percent – are pushing real interest rate even lower. More than 30 per cent of global government debt is trading at negative nominal yields. Yields on sovereign and corporate bonds, which pay a spread over government debt, have fallen in tandem. Conversely, in equity markets, historically-low real-interest-rates have pushed asset prices high and created asset bubbles, boosting investors’ returns via capital gains. However, as profits grow in line with the economy, investment income (the dividend yield) steadily declined.
35 In DMs, yields on safe assets are likely to decline further, reflecting expectations of a more gradual pace of monetary policy normalization, a higher global risk aversion and compressed term premia, but yields are already low or negative, and core DM bonds (UST and German Bunds) will benefit only from shocks.
36 In EMs, RE has a lower regulatory volatility than PE.