Until recently, good news (a solid rebound from the COVID-19 pandemic) was bad news (higher interest rates). Now, bad news (an economic slowdown) is good news (accommodative policies). For investors, previously successful investment strategies carry risks. Economic activity, based largely on government stimulus, low borrowing rates, central bank cash infusions and pent-up demand funded by lockdown savings, will stagnate. Inflation may abate (as price changes slow) but absolute costs will remain elevated. This combination reflects fundamental shifts that the markets may not have fully priced in.
Going forward, failure to invest in existing energy sources is likely to result in a long-lasting power-grid deficit. The energy transition and decarbonization will be slow and expensive due to the need to first electrify many industrial processes, reconfigure the grid, inefficient power storage and shortages of materials (lithium, cobalt, nickel, copper, rare earths). Climate-change effects on food supplies, transport links and insurance costs will increase. On a geopolitical level, the return of great power rivalry will complicate matters. Trade restrictions and sanctions will impede cross-border commerce. Higher defense spending and, eventually, rebuilding Ukraine (perhaps as much as $1 trillion or 1% of global GDP) will absorb scarce resources. Focus on sovereignty and minimizing unexpected disruptions will mean rearranging supply chains to avoid bottlenecks, such as China (the world’s factory) and its zero-Covid policy. Reshoring or near-shoring production will be slow and costly. The global supply of cheap labor and raw materials will not contain costs and underpin prosperity, as it has done for almost three decades. Adverse demographics will also be a major factor. Declining work forces, the COVID-19 fueled Great Resignation, aging populations, lower birth rates, immigration resistance — will compound the difficulties. Interest rates and the cost of capital will rise and liquidity will tighten as central banks normalize policy and governments repair public finances. De-globalization, concerns about confiscation of foreign investments, following the West’s actions against Russia, will impede global capital flows from savings-rich Asia, which has been providing cheap funding. These self-reinforcing factors will work through multiple channels and feedback loops. Here’s what should concern investors now: 1. Asset prices: Equity valuations are elevated, especially considering prevailing market structures; large numbers of firms are earnings and cash-flow negative (about one-third of Russell 2000 index
RUT,
+3.50%
) and cross-border trade is declining (40% of S&P 500
SPX,
+2.76%
companies’ revenue originates outside the U.S.). Housing, the biggest asset class, is encountering higher mortgage rates and threats to strong employment markets, which has been sustaining it. 2. Financial crises: Debt levels are high and personal, business and government balance sheets are stretched. Declining valuations will test borrowers, who have been supported by overvalued assets. Heavily indebted private-equity plays may become the flashpoint of a new crisis. Europe’s debt problems were covered up by the European Central Bank acting as buyer of last resort for almost-bankrupt members. France …