Age of Transformation

Thesis

Investors and policymakers alike will have to come to grips with a radically different macro environment over the secular horizon as the post-financial-crisis, pre-pandemic New Normal decade of subpar-but-stable growth, below-target inflation, subdued volatility, and juicy asset returns is rapidly fading in the rearview mirror. What lies ahead is a more uncertain and uneven growth and inflation environment with plenty of pitfalls for policymakers. Amid disruption, division, and divergence, overall capital market returns will likely be lower and more volatile. But active investors capable of navigating the difficult terrain should find good alpha opportunities.

Initial conditions

As such, this year’s secular thesis further develops the themes we highlighted in our 2020 Secular Outlook, “Escalating Disruption.”  We argued then that the pandemic would serve as a catalyst for accelerating and amplifying four important secular disruptors: the China–U.S. rivalry, populism, technology, and climate change.

Developments over the past year have reinforced those expectations. China–U.S. tensions have not only continued but intensified under the Biden administration. Populism and polarization have been on the rise in many countries, further fueled by politically charged divisions over lockdowns and vaccines. Digitalization and automation have been turbocharged by the pandemic. Extreme weather conditions in many parts of the world have also inflicted severe human and economic losses and contributed to major gyrations in energy markets. In our forum discussions we concluded that each of these secular disruptors will remain active in the foreseeable future.

Another important initial condition for the secular outlook is the sharp further increase in public and private sector debt caused by the pandemic recession and the policy responses. To be sure, with borrowing costs at or close to record lows, record high debt levels are not an immediate concern. However, higher leverage implies heightened vulnerability of public and private sector balance sheets to negative growth shocks and to positive interest rate shocks, thus increasing the risk of destabilizing runs on sovereign and private borrowers. Moreover, elevated debt levels and highly financialized economies as measured by wealth-to-income ratios will likely constrain central banks’ ability to push interest rates aggressively higher without causing severe economic pain – a financial market dominance theme to which we will return below.

Last but not least, the pandemic either forced or encouraged many individuals to pause and rethink their lifestyle and the work-life balance. It is still too early to tell if and how preferences will change and how lasting any changes will be. However, it is well possible that we will see significant shifts in preferences for work versus leisure, for working from home versus the office, and for working in certain sectors or locations versus others. Also, consumption patterns may change permanently as many people may no longer be comfortable traveling or participating in mass gatherings even after the pandemic ends. This calls for a larger dose of humility in trying to predict economic outcomes over the secular horizon and strengthens our earlier point about elevated macro uncertainty in the years ahead.

Secular drivers

In our discussions, we identified three broad trends that are likely to drive a major transformation of the global economy and markets.

The transition from brown to green. With increasing voter and consumer focus in many parts of the world, governments, regulators, and the corporate sector are stepping up their efforts to decarbonize and achieve net zero emissions by 2050. This means that both private and public investment in renewable sources of energy will be boosted over our secular horizon and for years to come. While the heavy lifting will have to be done by the private sector, both the U.S. bipartisan infrastructure bill and the EU Next Generation fund will support the transition with sizable spending on “green” infrastructure over the next five years.

Of course, higher private and public spending on clean energy is likely to be partly, but not fully, offset by lower investment and capital destruction in brown energy sectors such as coal and oil. During the transition there is a potential for supply disruptions and spikes in energy prices that sap growth and boost inflation, as recent events in China and Europe have demonstrated. Moreover, as the process creates winners and losers, there is a potential for political backlash in response to job losses in brown industries, higher carbon taxes and prices, or carbon border adjustment mechanisms that make imports more expensive. While the destination – a net zero world – is desirable for many reasons, including economic ones, the path to this destination is unlikely to be smooth.

Faster adoption of new technologies. In last year’s outlook we expected the pandemic to turbocharge digitalization and automation. This is borne out by the data available so far, which show a significant rise in corporate spending on technology. Similar increases in investment in the past, e.g., during the 1990s in the U.S., have been accompanied by an acceleration in productivity growth. Developments over the past year suggest this may again have been the case as productivity has surged, though the cyclical rebound clearly also played a role. It remains to be seen whether the recent surge in tech investment and productivity growth is a one-off or the beginning of a stronger trend, but the data so far do support the notion that the pandemic served as a catalyst for a faster adoption of new technologies.

Digitalization and automation will lead to better economic outcomes overall by creating new jobs and making existing jobs more productive. But it will also be disruptive for those whose jobs will disappear and who may lack the right skills to find employment elsewhere. As with globalization, the dark side of digitalization and automation will likely be rising inequality and more support for populist policies at both ends of the political spectrum.

Sharing the gains from growth more widely. The third potentially transformative trend underway is the heightened focus by policymakers and society at large on addressing widening income and wealth inequality and making growth more inclusive. The latest case in point is the new focus by China’s leadership on “common prosperity,” aimed at narrowing the private wealth and income gap. As we write this essay, another example is the U.S. Democrats’ proposed $3.5 trillion “soft infrastructure” spending package, which is mainly focused on social safety net programs such as Medicare and includes, among other things, expanded child tax credits for working families, universal preschooling, and free community college. While the size of a package that will pass Congress is likely to be much smaller, the changes would “hard-code” such policies for years to come.

Meanwhile, partly due to pressure from investors increasingly focused on ESG (environment, social, and governance) and partly due to self-interest, many companies are focused on improving working conditions, pay structures, and workforce diversity. Anecdotal evidence suggests that in many companies, the balance of power in the employer-employee relationship has started to shift from the former to the latter, thus improving workers’ bargaining power. It remains to be seen whether this trend continues or whether work from home with the help of technology eventually allows companies to outsource more jobs to cheaper domestic and global locations, thus preserving or even increasing employers’ bargaining power.

Macro implications

In an Age of Transformation characterized by disruptive trends and more interventionist policies, economic cycles may well be shorter in duration, larger in amplitude, and more divergent across countries. It is not difficult to imagine investment booms fueled by accelerating labor-intensive green investment and efforts to diversify or re-shore supply chains in order to increase resiliency, followed by busts caused by stop-go fiscal policies, energy price shocks, or overly ambitious and abrupt regulatory changes.

Cyclical divergence among regions and countries is also likely to increase as the various transformations progress at different speeds and as fiscal policy, which is often driven by election cycles that are asynchronous across countries, becomes a more dominant driver of demand. Moreover, with China becoming more self-sufficient and its economic growth likely to slow further over the secular horizon due to demographics, deleveraging, and decarbonization, one large common driver of export growth in many emerging and developed economies will likely fade in importance.

Like economic growth, inflation in the Age of Transformation is likely to become more volatile within countries and more divergent across regions. We continue to believe that inflation tails have become fatter, with periods of much higher, and periods of much lower, inflation becoming more probable. Upside risks emanate from the net zero transition and its impact on carbon prices, and from de-globalization, fiscal activism, and potential “mission creep” at central banks. Downside risks stem from companies learning to do more with less thanks to better technology. In addition, record high levels of debt and leverage increase the risk of debt deflation in the case of negative growth shocks.

Taken together, the pre-pandemic New Normal decade of subpar-but-stable growth, below-target inflation, subdued volatility, and juicy asset returns is rapidly fading in the rearview mirror. What lies ahead in the Age of Transformation is a more uncertain and uneven growth and inflation environment with plenty of pitfalls for policymakers.