Reaching for Resilience

Reality check

Beginning with a thoughtful review of our priors, we felt that the themes we discussed in our 2021 Secular Outlook, “Age of Transformation,” still very much resonate today. We anticipated a more uncertain and volatile macro landscape, and we identified green, digital, and social transformations as key drivers of disruption. We expected shorter growth and inflation cycles with larger amplitudes and more divergence across countries. All of these themes still ring true.

However, the obvious task at hand was to factor in the massive disruption that we did not anticipate last year: Russia’s invasion of Ukraine in February and the horrific war that has been waging since, as well as the far-reaching economic and financial sanctions and other policy responses by most Western democracies. In thinking though the consequences of these events for our investment thesis, we found it useful to distinguish between our near-term cyclical horizon (six to 12 months), the medium-term horizon (one to two years), and our longer-term secular horizon of five years and potentially beyond.

Near-term outlook: anti-Goldilocks

We briefly discussed and confirmed our cyclical thesis, which we shared in our March 2022 Cyclical Outlook, “Anti-Goldilocks.” Recent macro data underscore our view that the war and sanctions shock, along with the COVID-related lockdowns in China, is stagflationary: pushing inflation even higher in the near term and slowing economic growth in the major economies toward stall speed over the cyclical horizon. Also, with current headline inflation elevated across the globe, including around 8% in the U.S. and Europe at the time of this writing, major central banks seem determined to tame inflation first and worry about growth later, which brings us to our medium-term outlook.

Medium term: elevated recession risks

We see an elevated risk of recession over the next two years, reflecting greater potential for geopolitical tumult, stubbornly high inflation that reduces households’ real disposable income, and central banks’ intense focus on fighting inflation first, which raises the risk of financial accidents on top of the sharp tightening of financial conditions already seen.

Moreover, if and when the next recession arrives, we expect the monetary and fiscal responses to be more reserved and arrive later than in the last several recessions when inflation was not a concern and when government debt levels and central bank balance sheets were less bloated. Just as fiscal policymakers learned from the muted economic recovery following the global financial crisis and responded more forcefully to the pandemic recession, today’s high inflation may make policymakers hesitate to revisit these tools, particularly in the U.S.

Thus, while for many reasons our view is that the next recession is unlikely to be as deep as the Great Recession of 2008 or the COVID sudden stop of 2020, it may well be more prolonged and/or the following recovery may well be more sluggish due to a less vigorous response by central banks and governments.

Secular theme: reaching for resilience

A crucial longer-term consequence of the war in Ukraine and the responses to it is the widening of geopolitical fractures that could accelerate the move from a unipolar world to a bipolar or multipolar world. This fracturing had already been underway with the emergence of China as a major economic and geopolitical player and Western governments’ skeptical stance toward China.

In a more fractured world, we believe governments and corporate decision-makers will increasingly focus on searching for safety and building resilience:

• With the risk of military conflict more real following Russian aggression toward Ukraine, many governments – especially in Europe but also elsewhere – have announced plans to increase defense spending and invest in both energy and food security.
• Many corporate decision-makers are focused on building more resilient supply chains through global diversification, near-shoring, and friend-shoring. These efforts were already underway in response to U.S.–China trade tensions and because the COVID pandemic demonstrated the fragility of elaborate value chains, and are likely to be intensified given the more insecure geopolitical environment.
• Moreover, in response to climate-related risks and the COVID crisis, most governments and many companies have already increased efforts to mitigate and adapt to global warming and to improve health security for their citizens and employees.

This reach for resilience and the search for security may often come at the expense of short-term economic efficiency. We see five major macroeconomic implications of this secular trend:

First, higher spending in many areas, including defense, health care, energy and food security, more resilient supply chains, and climate risk mitigation and adaptation, to the extent that it won’t be matched by cuts in other areas, may well support aggregate demand over the secular horizon. However, much of this additional spending may not help long-term productivity growth, unless companies make additional efforts at increasing productivity growth through accelerated investment in technology. Also, the reach for resilience will likely be accompanied by more regulation and protectionism, which could weigh on long-term growth. Overall it thus seems unlikely to us that output growth will be materially higher over the secular horizon than in the pre-pandemic decade.

Second, the quest for resilience and security introduces some inflationary tailwinds as companies build redundancies into their supply chains and bring them closer to home. To the extent that governments become more restrictive on immigration, labor markets could become less competitive, potentially leading to higher wage pressures. Also, the green transition, which should eventually lead to lower energy prices from cheaper renewables, may well push energy prices higher for a while as the supply of brown energy may shrink faster than the supply of renewables expands. Ultimately, however, whether these factors lead to permanently higher inflation over the secular horizon will be a policy choice by fiscal and monetary authorities, in our view.

Third, given these inflationary tailwinds, central banks are facing a dilemma. Supporting aggregate demand and building resilience would come at the cost of higher inflation. Conversely, bringing inflation back down to target would be costly in terms of demand and employment. For now, given how far inflation exceeds central banks’ targets, most central banks are emphasizing the fight against inflation. The jury is out on whether they will still prioritize inflation once it has come back closer to target, or whether they will tolerate moderate overshoots. Our general view is that inflation risks over the secular horizon have shifted to the upside.

Fourth, we see a higher probability of private sector credit events and default cycles over the secular horizon. Public sector and corporate balance sheets will likely be under pressure from rising spending needs on security and resilience, debt service costs will likely be higher, and the risk of a recession is real. Elevated inflation implies central banks may be less willing or able to support private sector debtors. Governments may also be less willing to help due to a further surge in debt levels during the pandemic and the need to finance rising pension and health care costs given aging demographics.

Fifth but not least, we see a risk of financial deglobalization and more fragmented capital markets over the secular horizon – a “capital war,” according to one of our forum participants. The weaponization of financial sanctions and currency reserve holdings may well increase the home bias by public and private creditors in current account surplus countries and could lead to an ebbing of financial flows into the U.S. dollar over time. However, given the lack of good alternative currencies with deep and liquid capital markets to the dollar, any such shifts are likely to be glacial rather than abrupt and likely lie beyond our secular horizon.