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Quarterly Outlook
From transitory crisis to lasting change
Summary: Building an inflation-resilient portfolio should be a priority as we shift towards fiscal primacy.
Lessons from prior crises teach us that necessity is the mother of innovation. Throughout history, from the Great Depression through to the 2003 SARS epidemic, crises have become defining moments in sowing the seeds of innovation and defining consumer behaviour.
COVID-19 is set to be no different, becoming a catalyst for transforming economic, political and societal norms, driving decades of change in a matter of months.
The status quo
Everything worth investing in, other than a hard day’s work. This is the “everything bubble” in one sentence, where the Covid-induced abandonment of the status quo renders a shortage of just about anything in the real world.
The market and societal regimes have been defined by a decline in economic vitality and an excessive reliance on monetary policy. There has been a long-term downtrend in rates, TINA, FOMO and a mandate of financial “stability” above all else, with multiple asymmetric puts delivered by central banks around the world perpetuating an economic system that no longer serves the majority. This has promoted structural inhibitors to growth that have compounded inequality and intergenerational divides and fostered a polarised era tearing at our social fabric. Ultimately, monetary policy has limits in dealing with these challenges, and the efficacy of trickle-down economics has been debunked.
One of the big economic issues in recent years has been increasing inequality. Wages have stagnated and asset prices have inflated, alongside persistent wealth transfers to an ever-decreasing component of the population. Inclusive prosperity has become a distant dream; never has the share of income distributed to capital vs. labour been so distorted. Wealth concentration is out of control: for the bottom 50% income share has collapsed, and the pandemic has exacerbated these economic disparities. These imbalances are politically unsustainable.
This K shaped world went into overdrive as the Covid pandemic magnified pre-existing disparities and compounded structural shifts in key sectors and demographics, highlighting the need for radical social and political change.
As such, the Covid-19 crisis is now becoming the catalyst for a permanent shift away from the malaise of the status quo, and for a push to remodel geopolitics, societies and markets, forging new economic doctrines that will shape our future. Enter a new modus operandi of restoring economic vitality and fighting the polarising effects of social divisions and inequality, through delivering enhanced social safety nets and distributing wealth more equitably; most importantly, doing this within the constraints of the climate and our physical ecosystem.
We are now experiencing a seismic shift toward a policy regime that was previously unthinkable, where even in the age of extraordinary monetary intervention central banks have transformed from the heroes to bystanders as fiscal primacy takes the reins.
Within this great fiscal shift, the role of government and public policy is being redefined as a new social contract is established inside the constraints of the planet’s carbon budget.
Fiscal > Monetary
Covid-19 has assumed governments a new mandate to reduce economic insecurity and inequality, alongside the ability to exert greater powers to protect citizens.
In the US, following the enactment of the latest COVID-19 relief bill, on average the poorest quintile of households will see annual incomes boosted by around 20%, generating an increased capacity to consume for those with the highest marginal propensity to do so. In conjunction with (in some cases inelastic) supply constraints and an element of pandemic fatigue, as economic activity normalises it is not hard to see these transfers being inflationary.
This is particularly true as the crisis acts as a defining moment in a more permanent shift toward fiscal dominance: redistribution, enhanced social insurance, and an emphasis on increased economic security for lower-income households and the unemployed. Significantly higher spending and transfers to the individual will bring a lasting step-up in consumption; until inflation becomes a problem, why stop the cheques?
The February US Core CPI read showed benign inflationary pressures but watch out! Against incoming easier comparisons and pandemic-fatigued consumers that are vaccinated and ready to spend, inflation is coming to a price index near you. Transfers have bolstered incomes, the labour market is rebounding, savings are elevated, and US household spending expectations are at a 4-year high. This increase in demand will quickly meet supply constraints. Upward pressure on bond yields remains as this reflationary cocktail is delivered, and it is important to be on the right side of these trends: inflation, commodities and higher rates.
Labour > Capital
For many advanced economies, technological progress and hyper globalisation have seen the labour share of income in protracted decline since the 1980s, spurring an unprecedented wealth transfer away from labour and resulting in higher inequality. Corporate profits as a percentage of GDP have steadily risen while real wages and bargaining power have stagnated. Income gains for high-skilled workers and high-paid workplaces in the top end of the “K” have outpaced others, compounding even higher levels of income inequality. And an increase in capital income concentration at the top has further reinforced drivers of wealth inequality.
As the Covid crisis pushes policymakers to redefine our social contract with a focus on redistribution and reducing wealth concentration, reversing the decline in labour’s share of income will be a key tenet to addressing inequality. Higher returns to labour transmitting the effects of improved economic activity to the personal incomes of households are necessary to tackle the rise in income inequality, structural unemployment, and aggregate demand shortfalls.
Bigger government and bigger fiscal change, aimed at sustainable growth and job creation where money printing is aimed at demand generation, is inherently more inflationary.
Local > Global
The pivot to deglobalisation and reduced reliance on China emerged pre-Covid, but the crisis marked a boiling point for the “my nation first” impulse (just look at vaccine diplomacy) and with it, the shift to local over global. Moving forward, companies and nations will focus on reshoring critical areas and adding resilience and self-sufficiency to supply chains via localisation and enhanced regional ties, as well as bidding to secure supply, restore jobs and manage production tail risks. This is another reason to be long inflation, real assets, cyclicals and small caps.
The US/China trade war signalled this tectonic shift, but the pandemic has now accelerated the move on a global scale, including the shift away from China (e.g., Rare Earths). The race for technological supremacy is also spurred by the pandemic’s acceleration of digital adoption – technological disruption, innovation, splinternet and deglobalisation on fast forward.
The transition
The pandemic has turbocharged many pre-existing trends as well as forging new ones. With digitisation and disruption in overdrive, the reshaping of our world order is colliding with a physical world that cannot keep up. From semiconductor chips to copper, demand is on the rise while capacity remains constrained. We have underinvested in the production capacity required to meet accelerated digital adoption, green transformation, and the recovered spending capacity that comes with a seismic fiscal shift.
The constraints of the climate and real supply limitations are adding to “cost-push” inflationary pressures, alongside local>global and labour>capital shifts. Add to that the great fiscal shift taking care of “demand-pull” inflation and compounding supply constraints, and it is a cocktail for higher inflation.
A new investment paradigm
The new social contract is in many ways a poisoned chalice for markets as we know them, heavily in the throes of a monetary addiction: slow-flation, TINA, treasurised mega-caps and long duration. However, the status quo has delivered not just huge income inequalities but a polarised era that erodes political and economic stability. If taking a risk on inflation heals this precarity, it may be a price worth paying.
For investors, the macro paradigm shift toward fiscal primacy requires a more inflation-resilient portfolio.
A strengthening growth outlook and rising inflationary pressures are supportive of commodity-heavy indices, small caps, cyclicals, and real economy stocks, but are difficult for multiple highflyers and speculative bubble stocks to navigate. The capacity to shift market leadership has moved toward real economy stocks, non-US markets and commodities. The higher that yields go, the more pressure is on this rotation.
Expect higher volatility in this transitory environment: the entropy of the system results in suppressed volatility escaping. With inflation on the rise and fiscal dominance in the hot seat there are few elegant ways for central banks to continue to tame volatility.
Find a new hedge: 60:40 no more.
Real assets/Commodities: Real assets > Financial assets. The allocation to commodities and commodity producers must be higher. A hedge against inflation but also positioning for tailwinds of supply constraints and price-inelastic demand, and green transformation.
The focus for asset allocation in Q2 2021:
Inflation > Deflation
Natural resources > Technology
Cyclicals > Defensives
Covid Losers > Covid Winners
ROW > US
EM > DM
Small > Large