Great transformation – the dawn of a new era

Article by Michael Herzum

CFA, Head of Macro & Strategy

The world in which the US is the undisputed leading global power has now been consigned to history. China is striving for global hegemony and is increasingly challenging the US. Yesterday was about globalisation, but today the great power rivalry is the defining theme. This new world order has implications for the capital markets and beyond. We are at the dawn of a new era – the great transformation – with more economic growth, more inflation, higher interest rates and more volatility.

In a world in which the global domination of the US was never in doubt and China merely acted as a supplier to the West, there was no difficulty in focusing on the efficiency of supply chains. Strategic reliance on friends does not represent a risk. But when a friend suddenly becomes a rival, the picture changes and that strategic reliance develops into an existential threat. The speed at which it can be weaponised is illustrated by the war in Ukraine and, specifically, the dependency on gas. It is therefore crucial that supply chains for strategic products are secure and resilient. The US government is taking steps to bring the supply chains for technologies of the future (semiconductors, batteries, electric cars, critical minerals) back onshore or least move them to countries that it can count as allies. Government investment incentives of almost US$ 1,300 billion are already having an effect, with all of the major semiconductor and battery manufacturers announcing multi-billion-dollar investment projects in the US over the past twelve months. This trend will gather pace, unleash an investment boom and provide a long-term boost to economic growth. Although the investment boom is mainly emanating from the US, it will benefit European companies too.

The uptick in investing activities is increasing the demand for capital. This means that the price of money – i.e. interest rates – is going up as well. But the new era is also characterised by structurally higher inflation. The investment boom will trigger a surge in demand in some sectors, and supply will not always be able to keep up. The result is higher inflation. Less efficient supply chains and greater resilience will also lead to higher inflation, for example due to higher levels of inventory being held. Ultimately, the great power rivalry will be accompanied by artificial restrictions on supply. China is increasingly being excluded from strategically important supply chains for semiconductors, batteries and critical minerals. And reduced supply means higher prices.

Zero interest rates and inflation rates that are well below the central banks’ targets are now a thing of the past. The new environment also has consequences for the economy, and we expect the classic economic cycle to make a comeback. After all, higher levels of investment mean a return to greater capacity utilisation. We will therefore see phases of overheating and spikes in inflation more frequently, which will prompt the central banks to put up interest rates.

The classic economic cycle also creates more volatility in the financial markets. The great power rivalry is another contributing factor because it will cause the global powers to flex their muscles again and again – as in the case of Taiwan, for example. As investors, we therefore need to be prepared not only for more economic growth, more inflation and higher interest rates but also for more volatility.

We recommend adding asset classes to the portfolio that benefit from elevated inflation. One example is the commodities asset class, in particular industrial metals that are doing well out of the transition to a green economy. It is also a good idea for the allocation of equities to include infrastructure stocks. These companies can pass on higher prices in line with inflation and they are also receiving a tailwind from the digital and green transformation. In general, the new environment in the equity markets means that growth is less of a rare commodity. This in turn diminishes the appeal of growth stocks over value stocks, which may not be as fast growing but are valued more favourably. Among fixed-income investments, inflation-linked bonds that can replace some of the traditional government bond allocation are interesting because they offer protection against the overshooting of inflation.

The great transformation represents a challenge. But in this new era, a carefully selected portfolio can create new opportunities for investors.

As at 5 December 2022.