The Great Transformation: a new era for the global economy and the capital markets

By Dr. Frank Engels, 

member of the Board of Managing Directors of Union Investment responsible for securities portfolio management

The war in eastern Europe has not only cost tens of thousands of lives and caused immeasurable damage, it has also brought about the transition to a new world order. “Globalisation is giving way to rivalries between superpowers as China challenges US hegemony,” was Engels’ analysis of the situation. Where leading nations on the global stage previously sought to maintain a rules-based system of international cooperation, they are now much more distrustful. This environment fosters a stronger desire for security. From the perspective of national governments, it seems a rational choice to reduce strategic dependencies and minimise security policy risks, even if there is a price to pay in terms of prosperity. “Economic policy is becoming an aspect of security policy,” explained Engels.

Against this backdrop, the momentum that has been driving globalisation for the past 40 years is likely to wane. “International trade and global production chains will continue to exist,” Engels said. “But politicians and business leaders will think more carefully about the possibility of international crises and pandemics going forward. Strategic dependencies in supply chains, especially in the field of commodities, are fine between close partners – but those days are over.” If trading partners turn into geopolitical rivals, dependencies turn into an existential risk. “Resilience in key supply chains and more diversified energy supply structures are becoming a strategic imperative. ‘Near-shoring’ and ‘friend-shoring’ will therefore gain in importance,” Engels concluded. In other words, supply chains and production sites will, to some extent, be relocated to domestic territory or friendly countries.

This trend is preparing the ground for a physical investment boom, especially in the US. “The Biden administration wants to become independent from China in key industries and is pressing ahead with the necessary economic transformation,” noted Engels. With a combination of investment incentives and proactive industrial policy, the US government wants to ensure that supply chains for technologies of the future such as microchips, batteries and electric vehicles and those for critically important minerals are based predominantly in the domestic market or, failing that, at least in friendly countries. “The US wants to exclude China, its biggest rival, from these sectors,” said Engels. He believes that the investment plans of global chip and battery manufacturers in the US are already starting to reflect this. “This trend will continue to gain traction,” he predicted, “because proactive industrial policy initiatives have also started to provide incentives for leading European clean technology companies to invest in the US.”

Engels therefore expects the long-term growth potential of the US and continental Europe to rise. Investment in physical assets, e.g. the construction of factories, has a greater impact on growth than – for example – investing in software, because physical assets are less scalable. “This type of investment creates more jobs, leads to higher wages, and therefore ultimately results in more demand,” he concluded. In addition, more powerful production capabilities, better infrastructure and a strong focus on digitalisation would lead to productivity improvements. Engels believes that this effect will probably be stronger in the US, while Europe would likely prioritise energy security to begin with. He therefore sees a risk that European countries might postpone investments in digitalisation and the transition to a green economy. This could somewhat delay the positive effect on Europe’s potential for growth.

In 2023, overall inflation should weaken globally. But a lasting return to the inflation levels we were accustomed to before the coronavirus pandemic seems unlikely, certainly when talking about core inflation. Several of the trends that characterise the Great Transformation era have a structurally inflationary effect. Booming investment in infrastructure and new production capabilities will fuel aggregate demand, and supply will not always be able to keep pace. “In these situations, the market will rebalance itself through rising prices,” explained Engels. With the pandemic and the war in Ukraine still in mind, companies will assign much greater importance to the security of their supply chains, even if that comes at the price of higher costs. The selection of locations for production sites and other elements of the supply chain will be guided less and less by the highest possible degree of specialisation and low costs, irrespective of geographical location. Instead, factors such as security and stability will become much more significant over the medium term. “Resilience trumps efficiency,” summarised Engels.

The investment boom that Engels anticipates will affect not only inflation and the potential for growth. It will also result in a higher equilibrium interest rate after adjusting for inflation. “Capital will become more scarce and interest rates will go up in real terms,” he explained. Savings, i.e. the available capital supply, will at best remain stable, while demand for capital will be structurally higher. “It is not hard to predict how this will affect the cost of money,” added Engels. His assessment of the medium- to long-term impact: “Interest rates will have to remain at higher levels than those we have seen in the last decade.”

However, using current interest rates as a baseline, Engels believes that there is only moderate need for further increases. “In 2022, we have seen nominal interest rates go up substantially, not least because the central banks have shifted to a much tighter monetary policy regime. The US Federal Reserve and the European Central Bank, which hold great sway over the capital markets, will continue to raise interest rates moderately in the first half of 2023 with the aim of bringing real interest rates into positive territory. Although German savers are currently faced with negative real interest rates after adjusting for inflation, real interest rates should turn positive at the earliest in 2024 assuming that overall inflation continues to fall.”

The real economy and the financial sector have been susceptible to volatility in recent years. Engels believes that this will not change much going forward: “The geostrategic uncertainty that is arising from the war in Ukraine and the intensifying hegemonial rivalry between the US and China also creates greater macroeconomic and microeconomic uncertainty and, by extension, more volatility in financial markets.” Moreover, negative population growth in western countries and in China means that current shortages of skilled workers will turn into general labour shortages over time. “Periods of economic growth will drive wages and prices up more swiftly. The central banks will need to respond with further restrictive monetary policy measures, which means that we will ultimately find ourselves in an environment of greater volatility in growth and inflation, combined with structurally higher interest rates,” Engels explained.

In Engels’ opinion, the transition to the era of the Great Transformation will disrupt trends that have dominated the landscape in recent years. His recommendation to investors is therefore to keep the new growth regime in mind from now on for any future investment policy decisions. “The neutral US key interest rate, which acts as an anchor for the interest-rate markets, should rise back to around 3.5 per cent. This should put bonds back in the equation for many investors.” Engels believes that the bond markets are on the brink of a renaissance. From a technical point of view, the risk/return line in the capital markets is flattening, i.e. bonds are gradually gaining in appeal compared with equities. Ultimately, this means that many groups of investors will no longer be forced to climb the risk ladder in order to achieve their target returns.

Equity market performance will probably not be driven by growth stocks as much as it used to be. In the aftermath of the global financial crisis, growth became a scarce commodity and investors were willing to pay a premium for growth stocks. But as growth returns to structurally higher levels, this incentive will weaken and value stocks will become more attractive. On this basis, a balanced allocation among equities seems advisable.

With regard to stock-picking, Engels believes that greater emphasis should be placed on profit margins. “Since 1999, corporate profit growth has been achieved predominantly through margin expansion and revenue growth. In the era of the Great Transformation, profit margins will come under pressure,” predicted Engels. “Inefficient supply chains, limited availability of labour and higher interest rates will drive up costs and not all companies will be able to raise their prices sufficiently to make up for that.” Stable or growing profit margins will therefore be a crucial factor for investment performance. This makes companies with consistently high profit margins or low debt ratios attractive candidates, irrespective of industry or region. By contrast, Engels sees challenges ahead for those companies that have benefited strongly from globalisation in the past.

In Engels’ opinion, not all, but some of the Great Transformation trends are already affecting the current capital market environment. Looking back at the past few months, he explained: “Elevated inflation and interest rates and the stronger performance of value stocks in the equity markets are the harbingers of the new growth regime.” And he expects these shifts to continue. Commodities (especially industrial metals), equities (especially infrastructure stocks) and inflation-protected bonds are his picks for the likely long-term beneficiaries of the dawning investment era.

As at 16 February 2023.