2023 Outlook: A time of culmination

As we feared, the ‘challenges of normalisation’ – the theme of last year’s Outlook – are indeed substantial. Underlying inflation pressures from fiscal and monetary loosening after the pandemic, aggravated by the Ukraine conflict, proved much more severe than central banks had assumed, prompting sharp rises in official interest rates.

Whereas in the past central-bank orthodoxy would have led policymakers to tighten in advance of an inflationary episode – ‘getting ahead of the curve’ – a period of low inflation in the 2010s predisposed them this time to being more tolerant of price pressures. Now, they are clearly chasing the curve, leading to an abrupt reversal away from super-loose monetary stances.

Policy tightening sparked another ‘taper tantrum’ in both bonds and equities. As a function of an inflation shock occurring at a time when bonds had been pushed to severely overvalued levels by ultra-loose central-bank policies, equities and fixed income declined together to a degree not witnessed since 1969. The impact on financial assets has been particularly severe because of the excessive asset-price inflation in the post Global Financial Crisis (GFC) ‘zero rates’ period, which culminated in the response to the COVID shock.

Although much tighter liquidity conditions have greatly improved valuations and hence prospective longer-term asset returns, they have not yet materially slowed economic growth, the employment outlook or earnings expectations. That will come in 2023. Having held up surprisingly well, especially in the US, corporate earnings are finally being impacted. In time, central banks can pivot from worrying about inflation to worrying about growth. But not yet. In the interregnum, we can expect volatility to remain elevated and further financial-asset de-rating. We have yet to the reach the culmination of policy tightening that began in 2021, but it is drawing nearer – hence the title of this year’s Outlook.

Figure 1: Policy tightening is about to have an impact on growth and inflation

Source: Bloomberg, Ninety One calculations as at 31 October 2022.

For longer-term investors, periods of culmination present opportunities to acquire assets at good prices. Investor positioning is thoroughly cleansed; excesses are exposed; and positive risk asymmetry (i.e., when potential upside outweighs potential downside) is restored. 2023 could prove to be one such occasion.

As tightening feeds through to the real economy, interest rates should peak and inflation should eventually fall back sharply. COVID-related supply-chain problems have receded, causing goods prices to start to decline; consumers are resisting price increases; many commodity forward curves are already persistently backwardated (jam today costs more than jam tomorrow); and, importantly, key central banks, with a few dishonourable exceptions, are showing determination to prevent inflation expectations becoming unanchored. Just as investors were surprised by the duration and strength of the inflationary spike, they may be surprised by how quickly it eventually fades.

Defensive bond valuations are finally at, or approaching, attractive levels after many years of persistent overvaluation. They look more attractive because a recession is the price of a return to a moderate level of interest rates. One risk, of course, is that, against a backdrop of growing and by now surely excessive financialisation – a variously described term but by which we mean here that the financial sector is increasingly dominating economies – the US Federal Reserve (Fed) over-tightens and by so doing causes more severe economic damage, domestically and particularly internationally.

A rampant US dollar has been the direct consequence of the Fed’s response to US economic overheating, in the context of an energy crisis in Europe and Japan. Dollar dominance has signalled a sharp tightening of international liquidity, the greenback’s degree of strength reminiscent of the Reagan bull market of the mid-1980s. Of course, it could rise further. But there is a high probability that as the economy loses momentum, US interest-rate expectations will finally recede, resulting in a cyclical US dollar peak.

Policymakers in China have been bucking the trend. They were the first to tighten to address overheating in 2021, particular in the domestic property market, and have been easing credit conditions just as the US and other countries have been doing the opposite. The combination of earlier tightening and rigid adherence to a zero- COVID policy led to much weaker growth in 2022 than forecast. However, this is set to change in 2023. Efforts to stabilise the property sector and boost growth via higher spending on infrastructure should start to engender a moderate recovery, which should be reinforced by an eventual easing of COVID restrictions. China still faces significant and largely self-inflicted medium- to longer-term structural growth challenges, but the cyclical picture could brighten considerably.

Elsewhere among the major economic blocs, economic recoveries will more probably be a feature of 2024 than 2023. Short of a systemic crisis, interest rates are more likely to level off than pivot. Having got it so wrong, central banks (led by the Fed) will be reluctant to declare victory against inflation prematurely and will focus on lagging indicators such as unemployment to guide monetary policy – which in any event will take time to impact real economies. A risk is that they continue to fight yesterday’s battle – the post-COVID spike in inflation – and keep official rates too high. This notwithstanding, markets will eventually anticipate economic stabilisation and eventual recovery.

Finally, the Ukraine crisis is likely to recede as a material influence on commodity prices, either through exhaustion and stalemate or a conclusive outcome on the battlefield. Should this be the case, energy prices are likely to continue to subside, removing the most serious headwind for European economies in particular. Of course, the geopolitical consequences of the crisis could continue to be felt for much longer.

In 2022, government bond markets experienced some of their worst declines for decades as surging inflation caught central banks by surprise. Of the major central banks, the Fed has been the most emphatic in its drive to get ahead of the curve and prevent longer-term inflation expectations becoming unanchored. This has generally set the tone for sharp rises in yields in other developed bond markets, even if their central banks have been more tentative in raising official interest rates as growth has weakened. The only exception was the Japanese government bond market, where the Bank of Japan continued to cap long-term interest rates, leaving the yen to take the strain.

Our central case is that the Fed will have achieved its interest-rate target in the first quarter of 2023, and thereafter official interest rates will remain on hold for the balance of the year. To use late Fed chairman Paul Volker’s words, they will ‘keep at it’ until they are satisfied that inflation in the US is on a sustainable downward path towards their mandated target of 2%. The full impacts of tighter credit conditions in the US, which commenced in the second quarter of 2022, will be felt in 2023, with a recession highly likely. This is already the case in other parts of the world, notably Europe, which has borne the brunt of an energy price spike triggered by the Russia- Ukraine conflict.

Having been rendered uninvestible in the post-GFC ultra-low rates regime, government bonds are once more investible in several developed markets. Chief among them are the dollar-bloc markets, including Canada, Australia and New Zealand, with overvalued housing markets beginning to impart disinflationary shocks. South Korea faces similar challenges.

Our key assumptions are that the Fed in particular will have done enough to ensure that inflation assumptions remain firmly anchored over the medium to longer term, and that the overall trend in economic growth will remain constrained by demographics and debt. This will leave room for official rates to moderate eventually and for the yields on longer-dated bonds to anticipate this. Having been unusually correlated to equities in the recent past, bond-market behaviour should ‘revert to type’ now that valuations have normalised, potentially providing valuable diversification at a time when uncertainty about the length and depth of a global recession is set to increase. But we are not anticipating a return to the post-GFC interest-rate regime. That culminated in the policy errors following the COVID crisis, which threatened to unleash a self-sustaining inflation shock.

Extreme inflation pressures will begin to subside next year, especially in terms of tradeable goods. However, the lagged impact of rental-related prices, together with wage-related pressures, are likely to ensure that inflation remains at a higher level than was the case in the post-GFC period, causing central banks to pursue more conventional interest-rate policies. Importantly, we believe this represents a fundamental change in interest-rate regime in the West and, coupled with heightened geopolitical tensions, is likely to lead to a sustained increase in macro volatility. This will require more flexible approaches to asset allocation and portfolio diversification.

Figure 2: Bonds are starting to reach our fair-value estimates

Source: Bloomberg, Ninety One calculations as at 31 October 2022.

The US dollar’s recent dominance has been extraordinary but not unprecedented. The US currency was already strong, driven by flows into outperforming US dollar-denominated assets, when its dominant position was reinforced by the Ukraine crisis and finally the Fed’s aggressive move to raise interest rates. That took the greenback to levels last seen in the bull market of the mid-1980s. Dollar cash has become an extraordinarily crowded trade.

Certainly, the US would seem to possess many comparative advantages, from energy self-sufficiency, to relative market resilience in a downturn, to a powerful corporate sector. However, it would be wrong to assume (just as it was wrong in 1985) that such attributes can fully justify this level of overvaluation. We think there is a good case to expect the forces that have driven the US dollar to its current lofty level to begin to ebb in 2023 – though possibly from yet higher levels if US inflation remains stubborn – which would generally ease the pressure on currencies that have weakened substantially over the course of the last two years. Whether this is the beginning of a structural bear market in the US dollar is a moot point, but cyclical moves can be material, as we have witnessed.

Of other major currencies, the yen is an outlier in valuation terms, and as such has the most recovery potential should US growth show signs of severe weakness or a threat to financial stability force the Fed’s hand.

Figure 3: Cross-asset performance after US dollar peak is relatively strong, especially for non-dollar risk assets

Source: Bloomberg, Ninety One calculations as at 30 September 2022.

In nominal terms, credit markets moved significantly in response to the dramatic shift in inflation and interest-rate expectations, experiencing one of their worst years in history in outright performance terms. Spreads widened sharply, albeit from historically tight levels, but less so than in previous bear-market episodes and indeed have only retraced to long-term averages. In part, this has been due to better underlying market quality; corporate fundamentals have held up well and we have seen substantially lower issuance. Over the past two years, companies had clearly taken full advantage of low funding rates, pushing the ‘maturity wall’ out to 2024.

In other words, credit-market investors are pricing in a ‘soft landing/ low default rate’ scenario for the time being, given the lack of immediate catalysts for a significant default spike. However, the asset class will likely be tested in 2023 as liquidity conditions continue to tighten, key economies face recessions and corporate earnings come under pressure, and the spectre of growing refinancing requirements in the ensuing years becomes an elevated concern. In the past, credit has generally bottomed around the same time as equities, with the exception of the early 2000s cycle when it preceded the equity trough by a few months. If equities continue to derate, as we expect, then there is scope for a bit more downside in credit, especially in high yield.

Much will hinge on eventual default rates and whether leverage that seemed manageable in a zero-interest-rate environment is sustainable for many companies when the time comes to refinance debt at 2-3x the current cost. This in turn suggests that dispersion, having been very low in the sell-off in 2022, will pick up – resulting in greater rewards for successful security and sub-asset-class selection. Unusually, in the 2022 sell-off the higher-quality segments such as investment grade, and structured credit such as highly rated collateralised loan obligations (CLOs), fared worse on a relative basis. These areas now offer appreciably better risk/reward trade-offs in the event of weaker than- consensus growth or recovery. By contrast, the most vulnerable issuers will struggle to maintain their capital structures in the current interest-rate environment.

Figure 4: Absolute yields are more attractive, but spreads have room to widen further

Source: Bloomberg, Ninety One calculations as at 31 October 2022.

Emerging markets were the first to be impacted by rising inflation and the prospect of tighter global liquidity in 2021. Unlike developed-market central banks, those in the developing world are familiar with the twin challenges of inflation and liquidity, and have generally had to pursue more orthodox monetary policies. This, and generally good macro fundamentals such as current-account positions, should stand them in good stead over the medium term, despite the ravages of a strong US dollar and elevated inflation.

Figure 5: Current levels of yield and spread provide a cushion against near-term volatility

Source: Bloomberg, JP Morgan. Ninety One, 31 October 2022.

*YTM = Yield to Maturity. STW = Spread to Worst.

Source: Lazard Asset Management calculations. *30 September 2022.

Over the medium term too, if we are correct in our assumption that commodity prices could prove to be well supported in the next cycle, emerging market fundamentals have the scope to benefit from positive tailwinds, in contrast to the headwinds of the last cycle, when commodity prices corrected. In the meantime, the carry on local-currency denominated bonds is broadly attractive, especially if the peak in the current US rates cycle is fully discounted in the first half of 2023. Inflation in some key emerging markets is already rolling over and currencies are generally cheap.

Hard-currency denominated emerging market debt should be considered a derivative of US credit markets, with which it needs to compete for capital. At current nominal yields and spreads, it should be able to do so. In contrast to other periods of crisis, the major sovereign borrowers are in reasonable shape, but this does not seem to be reflected in current pricing. The emerging market corporate bond market has been particularly hard hit, although fundamental underpinnings, albeit with some notable exceptions such as some Chinese developers, have been stable. Many companies are fully funded and were never as levered as their developed market counterparts. The damage in spread terms has been done principally by massive capital outflows from the sector, driven by investor de-risking and concern about elevated geopolitical risks. These dynamics have arguably driven many securities within the broad universe to valuation extremes, with particularly compelling value in the BB/BBB area for medium-term investors.

During bear markets over the last century, the average S&P 500 Index decline was 38% from top to bottom and spanned 15-16 months. In the first nine months of 2022, the S&P 500 Index declined 25%. On this crude historical measure alone, it seems unlikely that we have yet seen the full extent of this bear market, particularly given the excesses of the prior cycle in terms of both stimulus and resultant valuations.

The decline to date can be primarily attributed to the sizeable shift in cyclical interest-rate expectations, which led to a valuation re-set, reflected in a sharp compression of earnings multiples. While starting to show some signs of weakness, recent earnings in the US market have remained broadly resilient thus far. This is particularly the case when one considers the significant US dollar headwind that many (particularly larger cap) companies have faced. Unsurprisingly, so-called long-duration equities (i.e., those seen as most sensitive to changes in interest rates) such as the profitless tech companies have been particularly hard hit.

In other words, higher rates have yet to materially impact the economy and therefore company earnings. We know that changes in interest rate policy and hence liquidity impact the real economy with a lag. Although they are already hitting some sectors, such as housing, and resulting in destocking, the full effect will be felt over the course of 2023 and is likely to cause a recession – although ex ante it is impossible to determine its severity. It seems reasonable to assume that there will be an earnings contraction in the US of the order of at least 15% and more. Such an outcome would be consistent with the median outcome of the last 11 recessions. This has yet to be fully factored into US equity market multiples, which currently look more ‘mid-cycle’. Should growth hold up better and core inflation fail to fall back, there would be a greater chance of an extended late-cycle phase and, given the upward pressure on inflation, eventually a harder landing. Capitulation by the Fed would provide some relief, but our expectation is that the US central bank is prepared to accept a recession as the price for keeping inflation anchored over the longer term.

Geopolitics are likely to play an outsized role in driving equity market volatility compared to the last decade or more. Whether this relates to the continuing Ukraine conflict, attempts to forecast the end of China’s zero-COVID policy or the trajectory of US-China relations, to name a few. Even in areas like sustainability, the debate is becoming increasingly politicised. Elements of the Inflation Reduction Act – which, among other green goals, is supposed to foster the development of the electric vehicle industry in the US – has faced criticism from South Korea and Europe over the requirement for domestic US assembly and material/component sourcing. While the politics is inherently difficult (impossible) to forecast, what we can say is that it will likely introduce more volatility.

Cosmetically, the European and UK markets would appear to be cheap and already discounting recessions and declining earnings. Their respective currencies have also declined materially against the US dollar. However, Europe and the UK’s structural challenges remain substantial as a result of chronic issues including demographics, over-indebtedness, a lack of competitiveness in digital technologies and financial systems which are hampered by excess capacity relative to attractive lending opportunities. This means that they will not be immune to further earnings deterioration. Europe will also be path dependent on the duration and outcome of the Ukraine conflict and the effective tax that resultant higher energy prices place on consumers and businesses.

Having disappointed for over a decade, emerging market equities would appear to have now de-rated to historically low absolute and relative valuations. The key to any sustained recovery is probably the currently deeply unloved and consequently very cheap Chinese market. Having tightened first and felt the consequences, the Chinese have loosened credit aggressively to support an economy severely disrupted by the zero-COVID policy, and taken steps to mitigate property sector weakness. There are some tentative signs already that China’s cycle is bottoming and a managed exit from the zero-COVID policy has the potential to unleash significant pent-up demand.

A recovering China should ultimately be supportive of emerging market equities more generally. Latin America could benefit from the impact on commodity prices of a recovering China. In Brazil, the central bank has been particularly ahead of the curve in raising rates, and so has greater scope to support a recovery when inflation dynamics allow. Emerging market equities more generally are likely to be particularly responsive in the event of a moderation in US interest-rate expectations and a peak in the US dollar. International investor positioning is light, which reinforces the case for asymmetry, even as growth weakens in the US and Europe. Should the eventual economic recovery turn out to be capital and commodity intensive, as we suspect will be the case, the recovery in the asset class could well turn out to be more substantive than a simple cyclical rebound.

From a sector perspective, earnings momentum will likely continue to be a significant factor in driving sector performance divergence. Defensive industries such as healthcare, utilities and telecoms will probably continue to make the running, at least until there is greater clarity about the depth of the earnings recession, but they have become expensive and failure to meet market expectations will likely be severely punished. Increasingly, energy, materials and financials look to be best supported and stand to benefit in the event of an eventual inflection point in the current downward trajectory.

Bear markets typically presage a shift in market leadership, and some large digital franchises are likely to face greater headwinds, such as media-spending and capital-expenditure needs in future. In the next cycle, capital expenditure could well take centre stage, benefitting more traditional industries and enablers of the energy transition. In turn, higher levels of nominal growth and interest rates through the cycle could transform the profitability of interest-rate sensitive financials. Within the universe of severely de-rated growth stocks, there are some compelling franchises that will rise to prominence in the future, in a way analogous to the period after the dot.com bust in 2000-2002.

While there is a risk that capital expenditure softens in response to a slowdown, we are already seeing companies decide that some areas of investment can’t wait for a more benign economic environment. For example, the electric-vehicle transition in autos has seen spending rise on related microchips, even as corporates are reporting slowing spending elsewhere.

Times of dislocation often provide the best entry points into areas of the market and regions set to benefit from growth ‘tailwinds’ over the medium and longer term. Looking at equity markets through a thematic lens, a number of opportunities stand out. As we emerge out the other side of the current economic slowdown, be that later in 2023 or early 2024, we will likely see companies look carefully at issues such as making their supply chains more resilient, whether through increasing the geographic diversification of their suppliers or by increasing investment in energy efficiency and renewable-energy generation. The latter increasingly makes sense from both a resiliency and economic perspective.

The energy transition has been accelerated by the Ukraine conflict, which has served to underline the importance of energy security at the national level, adding an additional impetus. Energy transition beneficiaries include many traditional industries, including providers of the resources and materials required in the build-out phase. The forces pushing de-globalisation have also been strengthened by the intensification of geo-strategic competition, resulting in increased defence spending and a new emphasis on supply-chain resilience, and not just cost effectiveness.

Finally, the end of US household deleveraging, where millennials are forming households and have the scope to take on leverage, will benefit sectors such as housebuilders, which have been notably weak because of cyclical concerns.

Figure 6: Equity prices follow the global cycle and will be depressed by a recession

Source: Bloomberg, Ninety One calculations as at 30 September 2022.

Against a generally bearish macro backdrop, commodities outperformed strongly in 2022. Supply disruptions due to COVID were exacerbated and prolonged by Russia’s invasion of Ukraine. Even with destocking in many metals over the summer, inventories have generally remained low. The underlying cause of this is that the world is coming out of a downcycle in capital spending on resource supply, which began in 2015 in response to the excesses of the preceding commodity supercycle. Yes, cyclical demand is slowing and will probably continue to do so as much of the world likely falls into recession. But there is simply not enough supply of a number of key commodities. Mining companies have been under persistent investor pressure to strengthen their balance sheets rather than initiate new projects. In addition, permits have been harder to obtain as environmental and social concerns have increased.

Pressure on energy and energy-related commodities might ease in the nearer term if the Northern hemisphere winter proves mild, and more so if the Ukraine conflict is resolved. But access to capital remains a significant constraint, especially as the energy transition looms. The one bright spot on the cyclical demand side is a potential revival of Chinese demand as that economy begins to recover. This is likely to be led by infrastructure investment which, of course, is commodity intensive.

While cyclical demand may look weak in aggregate in the short term, our longer-term outlook for many commodities is strongly positive as the world transitions its power-generation systems. People have talked about decarbonisation for some years in an abstract way. But 2022 showed that it really can have an effect on the micro realities of supply and demand. In addition, ‘strategically critical minerals’, ‘security of supply’, and ‘local production’ are terms that we will become increasingly familiar with. Demand for resources is also likely to be spurred by a wave of investment in reconfiguring supply chains required by a de-globalising world.

Figure 7: Will the capital cycle trump the commodity cycle?

Source: Bloomberg, Ninety One calculations as at 30 September 2022.

Finally, many consider gold to have been a poor performer in 2022, but much of this has been a US dollar effect. In non-dollar terms, gold performed considerably better. It could be argued that it held up well in the face of a dramatic rise in long-term real interest rates, typically a major headwind for the metal. There is a high probability that the twin headwinds of US dollar strength and higher long-term real interest rates will begin to moderate later in 2023. That investor positioning is light and the splintering of the post-Cold War world order should all be supportive factors.

Thematic investing is about grasping, and getting on the right side of, multi-year top-down trends. Our Road to 2030 project, which we launched in 2020, highlighted five thematic areas – debt, demographics, the rise of China, technology and climate change – and various secondary, tertiary and quaternary themes, and the connections between them, that were relevant for investing over this decade. Developments since – a pandemic, war and persistent inflation – have highlighted the importance of thinking thematically and contextually about the phenomena that are affecting portfolios.

There are any number of general observations that can be made about medium-term thematic trends. We restrict ourselves here to three narrow, analytical points. First, monetary policy tightening is going to constrain fiscal policy for the foreseeable future. Second, US-China tensions are not likely to end globalisation but to push in favour of regionalisation in the years ahead. Third, we are seeing an historic acceleration in fossil-fuel demand destruction as a result of the Russia-Ukraine conflict.

“Toto, I have a feeling we’re not in Kansas anymore” – this line from The Wizard of Oz will feel more familiar to investors as the decade unfurls. Looking at the energy transition (which, as we’ve noted, has been accelerated by Russia-Ukraine conflict), deglobalisation (underpinned by both geopolitical tensions and lockdowns), the end of household deleveraging in the US (as millennials form households, move to the suburbs and take on more leverage), and the fact governments crossed the Rubicon during COVID when it comes to joint fiscal-monetary policy, over the next 10 years we are likely to find ourselves in a very different cycle from the secular stagnation period of the 2010s.

This implies somewhat higher and more volatile inflation, more volatile interest-rate cycles, higher asset correlations, multiple de-ratings, and a capital and resource intensive cycle – all of which could drive new market leadership.

Tightening monetary policy is going to constrain fiscal policy

Because of above-target inflation, the world is undergoing the most comprehensive tightening of monetary policy in history. While the Volcker moment after 1979 involved steeper interest-rate rises, today’s moment involves far more central banks. This matters because, since the GFC, both conventional and unconventional central-bank policy has tended to constrain debt-service costs from rising too fast. Interest costs as a percentage of GDP for the US are nearly half where they began in the early 1990s, despite debt doubling during that period.

Figure 1: US federal outlays vs. federal debt

Source: US Federal Reserve

Monetary tightening reverses this dynamic: now, higher debt levels cannot go hand-in-hand with lower interest costs. On balance, this puts pressure on treasuries to constrain spending and increase revenues. In other words, higher rates will squeeze budgets. To the extent that governments choose not to add these costs onto existing debt loads, they invite more attention on medium-term policy frameworks – which is exactly what happened in the UK in September 2022.

Just how big of an impact is this likely to have? In the US, the Congressional Budget Office (CBO) estimates that net interest outlays are projected to increase from 1.7% of GDP in 2023 to 3.3% in 2032, well above the 50-year average of 2.0%¹. In US dollar terms, that means net interest outlays will triple from US$399 billion in 2022 to US$1.2 trillion by 2032. Total net interest outlays from 2023-2032 are expected to be US$11 trillion, but just 18 months ago that figure was estimated to be US$2.5 trillion lower². This figure is equivalent to two years of current Medicare and Medicaid spending, an extremely large amount. The assumptions behind these CBO forecasts are not particularly onerous – it is easy to imagine worse scenarios. They include that inflation settles at 2.4% by 2027-2032 and that the 10-year treasury settles at 3.8%.

Why does this matter for investors? Over the past decade, investors benefited from a consensus within central banks and the economics profession that, most of the time, it was far better to have too much macroeconomic stimulus (high deficits, very low interest rates) rather than too little. We are now going into a world where the assumption behind that thinking has been destabilised.

Going forward, tighter budgets increase the probability of higher taxes on companies and investors; they raise the cost to governments of spending to boost growth, even during downturns; austerity policies increase the likelihood of distributional conflict and political polarisation; and tighter budgets increase financial stability risks at the margin. At the very least, this implies more uncertainty, greater cyclicality and greater volatility in cash flows – and lower multiples for risk assets.

The multi-polar order will lead to regionalised supply chains and disproportionately benefit non-aligned third countries

Our second high-level observation is that supply chains will continue to evolve in a regional direction, given the rising salience of values in geopolitics and the tensions brought about by multipolarity. This order will disproportionately benefit non-aligned countries. This is a much more complex picture than the simplistic deglobalisation narrative that has often been referenced as a tail risk. For one thing, supply chains were never very globalised, as charts of complex value chains compiled by the World Trade Organisation reveal. Except for US-China direct trade, goods-related globalisation was already becoming more intra-regional than interregional. For example, in the early 1990s, North America absorbed 35% of East Asia’s exports, while today that figure is under 20%. East Asia’s share of exports to itself grows every year. For another, if headline measures of globalisation have stalled in recent years, it is because Asian countries are consuming more of what they produce, an entirely natural outcome as they move up the value chain.

Most supply chains were anyway regional, as the charts below show. Trade is likely to evolve in that direction.

Export destination partner shares for three regions

Source for Figures 2,3,4: World Integrated Trade Solution, “Exports, imports and trade balance by country and region,” 2018.

Yes, global businesses that did depend on the vast political and trading relationship that was Chimerica are now beginning to search for alternatives. What they are doing is creating ‘China for China’ supply chains, and rest-of-the-world supply chains. Apple is a prime example. China-based factories now churn out the majority of Apple’s products, yet the company has made a concerted effort to diversify production bases out of China to India and Vietnam. This is in part because consumption from India and Vietnam has continued to grow, but it is also because those countries are relatively non-aligned in the new world. Whereas today less than 5% of Apple’s products are made outside China, by 2025 the figure is estimated to be around 25%³. ASEAN⁴ and South Asia are set to benefit disproportionately from the manufacturing boom.

The next cycle looks likely to see an acceleration of the regionalisation trend. Many companies are actively discussing de-globalisation, reshoring and improving supply-chain resilience⁴. We think that will continue.

Investors may benefit from being exposed to the regional (primarily Asian) economies that are non-aligned, as well as small caps over large caps on the grounds that large caps are more likely to have global businesses. There may also be headwinds for large global businesses in sensitive areas like technology and healthcare, where national security considerations are demanding resilience and consequently domestic production capabilities.

Figure 5: Share of sentences mentioning supply chain reshuffling in Russell 3000 earnings calls

Source: GS DataWorks, Goldman Sachs Global Investment Research.

Fossil-fuel demand destruction is accelerating

Finally, we are seeing a historic acceleration in fossil-fuel demand destruction as a result of the Ukraine crisis, particularly in Europe. As the International Energy Agency (IEA) has pointed out, the global energy crisis has “turbo-charged” the shift away from fossil fuels⁵. Global solar capacity will climb 18% higher by 2030 than expected last year, and wind 14%. CO2 emissions are now set to peak by 2025 at the latest, potentially putting the world on target for 2.5-degree warming from pre-industrial levels. The IEA report was prepared throughout the first half of 2022, so these estimates are likely conservative.

The policy mechanisms behind these shifts differ by region. The EU's Green Deal had already aimed at making the EU carbon neutral by 2050, but the REPowerEU package after the invasion of Ukraine accelerated that. In the US, the Inflation Reduction Act prioritised green investment in a number of different areas. The expected shift in gas consumption has been most dramatic. Last year, gas demand was expected to grow 20% by 2050. Now the figure is just 2%, though consumption may well rise in certain regions before it goes into structural decline. The role of natural gas as a ‘transition fuel’ continues to divide opinion.

Resource efficiency in particular has been a big driver of demand destruction. We know from the past that resources were being consumed inefficiently. In Cape Town, water use in agriculture declined between 2017 and 2018 by 60% after persistent drought changed behaviour⁶.

Today, too, efficiency is increasing. We are seeing strong adoption of consumer and industrial technologies to structurally reduce use of resources. For instance, since April, gas consumption by households and businesses in Germany is running at 75% of 2021 levels⁷. Heat-pump sales in Finland jumped 80% in the first half of the year⁸.

For investors, there are clearly opportunities. For one thing, demand destruction for fossil fuels is unlikely to precipitate a supply response in commodities. So, paradoxically, the prices of those commodities are likely to stay high, a condition the European Central Bank’s Isabel Schnabel calls ‘fossilflation’. Investing in transition assets – those with heavy emissions today but with credible plans to transition – may deliver good outcomes for society and investors.

Beyond the traditional commodity sector, the IEA report looks at the manufacturing capacity needed for key clean-energy technology supply chains. It finds that for solar, batteries and electrolysers, enough capacity is planned by 2030 to meet current climate pledges. However, for heat pumps, lithium and copper, there is a shortfall relative to what will be needed.

Meanwhile, there is a large gap between the cost of clean-energy finance in developed versus developing economies. The cost of capital differential was 9.0-13.5% in emerging markets vs 2.5-5.5% in advanced economies and China. That high cost of capital is not good for the transition in the long run, but in the short run there is an opportunity for investors.

Figure 6: The global energy crisis is dramatically accelerating the shift away from fossil fuels

Source: CarbonBrief Clear On Climate, October 2022.

Evolution of the Road to 2030

There are always top-down trends that structure the experience of market participants. But since 2020, we have lived in a world in which these have arguably grown more powerful. The three trends outlined here – the impact of monetary policy on fiscal policy, the shift towards regionalisation and fossil-fuel demand destruction – are but three that are putting us in a very different context from the low-growth, lowinflation world of the 2010s. This implies potentially quite different market leadership over the next cycle, in the context of somewhat higher and more volatile inflation, more volatile rate cycles, higher asset correlations, multiple deratings, and a capital and resource intensive cycle.

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¹ Net interest outlays consist of interest paid on Treasury securities and other interest that the government pays (for example, interest paid on late refunds issued by the Internal Revenue Service) minus the interest that it collects from various sources (for example, from states that pay the interest on advances they received from the federal Unemployment Trust Fund when the balances of their state unemployment accounts were insufficient to pay benefits promptly). Net interest outlays are determined mostly by the size and composition of the government’s debt and by market interest rates.
² Congressional Budget Office, August 2022.
³ The Economist, October 2022.
⁴ ASEAN = Brunei, Cambodia, Indonesia, Myanmar. Lao, Malaysia, Philippines, Singapore, Thailand, Vietnam.
⁵ Oppenheimer postmodern cycle piece GS.
⁶ CarbonBrief, October 2022.
⁷ Water security in Cape Town, South Africa. OECD iLibrary.
⁸Bundesnetzagentur.
⁹ Politico, October 2022.

Big picture: prepare for a new market regime

• Runaway inflation in 2022 finally ruptured the market regime that has persisted for more than a decade. As we enter a new era, investors must carefully assess their positioning and investment approach.
• For longer-term investors, periods of culmination present opportunities to acquire assets at good prices. They also often provide entry points into areas of the market and regions set to benefit from growth tailwinds.
• Higher inflation rates and the change in interest-rate regime in the West, coupled with heightened geopolitical tensions, are likely to lead to higher macro volatility. This will require more flexible approaches to asset allocation and portfolio diversification – both to target capital growth and resilient income streams.

Equities

• Bear markets typically presage a shift in stock-market leadership. Some large digital franchises are likely to face greater headwinds. In the next cycle, more traditional industries and enablers of the energy transition may benefit – not least as the energy transition has been accelerated by the Ukraine conflict.
• After over a decade of disappointing performance, emerging market equity valuations are now historically cheap. The recovery in the asset class could well turn out to be more than a simple cyclical rebound.
• The more volatile, higher interest-rate environment we expect will be testing for many companies. Those with durable competitive advantages, less sensitivity to economic cycles, strong balance sheets and exposure to structural growth may add resilience to a portfolio, subject to their valuations.
• Among equity sectors, energy, materials and financials stand to benefit in the event of an eventual inflection point in the current downward trajectory.

Bonds

• Having been uninvestible since the Global Financial Crisis, government bonds are once more investible in several developed markets.
• More broadly, defensive bond valuations are finally at, or approaching, more reasonable levels after many years of persistent overvaluation.
• Bond-market behaviour should ‘revert to type’ now that valuations have normalised, rather than being correlated to equities, potentially again providing a source of diversification at a time of considerable uncertainty.

Regional

• The full impacts of tighter credit conditions in the US, which commenced in the second quarter of 2022, will be felt in 2023, with a recession highly likely.
• The Ukraine crisis is likely to recede as a material influence on commodity prices. Consequently, energy prices should continue to subside, removing the most serious headwind for European economies.
• China’s efforts to stabilise the property sector and boost growth should start to engender a moderate recovery. It still has structural challenges, but the cyclical picture could brighten considerably.

Commodities

• While cyclical demand may look weak in aggregate in the short term, our longer-term outlook for many commodities is strongly positive as the world transitions its power-generation systems, while the imperative to move to net zero caps the traditional supply response.