Oct 31

Better client outcomes in a future that’s very different from the past

Ernst Knacke
Head Of Research at LeifBridge and Shard Capital

Winds of ChangeOver the last 40 years three factors have come together to underpin what has been an era of unprecedented rise in prosperity:

-Globalisation and the structural exporting of deflation into developed economies,

-An unprecedented rise in demand as the boomer-generation entered the labour force, and

-Accelerated demand fed by an extraordinary rise in credit creation.

The consequences: a collective realisation of price stability, disinflation, and robust growth in demand. Alongside thriving capitalism and property rights, innovation has flourished. These dynamics have resulted in an unparalleled increase in the aggregate quality of life in developed economies. However, it has also resulted in an exceptional rise in inequality. Whilst this growth in inequality is imbedded into the theory and structure of capitalism itself, it is an unsustainable factor in the presence of regulation, or a rejection by the majority.

With this in mind, there are several reasons to believe the next decade will be vastly different from what we’ve experienced in recent history.

In our view, there are many uncertainties and factors that will determine the path forward. But three key questions, in particular, are:

-Will labour trump capital in the decade ahead?

-Will society accept the cost of de-globalisation and the localisation of supply chains?

-Will aggregate demand slow as demographics turn upside down and credit-growth falter?

Individually, we can put forward a very strong argument as to why the answer to each of these questions might be yes. However, the consequences will be beyond extraordinary if they were to all materialise collectively.

We know demographics in developed economies have likely reached their zenith. Looking ahead, the rate of growth in our workforce is expected to be significantly slower than that of the elderly population, those aged sixty-five and older. Historical patterns suggest that this situation will lead to a deceleration in discretionary spending and consumption, a decrease in government tax revenue, and a surge in healthcare and pension obligations. One solution is to increase the retirement age. More specifically, the age and duration at which we achieve and can maintain peak earnings, especially in women. However, as evidenced by challenges faced in countries like France, implementing such measures is no easy task. In the absence of measures to increase retirement age and the duration of working lives, governments may resort to funding their growing fiscal deficits through monetary expansion, a course of action we see as highly likely. This, in turn, would devalue fiat currencies and drive-up inflation!

Another significant shift we are witnessing is a change of global supply chains. For many years we have enjoyed the benefits of offshoring and exporting manufacturing needs to emerging economies with cheap labour. This has been a significant and material disinflationary force. Alongside productivity gains in transport and technology, we have effectively maxed out efficiency gains in supply chains to provide the cheapest possible products to consumers. Risk to the current state of global supply chains were highlighted during the pandemic. However, with the significant improvements we are seeing in robotics and automation, alongside ongoing trade disputes and nationalist and populist views, a shift from a global, just-in-time supply chain to a local, just-in-case supply chain, is inevitable. This shift will potentially have many social consequences, but at least, initially, will come with a large price tag, known to some as inflation!

In the absence of a growing labour force, the proverbial pie can be increased through credit creation.Indeed, the capitalist system we live in today are build on credit. The cost of debt, however, has risen materially in recent months and the era of zero and negative interest rate policy is most likely behind us. Evidence suggest ZIRP creates more concerns and uncertainties than growth and productivity. As such, we believe interest rates will be structurally higher in the years ahead as compared with recent history. As the cost of debt rise, demand for it will slow. We believe it is highly likely we’ll see societies and governments reduce debt following a period of unprecedented rise in debt. A deleveraging cycle is effectively austerity – and constrains growth.

In short, what we’ve seen in the last four decades, consistently stable and falling prices, is an anomaly. Alongside demographic changes and a structurally higher cost of capital – likely still low, but not zero! – a period of volatility is ahead of us. Indeed, we see a future where inflation is volatile and growth hard to come by.

Inflation destroys the value of cash, and your fixed pension pot will not suffice! If you have a pension from a Latin America or African country, you will understand. Fixed Income gets killed during periods of volatile and persistent inflation. This is why it is more important today to invest than at any stage in the last 20 years.

Another outcome will be that it will become more difficult to start and run companies. Money is not free...yet! Although capital markets and private equity behaved as if money was free in 2020 and 2021. Typically, periods of volatile and persistent inflation are accompanied by lower equity valuations and positive correlations between credit and equity.

This immediately raises the question of portfolios – most often, sadly, uninformed pensioner portfolios – which are filled with bonds and equities. A typical 60-40 portfolio, or 35-65 portfolio, if you’re 65 years old, will not cut it. You will likely run out of money before you run out of steam.

In our asset allocation approach, we break the world up into four quadrants, split between inflation and economic growth, as per below. During the past four decades the world has spent much of its time in a disinflationary boom environment. This scenario is depicted by falling inflation expectations and interest rates and rising economic growth. The perfect backdrop for a typical 60-40, equity-bond portfolio.

In our opinion, we will spend significantly less time in this quadrant than we have over the last four decades, and much more time in the other three quadrants. This necessitates a better approach to asset allocation, one that understands asset price behaviour in different economic scenarios, a greater focus on value and a need for active management.

The key objective should be to ensure a better client outcome and a better client experience. This is arguably our fiduciary duty, not least due to consumer duty.

Another is a keen focus on fees. Fees are not black and white, cheap is rarely better. Indeed, there is value in quality, and quality often comes at a premium. However, the era of 2% plus management feeand a 20% plus performance fee is behind us.

We also believe rigorous, in-depth manager and fundamental research is essential in achieving better long-term outcomes. As is an active approach towards ESG and sustainability, supported by active engagement.

From a risk-return perspective, we focus on limiting drawdowns and maximising returns within a specific volatility framework.

Finally, actively allocating to real assets and alternative investments alongside our equity and fixed income opportunities ensures better portfolio diversification across different economic scenarios. We say ‘better’ diversification, because too often we come across portfolios that are heavily diversified...but still carry significant risk.

Investors want to diversify away risk...not returns. And diversifying across economic scenarios is crucial in order to achieve long term return objectives and better client outcomes.