The world is fragmenting.
This fracturing had already been underway with the emergence of China as a major economic and geopolitical player and Western governments’ skeptical stance toward China. The war in Ukraine and the responses to it are widening these geopolitical fractures and could accelerate the move from a unipolar world to a bipolar or multipolar world.
In a more fractured world, we believe governments and corporate decision-makers will increasingly focus on searching for safety and building resilience:
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With the risk of military conflict more real following Russian aggression toward Ukraine, many governments—especially in Europe but also elsewhere—have announced plans to increase defense spending and invest in both energy and food security.
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Many corporate decision-makers are focused on building more resilient supply chains through global diversification, near-shoring, and friend-shoring. These efforts were already underway in response to US–China trade tensions and the COVID pandemic, and are likely to be intensified given the more insecure geopolitical environment.
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Moreover, in response to climate-related risks and the COVID crisis, most governments and many companies have already increased efforts to mitigate and adapt to global warming and to improve health security for their citizens and employees.
Investors will reach for resilience in their portfolio construction.
Five Macroeconomic Implications
First, higher spending in many areas, including defense, health care, energy and food security, more resilient supply chains, and climate risk mitigation and adaptation, may well support aggregate demand. However, much of this additional spending may not help long-term productivity growth, unless companies make additional efforts at increasing productivity growth through accelerated investment in technology. Also, the reach for resilience will likely be accompanied by more regulation and protectionism, which could weigh on long-term growth.
Second, the quest for resilience and security introduces some inflationary tailwinds as companies build redundancies into their supply chains and bring them closer to home. Government restrictions on immigration could make labor markets less competitive, potentially leading to higher wage pressures. The green transition, which should eventually lead to lower energy prices, may well push them higher for a while.
Third, central banks are facing a dilemma. Supporting aggregate demand and building resilience would come at the cost of higher inflation. Conversely, bringing inflation back down to target would be costly in terms of demand and employment. For now, given how far inflation exceeds central banks’ targets, most are emphasizing the fight against inflation. Our view is that inflation risks over the five-year secular horizon have shifted to the upside.
Fourth, we see a higher probability of private-sector credit events and default cycles over the secular horizon. Public sector and corporate balance sheets will likely be under pressure from rising spending on security and resilience, debt service costs will likely be higher, and the risk of a recession is real. Elevated inflation implies central banks may be less willing or able to support private-sector debtors. Governments may also be less willing to help due to a further surge in debt levels during the pandemic and the need to finance rising pension and health-care costs.
Fifth, we see a risk of financial deglobalization and more fragmented capital markets. The weaponization of financial sanctions and currency reserve holdings may well increase the home bias by public and private creditors in current account surplus countries, and could lead to an ebbing of financial flows into the US dollar over time. However, given the lack of good alternative currencies with deep and liquid capital markets, any such shifts are likely to be glacial rather than abrupt.
Investment Themes
We believe that we have firmly moved beyond the world that we once characterized as the “New Normal” of subpar but stable growth and inflation stubbornly below central banks’ targets. During that period, many investors were rewarded for “reaching for yield” and for “buying the dip.” However, over the secular horizon, we believe that central banks may be less able to suppress market volatility and to support financial asset market returns.
Looking forward, rather than reaching for yield, we believe that investors will be reaching for resilience in their portfolio construction, looking to build more robust asset allocation in the face of a more uncertain environment for macro volatility, market volatility, and central bank support.