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Panel discussion: Change as a norm disruptor

At the Aberdeen Standard Investments Annual Conference held in November, Steph McGovern, Business Broadcaster (SM) chaired a lively panel discussion on the outlook for the global economy, and the opportunities and challenges ahead for investors. Speaking are Lucy O’Carroll (LoC), Chief Economist, James Athey (JA), Senior Investment Manager, Andrew Milligan (AM), Head of Global Strategy and Jeremy Lawson (JL), Chief Economist.


SM: When will the current global expansion come to an end?

JA: We are experiencing one of the longest economic expansions on record. Now we are in the midst of a monetary-fiscal handover, where governments are taking over from central banks in supporting their economies. We’ve relied on monetary policy almost exclusively since the global financial crisis. Many countries entered the crisis with challenging fiscal positions, which have only worsened since. Some governments are using further fiscal stimulus to boost growth, for example, China, South Korea and Canada. We are slowly moving back to a “normal” world.

The reversal of quantitative easing is a particular vulnerability.

LoC: Expansions do not always die of old age. The current global expansion has lasted eight years, and in the U.S. is in its tenth. There have been expansions in Australia and the Netherlands that have lasted 26 years. What brings them to an end? Often, it’s policy error. This time, the reversal of quantitative easing (QE) is a particular vulnerability.

JL:To use a metaphor, business cycles can die for several reasons. They might have a terminal illness such as a credit or asset price bubble. They can experience a sudden heart attack like an oil price shock. They can be euthanized by central banks seeking to unwind economic and financial imbalances. Or they can be accidently killed by policy errors. We can account for many of these things in models and calculate the probability of recession at different points in time. Our models suggest that across most markets, the probability of recession is currently quite low. So the expansion could continue for three to four or five to seven years, but we have to be alert to emerging imbalances, most notably China, where imbalances are currently very large.

SM: The emerging market share of global gross domestic product (GDP) has increased from 43% in 2000 to almost 59% today. What do you think will happen to this share over the next 10 years?

JL: I expect the emerging market share to continue to rise, but more slowly than the pre-crisis years, to between 60% and 65%. Some special factors contributed to strong emerging market growth between 2000 and 2013, particularly China’s rapid growth and the commodities super cycle. But many of the forces that have propelled growth are starting to fade. China’s growth is decelerating, while productivity is slowing across emerging markets. How much trend growth slows, and in which economies, is partly down to policy choices. If emerging markets can undertake significant structural and political reforms, they could sustain higher growth rates than we currently anticipate.

Demographics are critical to the outlook for emerging markets.

AM: Demographics are critical to the outlook for emerging markets. For example, India’s population is growing rapidly, so the number of inhabitants should overtake China by about 2025. A young population also means there will be very strong growth in household consumption. Africa’s population is expected to take off in the 2030s while, in contrast, population growth in developed markets will slow sharply or even stagnate. So we can speculate whether India’s economic growth will overtake China’s and, later on, Africa’s will overtake India’s. The next question for emerging market investors to consider is around the composition of emerging market GDP growth – whether it is more investment-led or consumption-led, for example, and how will the mix evolve over time. We also need to distinguish between emerging markets, some of which are actually very advanced, for example South Korea, and the frontier markets.

LoC: The problem with population forecasts is that they are even less reliable than GDP growth forecasts. Nevertheless, they are fundamental to the story. But while population growth is important, it’s also about labor market inclusiveness and this depends on access to education, female participation and urbanization. We all know about China’s rapid ascent, but China has unusual demographics because of its one-child policy. Now the government has abolished this policy, it will be interesting to see the impact on economic growth.

JA: The United Nations estimates that, by 2050, Asia will contain half the world’s population, but Africa will contain a quarter and will have the fastest-growing population in the world. But Africa is faced with challenges that it will have to overcome, for example, political corruption, particularly in mineral-rich countries.

SM: What is the most important objective for major central banks in the next two to three years?

LoC: Central banks have to meet certain objectives, of which price stability is usually the main one, via inflation targets. However, price stability will not be the central banks’ main concern over the next few years. Rather, it will be maintaining their credibility so they can continue to influence the economy through inflation expectations.

The first challenge to this is the perceived interference of politicians, particularly because some of the monetary policy tools used by central banks blur the lines between monetary and fiscal policy. The second point is that some central banks think they have been too successful and so have anchored inflation expectations at such low levels that it’s very difficult for inflation to increase and, therefore, for interest rates to be raised beyond the effective lower bound. As a result, many central bankers, including Janet Yellen, are now debating if they should change inflation targets (from 2% to 4%, for example) or change the target itself (to nominal GDP, for example).

JL: I will defend central banks, to a certain extent. It’s not long ago that people were arguing that the European Central Bank’s (ECB’s) QE program would be a failure. Now, around two years later, although inflation remains low, the Eurozone economy is growing well above trend, and unemployment is falling. None of this would have occurred without the actions of the ECB.

Central banks have carried too much of the load of dealing with the problems that emerged from the financial crisis.

We must remember that monetary policy is not a solution to long-term growth problems or even demand shortfalls when countries are stuck in liquidity traps. Instead, it is more of a bridge during periods of weak demand, providing the space for governments to undertake fiscal or regulatory policy, or structural reforms. Central banks have carried too much of the load of dealing with the problems that emerged from the financial crisis. We need to foster an environment where governments take up more of the slack because it is their decisions and their influence on the private sector that determines long-term growth.

JA: The success of any policy should depend on the long-term impact of that policy. In research looking at balance sheet recessions, particularly in Japan, economist Richard Koo makes an important point that the success of a QE policy cannot be judged until it’s been unwound.

Secondly, we need to broaden our analysis from simply looking at one variable. An inflation target is akin to taking your car to a mechanic and they diagnose problems simply by listening to the engine. And cars are, of course, much simpler than even the simplest economy. The notion that we can assume a variable – an inflation target, for example – is more important than another is a dangerous place to begin. For example, the relatively stable inflation in the UK in the 1990s and 2000s masked several underlying problems. In reality, large amounts of imported disinflation from China were being offset by domestically generated services inflation so we cannot really say that central banks were achieving their monetary policy objectives. Meanwhile, debt was building up rapidly, particularly in the financial sector.

JL: Central banks do indeed recognize that they need to not only consider an inflation target but also financial stability. Central banks cannot tackle all problems with one instrument (interest rates). Japan is an example of a country that allowed inflation to fall to very low levels over a prolonged period, which amplified the deflationary mind-set that had developed. Now, it is almost impossible for monetary policy to counteract this because the Bank of Japan cannot lower real interest rates enough to drive growth up. The Bank’s credibility to get inflation up was undermined. As the Japan example shows, when inflation and nominal interest rates are low during a downturn, volatility of asset prices can increase as the policy instruments available to counteract a downturn are much weaker.

The real problem is one of demographics, particularly the size of Japan’s working-age population and the large and growing proportion of dependents.

JA: Actually, there is no evidence of a deflationary mindset in Japan. The real problem is one of demographics, particularly the size of Japan’s working-age population and the large and growing proportion of dependents, which raise the question of how well it is able to support itself. In fact, post-financial crisis, Japan’s GDP per capita has increased more than many other countries so it’s more a question of the nominal aggregate pie shrinking rapidly.

SM: Which alternative investments would best fit your current portfolio?

AM: Investing in infrastructure certainly looks good on paper. But how to invest matters considerably; for example, investors should remember that every infrastructure deal is unique and government regulation – which has a big impact on infrastructure – can change quickly. The devil is therefore in the detail. So the political aspects around infrastructure need to be thought about very carefully. Elsewhere, there are also many opportunities in the private markets, say private equity or private credit. The timescales and illiquidity of these assets can be attractive to some investors. Lastly, if you believe the economic expansion will last for several years then there is plenty of money still to be made in the commercial real estate cycle.

JL: Impact investing is a very interesting area. For example, Africa has a deep problem of lack of access to water. Rapid climate change could see this problem worsening. Australia has experienced changing weather patterns and a higher incidence of droughts and fires. Climate change is a critical long-term challenge and there is a role for the asset management industry to play a constructive part in this process.

Positive change could come from young people, particularly millennials. As they make up a larger proportion of the investment pool over time, there will be more pressure on the asset management industry to broaden its objectives from purely investment returns.

Climate change is a critical long-term challenge and the asset management industry can play a constructive role in this process.

SM: What are the biggest political risks that you are facing and how should we best build portfolios to withstand these risks?

JL: The international system is changing in important ways. During the Cold War we lived in a bipolar world, which became a unipolar world led by the U.S. following the collapse of the USSR. Today, with the rise of China, India and other countries, the world is multi-polar in terms of sources of power and influence. Technology is evolving, political incentives are changing and power vacuums are being created. International institutions are struggling to mediate in this environment.

Populist forces have been building for a long time, not just with Brexit or the arrival of President Trump. The cleavages in society driven by rising income and wealth inequality have their roots in the 1980s, and were partly triggered by the deregulation of labor and product markets. The original aim of deregulation was that “a rising tide lifts all boats,” but it ended up being “winner takes all.” When we add the financial crisis, political incompetence and corruption to the mix, it’s not surprising that people perceive the system to be rigged and that it’s not working for them. They then start to consider alternatives. This is a long-term challenge and could get worse before it gets better.

Technology is evolving, political incentives are changing and power vacuums are being created.

JA: There are two ways of looking at which risks are important – the most likely risks that could disturb your current strategy and those with the highest impact (even if not the most likely). Starting with the latter, China has the potential to disrupt the world economy and markets as it moves from a developing to a developed economy. It is now in a critical position as it faces the middle-income trap – it has a huge and growing debt burden, which is supporting the economy in the absence of consumption.

In the near term, the more likely destabilizing event (and with unknown impact) is the global exit from monetary stimulus. The figures on central bank balance sheets are eye-watering – the Federal Reserve (Fed) and ECB each roughly hold around $4.5 trillion, and the balance sheets of the Bank of Japan and People’s Bank of China are also massive. We are in uncharted water. In the U.S., the Fed has begun the process of unwinding its balance sheet and tightening rates. The liquidity withdrawal will put pressure on the U.S. dollar and less liquid asset classes and should lead to a rise in Treasury yields.

AM: If investors are sufficiently concerned about all the political uncertainty out there, they can diversify their portfolios, for example increase weightings to such currencies as the Swiss franc and the Japanese yen. The global outlook certainly appears to be uncertain, so investors could consider more defense industry stocks. The other way to frame the question is: How much risk do you want to take in your portfolios? Economic growth looks decent for the foreseeable future, capital spending is picking up, and profits growth is steady so we’ve had an excellent year for equity returns, but now there are, of course, valuation worries out there. At its simplest, the question investors should ask themselves is: Should I look to hold more cash in my portfolio to provide ballast when market volatility picks up, or look at other solutions such as absolute return or total return investing?

Change is all around us but not all change is negative.

LoC: Change is all around us but not all change is negative. It’s a human tendency to focus on negative change more than positive change. Ultimately, those who embrace change will be the most successful.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

ID: US-191217-54324-1