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Investment Institute
Point de vue : CIO (en anglais uniquement)

Moins de drame, plus de prospérité

  • 21 juin 2024 (5 minutes)

Central banks appear to have got it right. Markets are performing well even though monetary easing has been delayed. The global economy is normalising, the cycle is not too hot and not too cold. Markets like that and it allows investors to focus on fundamentals. Companies are delivering earnings and managing their balance sheets well. This has been good for equity and debt investors. A less dramatic cyclical position is combining with secular themes that promise greater prosperity in the future. Let us hope that politics does not mess things up.


Normal service 

It is mid-summer and, for once, the UK is finally enjoying a run of pleasant weather just in time for the Wimbledon tennis championships (it has been a summer to forget so far). Aside from the weather, I would say this is turning out to be a much more normal year than the ones we have recently experienced. The pandemic-based disruptions to the global economy are mostly resolved. The residual inflationary effects are slowly easing and there is not much evidence that long-term inflationary expectations have de-anchored. Certainly, market-based inflationary expectations – taken from inflation-linked bond markets – are stable with five-year forward breakeven inflation swaps trading around 2.6% for the US, 2.3% in Europe and 3.3% for the UK (which is still based on retail price inflation so equivalent to around 2.5%-2.75% based on consumer price inflation).

These are a little higher than during the period when inflation was low and embed a bit of an inflation risk premium relative to central bank targets. But, in the big scheme of things, they do not suggest that financial markets are pricing in a permanently higher rate of inflation. Consumer surveys of inflation expectations, more impacted by recent data, are also consistent with the broad 2% medium-term expectation for inflation remaining intact. There is a common view that central banks might have to work harder to protect those inflationary expectations, but there is general acceptance of that, meaning that interest rates will be higher than they were in the 2010-2020 decade. The world can cope with that if there is medium-term stability.

Going up 

Aside from inflation, growth has held up well, supported by a combination of improving real consumer incomes and positive wealth effects, especially in the US. The performance of companies related to the development of artificial intelligence (AI) highlights the importance of that secular theme with huge investment going into the manufacturing of ever more powerful silicon chips and data centres needed to store the required increases in computing power. The poster child continues to be the chipmaker Nvidia whose market value recently increased above $3trn, overtaking Apple and Microsoft to become the most valuable company in the world. Those three companies now have a combined market value of $10trn, around double what it was when the Federal Reserve made the first interest rate hike in March 2022. It is important to always distinguish the secular from the cyclical.

Technology revolution 

Optimists focus on AI and renewable energy developments as part of a broader shift to a lower carbon future, as potential revolutionary economic developments. Just look at the cover of this week’s The Economist – “The exponential growth of solar power will change the world.” I have written before about the potential benefits of cheap and clean energy in the future and how the world will benefit from reducing its reliance on oil, gas and coal and the politics that go with some of those industries. Both AI and cheaper energy will boost productivity with benefits for emerging market economies that are dealing with the impact of climate change. A great hope is that technology can revolutionise agriculture in emerging markets, increasing yields but reducing environmental degradation.

But core risks remain

The current political uncertainty in France has focused market attention on government debt and whether many countries will face either higher funding costs or fiscal retrenchment in the medium term. This week, the European Union issued notice that several countries would need to enter its Excessive Deficit Procedure under which governments have to produce plans to reduce borrowing. The fear in bond markets is that the drift towards populism will make this difficult – right-wing parties do not tend to be associated with fiscal conservatism these days. After having the inflation story almost snatched away from them, bond bears are increasingly focusing on the risk of waves of government borrowing, higher debt-to-GDP ratios, higher long-term yields and sovereign default risk.


Can governments benefit? 

One must question whether governments have the capacity to leverage the positive secular developments related to AI and the green transition. Many are still struggling to implement systems based on the digital technology of 30 years ago. On paper there is a commitment to accelerate renewable energy but it is not clear politicians have squared that with what it means for revenues derived from taxing fossil fuels. Producing electricity from renewables like wind and solar is getting cheaper all the time, which can offset lost tax revenue, while still leaving costs to consumers lower and more stable than currently. But my main thought here is whether technology-driven productivity growth can be a source of good for the fiscal outlook as well. Growth will be stronger, job creation might be more robust, and social policies could be more effective through the use of AI. A clear beneficiary could be healthcare where developments in biotechnology, using AI, will make health screening, diagnostics, and drug development cheaper and more effective. Reducing the growth in healthcare costs in ageing populations will be a net win for society and for public finances. There are also potential benefits in areas like education and in regional economic policies that could leverage off cheaper and cleaner electric transportation modes. But all of this requires politicians with vision or a reduced state to allow these economic developments to be driven by private enterprise.

Focus on the dismal… 

Economics is known as the dismal science because it tends to focus on risks and what could go wrong. There are plenty of things to worry about. Population growth in Western economies is falling and is below the replacement rate in many cases. This means higher dependency rates and a higher tax burden for those of working age. That is not good. It ties in with the poor outlook for fiscal balances. Governments will need to keep spending on healthcare for the aged while exhausting the tax capabilities of those in work. Immigration is already filling the gaps in many countries – it has boosted US economic growth in recent times. But that comes with political and social issues. It will get worse as global temperatures rise and parts of the world become increasingly inhabitable. The benefits of immigration in the long term are known but there are huge upfront social and fiscal costs.

…or the sunny uplands? 

However, economics can be hopeful too. Economists have tended to underestimate the impact of major technological revolutions – going back to the Romans introducing the latrine. The exponential and network effects often turn out to be much bigger than thought. This is likely to be the case with AI and clean energy. There is a lot of popular focus on generative AI being able to author monthly reports or compose a song in the style of the Rolling Stones. That is fun and, it must be said, that there will be productivity improvements from automating some services that are done by humans today. But the real value is the huge computational power that allows big structured and unstructured data sets to be analysed for a particular purpose – for example, data generated by satellite imagery used to predict crop yields in a more volatile climate; use of digitised DNA data to better understand the incidence of chronic diseases and to find cures for them; better understanding of consumer spending trends to allow companies to more efficiently manage inventories and supply chains.

A year of, so far, limited drama 

The focus on these secular issues is a luxury afforded by the fact that the current cycle is going through a low drama phase. Markets can always identify potential risks (turning to European politics now) but not a lot is materialising into something that will destabilise the cycle. Hence, financial market returns are doing something that seems to have been forgotten – providing returns based on the fundamental performance of companies against a stable monetary backdrop, which is likely to become more favourable in the months ahead. Returns from most bond and equity markets are solid so far in 2024. Corporate bonds and other credit instruments are delivering income and companies that borrow money are in a good position to manage those borrowings and keep paying that income. Equities have performed well based on earnings growth that is consistent with current trends in nominal GDP and by the promise, in some sectors, of the benefit of the secular trends discussed above. A stylised 60:40 US equity and bond portfolio would be up about 16% compared to a year ago at the end of last month.

If there is any such thing as normality, 2024 is it in economics and market terms, characterised by modest expansion, low and (hopefully) declining inflation, the prospect of some easing of monetary conditions, and good returns from public investment markets. It will not last – politics will become an issue, consumers might become more pessimistic, geopolitical risks might materialise. But for now, when the sun is shining, enjoy!

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 20 June 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns

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