DAVID KNEE: Is there a new financial equilibrium ahead?

Developments such as the Covid-19 lockdowns, the Russia-Ukraine war, Brexit and US-Chinese competition have all challenged the more open, globalised trends of the past four decades. Any reversal of these trends is likely to cause unease among investors, with financial markets already reflecting sharp disruptions, which have heightened risks and volatility.

Although asset values are cheap across most areas, investors need to carefully assess the downside risks that have risen almost as quickly as inflation and interest rates. Human nature naturally inclines us to anchor to the recent past and extrapolate it into the future. However, outlandish views of the future now have a greater chance of being right than some notion of a tweaked version of today.

Our sense of financial balance has been built on 40 years of successful inflation fighting, falling real interest rates, rising globalisation and increasing profit shares. In society the corollaries have been huge reductions in global poverty and sharply rising real incomes but commensurate increases in global inequality.

The net effect is neatly summarised in one example: despite a five-fold improvement in living standards since 1950, people in Japan report being no happier now than then. Which raises the awkward question: how might we feel in a world of rising interest rates and rising inflation? And what might the path to this new equilibrium imply in terms of economic and market outcomes?

An uncertain path ahead

Of course, the answer is “we don’t know”. But I suspect if that is where we’re headed, the journey isn’t going to feel good. In just a few months economists have slashed their forecasts for 2023 European growth from 2.5% to 0.7%, with a clear bias to cut more. Equity and bond markets (and global central banks) have had to pivot from a view that inflation was a “transitory, supply bottleneck-driven phenomenon” to a “don’t worry, it’s just a temporary energy and food shock”, to an understanding that the primary engine at work here is now demand.

Over 60% of the US inflation basket is rising at an annual rate of 4% or more. Excluding food and energy, US core inflation is zipping along at 6%, the highest since 1982. Thoughts only a couple of months ago that we might see rate cuts before the end of 2023 are gone, leaving a sense of unease that we don’t have a grip on what’s going on at all. The result is intense market volatility, with sharp moves with each economic data release and every speech by a Federal Reserve governor.

Keep an eye on labour costs

Key to the question of whether inflation might become unanchored are near-term developments in unit labour costs. Wages per unit of productivity are a critical input cost for businesses and therefore when wages persistently rise faster than output an underlying inflationary dynamic is likely to build that might prove painful to reverse. With the latest US non-farm unit labour costs rising at 9.3% year on year (the highest rate since 1982), focus on this is understandable.

History may have something to tell us in that sticky wages were a key problem in the late 1980s, ’90s and before the global financial crisis. After a profoundly painful recession in the early ’80s, Western labour markets were zinging along by 1988. On each of these occasions the Fed had to raise interest rates until they were above (or close to) the rate of growth in nominal GDP before an economic slowdown manifested and wages and inflation dropped.

These episodes tended to go together with substantial rises in unemployment. The challenge now is that nominal GDP is expanding at over 9% and interest rates are at only 2.5%. Nominal GDP will slow as inflation peaks and falls but it still might leave a substantial gap that higher rates would need to fill if previous cycles are repeated.

In the past two decades there was little obvious relationship between wages and unemployment, a common explanation being that globalisation had broken local wage-setting frameworks and replaced them with a disinflationary impulse courtesy of low wage rates in emerging markets.

Factories and call centres were established in Asia and Eastern Europe, cementing a contract whereby advanced economies received cheap goods and services, and in return emerging economies generated jobs and rising living standards. This win-win relied on a stable geopolitical environment in which peace prevailed.

Old global paradigms dented — or broken?

Russia’s invasion of Ukraine and China’s sabre-rattling and recent blockade of Taiwan have dented this contract. On-shoring and self-sufficiency in key goods like energy, food and defence are narratives that are building support, aided by supply chain disruptions as countries emerged from pandemic lockdowns.

Reducing Europe’s dependency on Russian energy is now a top political imperative and may drive Europe into outright recession next year. In the US, Congress recently passed a bill providing $50bn of support for the US semiconductor industry, recognising that the country doesn’t want to be held to ransom if Taiwan is prevented from supplying these vital inputs for the global economy.

Exercise caution 

Against all of this uncertainty, how does one invest? If advanced economies nudge into recession in 2023, equity earnings are at risk. The magnitude of any earnings downgrades would be amplified if interest rates are still rising due to sticky inflation. While the outlook is challenging, valuations can compensate for the prevailing risks. If they offer decent levels of protection against adverse outcomes and compelling returns in muddle-through or favourable outcomes, the right investment action is to stay invested.

Global market valuations have become significantly more exciting given the market declines this year. Many markets are cheap in all scenarios except a hard recession, and even then pricing suggests losses would be short term.

• Knee is chief investment officer at M&G Investments.