In 2019, Lombard Odier invited clients across Asia to rethink the way capitalism would have to evolve to address extraordinary challenges. The conclusion was this: in order to achieve a more sustainable equilibrium, the economy must rebalance from a growth model driven by markets, debt and asset prices, to an economic engine fueled by wages, social transfers and public investments, and this transformation could take maybe a decade or more.
The Covid-19 pandemic then dramatically magnified this perspective. 15 months later, investors share the perception that a renewed form of Beveridge capitalism may ultimately replace the financial markets’ rule for the past 30 years.
Lombard Odier's Chief Investment Officer for Asia, Jean-Louis Nakamura, shares his views on what the ultimate consequences may be in terms of financial and real assets’ repricing for investors.
Jean-Louis Nakamura, could you elaborate on the «growing disconnect» between asset prices and its underlying economic fundamentals?
Since the early 1990s, assets prices and economic fundamentals have evolved at very different paces. Globalization and automation have placed increasing pressure on workers’ compensation. Rapid aging populations have stepped up on their saving efforts. Private businesses have lowered their investments needs, making them less tangible.
«The implications of this dynamic are well-known»
Against the backdrop of higher saving rates and lower wages, growth had to rely on new drivers. Leverage and wealth effects emerged then as the perfect match. Cheap money, large access to credit and financial innovations provided the funding that the global economy needed, with excess money supply flooding property, private assets and public markets.
The implications of this dynamic are well-known: excessively inflated assets prices, extreme wealth inequalities, generalized moral hazard behaviors, artificial lifelines granted to «zombie» companies weighing on productivity growth, and ultra-low equilibrium levels of interest rates, amongst others.
As the economy shifts towards a new equilibrium, what does it mean for investors?
From there, we can imagine what the consequences could be for investors, if and once the global economy were to reverse into a symmetric regime where income, consumption and investment growth would persistently outpace debt-dependency. Nominal yields from bonds’ coupons, equities’ dividends or properties’ rents should be higher on average while the overall pace of capital appreciation for all assets would be significantly lower.
«Re-invented fundamental stock-picking strategies may ultimately return as the winning ones»
With monetary policies no longer forced to suppress market volatility, the price for risk will be rediscovered, leading to wider credit spreads and equities’ premium distributions. Exciting investment opportunities will continue to exist, with returns, however, more directly influenced by idiosyncratic factors specific to business models’ long-term profitability, capacity to innovate and compliance with broad societal priorities. Re-invented fundamental stock-picking strategies may ultimately return as the winning ones, after the long age of market beta dominance.
On the back of strong structural disinflationary forces at work for nearly two decades, the global economy faced an unprecedented cyclical deflationary shock when Covid-19 swept the globe. Has this affected the economy’s transition towards its new equilibrium?
It is quite natural to share this perception as, over the last 15 months, we are seeing many developments that look furiously consistent with the shift towards the new equilibrium described above. Governments have led extraordinary efforts to buffer the pandemic shock through massive fiscal transfers and contemplated rebuilding their economies with substantial investment plans.
The surge in demand and shortages in a few markets have caused a stretch in supply and delivery chains as well as the services industries. Some investors are still considering the possibility of inflation spiraling out of control from central banks – for the first time in nearly four decades. The regulatory crackdown on Tech giants has been accelerating in China and is at the top of the agenda for the U.S. and Europe.
«Such a strategy requires time and may prove hazardous»
Despite these developments, we believe, however, that the reality is more nuanced. On the necessity for investments to comply with societal and policy priorities, the toothpaste is out of the tube and shall not re-enter. That said, we remain more skeptical regarding the capacity of the global economy to reflate itself, more or less independently from the assets’ inflation perpetuated through excess liquidity.
The cyclical use of fiscal policy has been impressive. However, given the medium-term landscape shaped by structural forces, could you elaborate on the expectations of central banks and their approach in stimulating economies?
With the brutal route of hard deleveraging being denied for major economies after the 2008 Great Financial Crisis, governments’ only alternative was to target productivity and/or income boosts while containing the rise in additional leverage through tighter macro-prudential regulations and selective defaults. This is the narrow path engaged by China and this is – probably – the way the Biden administration would like to engage the U.S. economy.
Such a strategy requires time and may prove hazardous. The debt addiction of most economies is just too high. In China, refinancing conditions for highly indebted borrowers will probably have to ease again if a large default or a systemic chain of debt restructuring starts threatening key sectors. In Western democracies, the political consensus that prevailed at the start of the pandemic to unleash massive spending looks much more fragile now that the stake lies in pulling economies out from their structural gravitational deflationary forces.
«The debate at the U.S. Congress also reflects conflicts between generations»
Beyond some stark political divisions, the debate at the U.S. Congress also reflects conflicts between generations. Baby-boom born savers are reluctant to see the inflation pendulum move back from financial to goods markets.
How the coalition of millennials, X and Z generations would implement a true and lasting progressive agenda remains to be seen. In the interim, and beyond the very short-term cyclical developments, economies will continue to suffer more from disinflation than inflation, while central banks will continue to do «whatever it takes» to prevent the debt pyramid to collapse.
How then should investors drive their portfolios in this twilight zone?
One of the key anchors of Lombard Odier’s offering in Asia is in the conviction portfolio mandate/proposition, where assets are structured between a core liquid and diversified multi-asset portfolio, and satellite investments, which are additional investments that complement the core.
As long as we stay in this transition between the two different regimes, investors must remain invested, with their core holdings remaining liquid enough to be re-adjusted swiftly as we may move from one equilibrium to another. Core equities and credit positions should be transitioned, if not already done, to issuers whose profitable business models are aligned with new societal and policy priorities.
«Investors should also maximize the diversification between risk factors for their core portfolios»
For stock portfolios, investors should focus on large, quality names whose earnings growth would make up for a possible compression in multiples.
Investors should also maximize the diversification between risk factors for their core portfolios, in order to face possible extreme alternative outcomes, while achieving a high level of efficiency in terms of risk-adjusted returns. More aggressive investors could then redeploy the risk savings from core holdings into a few themes representative of the dramatic structural disruptions that the global economy will have to digest over the next few years.
In this specific field, sticking either to premium brands supported by large consumers’ markets or to smaller technology disrupters likely to capture rapidly higher market shares might prove a successful barbell.
This type of overall portfolio construction should be kept within a tight risk framework likely to survive sudden and rapid transitions.
Jean-Louis Nakamura is the Chief Investment Officer for Asia Pacific and the Head of the Hong Kong office at Swiss private bank Lombard Odier.
