Pictet Group
Gearing up for change
Acceleration in geopolitics
The “radical uncertainty” mentioned in 2022 by the EU’s chief diplomat, Josep Borrell, has become the norm. Geopolitical divisions have widened and a new armed conflict has broken out in the Middle East. Governments’ involvement in economic decisions has increased significantly, often in a new guise. Rebuilding military capacity has become an urgent strategic goal for many European countries since the Russian invasion of Ukraine, with the risk of diminished US support for NATO adding to that sense of urgency, illustrated by Finland and Sweden joining the alliance. Increased spending on defence, on top of already large budget deficits, may, at some point, create tensions in financial markets, especially as central banks continue to reduce their purchases of sovereign debt. Where budget deficits are limited by law, increased defence spending could come at the expense of other programmes (unless it is moved off-budget). In a worst-case scenario, spending on renewable energies could drop down the list of government priorities even as the earth experiences record temperatures.
Acceleration in reindustrialisation
In the US, the Inflation Reduction Act (IRA) and the Chips & Science Act, both passed in 2022, have brought back industries qualified as strategic by the Biden administration to the US. Investments in electric vehicle (EV) batteries, semiconductors and clean energy production in the US have increased significantly, creating a new infrastructure boom. In Europe too we are seeing active, state-driven industrial policies reappear, notably in the area of semiconductors. But after the loss of cheap Russian gas, the continent is suffering from a higher cost of energy than the US. Moreover, some European industries are increasingly challenged by cheaper imports from China as Chinese companies try to compensate for domestic overcapacity by exporting. Overall, we expect state industrial policy to further gather steam, driven by increased expenditure on defence capabilities.
Acceleration in economic fragmentation
Recent years have seen an acceleration in the regionalisation of supply chains in parallel with a rise in geopolitical tensions. Many multinationals have decided to reduce their presence in China and develop production capacities in other Asian countries instead. Hence, the concept of an independent Asian economic bloc has developed in a short period of time. As more Asian countries become production hubs and develop their industrial capacity, the range of investment possibilities in the region will grow. The negative side of this development is growing overcapacity in several Chinese industries. This could lead to a trade war as developed countries introduce high import tariffs to defend their industries against cheap Chinese imports. The reshaping of global supply chains will continue to put pressure on already tight labour markets in the West, all the more so given the growing mismatch between the qualifications needed to drive reindustrialisation and the qualifications of resident populations.
Acceleration in technology
Artificial intelligence (AI) has swiftly become a reality for many, including participants in financial markets. This increasingly accessible technology is spurring a new investment cycle and will probably change many industries in a profound way. The AI ecosystem is still at an early stage of its development, but many industrial processes are set to be improved. AI may also alleviate the high labour costs facing firms that relocate their production to developed countries. AI’s emergence has not gone unnoticed by financial markets, with recent equity gains in the US heavily concentrated in AI-related tech companies.
Acceleration in divergences
The impact of high inflation since the end of the covid pandemic has differed depending on income. Higher prices combined with higher interest rates have compressed disposable income for households at the lower end of the income scale, especially in countries with a high proportion of variable-rate mortgages. High earners have benefitted from the rising value of financial assets (the wealth effect) and from the increased interest earned on their savings. Thus, depending on how wealth is spread in the population and on whether mortgage financing is at fixed or variable rates, there is a growing divergence in society’s wellbeing from one country to the next. This requires tailored responses from individual governments and central banks, meaning that policies are becoming steadily less synchronised.
Differences between countries could continue to widen in the coming years as the impact of AI could be highly unequal given its cost. The development of large servers and applications will to a great extent depend on the investment capacity of the private and public sectors, leading to increased divergence in economic performance.
The events of the past three years have profound implications for economies and financial markets alike. First, we think inflation in the coming 10 years could be structurally higher than in the previous 10. This is because the global trading system could become less efficient given the potential increase in trade tariffs. Inflation could also result from the reshoring of some industries in the US or Europe, which will increase labour demand in tight job markets. AI should enable companies to make productivity gains, but its deployment will probably be gradual and uneven.
Structurally higher inflation implies a different interest-rate environment, with financing costs becoming an issue for corporations and governments alike. Highly leveraged companies will be particularly exposed (depending on their refinancing schedule). Government spending will be constrained and choices will have to be made between new strategic priorities (such as defence) and the energy transition. Higher interest rates should be good news for investors’ fixed-income portfolios, but they will need to keep risk at a reasonable level to reach their investment objective. Such a scenario calls for active management and renewed attention to country allocation.
The surge in geopolitical tensions has recently taken centre stage. But other problems continue to fester. The hottest year on record on this planet was 2023, with a large number of extreme weather episodes around the planet. Addressing the long-term challenge of global warming is a human imperative, but also a financial one, potentially impacting portfolios’ risk and return parameters over the long term. Thus, the term “radical uncertainty” may also apply to climate issues. The increasing number of extreme weather events leaves corporations facing the prospect of asset impairments, the loss of production facilities and severe operational problems. Some assets may simply become uninsurable, leading to a sudden increase in financial stress and/or outright exit from some activities. New climate regulations may force some industries into costly reorganisations, with immediate consequences for valuations. Understanding, identifying and mitigating these risks will be a challenging task for those involved in asset allocation and portfolio construction in the coming years. We are convinced that a thorough analysis of companies’ and industries’ exposure to event risk will be an integral part of the investment process.
In conclusion, we think that understanding the origins, effects and particularly the interconnection between the rapid changes in the geopolitical, financial and environmental landscape we are experiencing should be the starting point of any investment journey.