CIO Letter


History shows that the economy and financial markets are dominated by long-term regimes that at some point come to a break point, where one regime gives way to a new one. This shift may not be easy to detect. Trapped in their comfort zones, with a short-term perspective, few may see it coming.
The arrival of Paul Volcker at the helm of the Federal Reserve, after a long period of inflationary pressure, symbolically brought to a close the macro-financial regime of the 1970s (the Great Inflation) and prepared us for the regime we are leaving today (low inflation, low volatility regime), albeit passing through a “bubble and burst” phase in the 1990s. A change in regime is brought about when the imbalances that it causes are no longer tolerated by society. Such a change is also and always one of the institutions (central banks, political parties, etc.) that structure the regime itself. Aware that every force produces a counterforce, like the movement of a swinging pendulum, we see the Volcker sequence now ending.

We are seeing cracks in the current macro-financial regime starting to show. Many challenges are escalating, including ballooning debt in the economic system, the impasse central banks face in abandoning their extraordinary monetary stimulus, rising protectionist pressures and worrying income inequality. Capitalism and profit have not been as unpopular as they are today since the 1970s, and the conditions for a road back to a similar macro-financial regime are materialising.

Intellectual victory and academic consensus around specific topics also always precede regime shifts. Today, with inflation progressively forgotten as a threat, the idea has spread that the current high debt levels are not an absolute obstacle to budgetary stimulation, while room for manoeuvre exists and could be used for focused policies.
With safe interest rates in the US below growth rates, an historical norm expected to continue to hold, “public debt may have no fiscal cost”, according to Blanchard, as the ratio of debt to GDP could decrease over time.
In addition, the welfare costs associated with public debt reducing capital accumulation may prove more limited than feared, as the marginal productivity of capital could be lower than expected. Consequently, a low risk-adjusted rate of return to capital would justify the use of fiscal expansion and debt to finance public investment. Taken to the extreme, the so-called Modern Monetary Theory (MMT) suggests that modern advanced economies should always be able to avoid a default event on their sovereign debt in their domestic currency, as central banks should be able to repay public debt by printing domestic currencies. Under MMT, fiscal and monetary policy roles may switch as MMT assumes that expansionary fiscal policy could be financed by money creation (Mitchell et al.). The temptation may be growing among economies stuck at the zero lower bound and/or faced with a risk of recession.

As Blanchard notes, some relate these low rates to the “secular stagnation” thesis, i.e., structurally high savings and low investment (Summers) or higher demand for safe assets (Caballero et al.). The fact that the natural interest rate of equilibrium, though not observable, has arguably shifted significantly downward in the private sector (Summers), paves the way for “greater tolerance of budget deficits (and) unconventional monetary policies”.
This set of hypotheses comes with considerable uncertainty. For example, liquidity discounts reflecting distortions such as financial repression forces may have played a role. Furthermore, the fact that investors attach a low probability to a significant pick-up in inflation and/or rates (looking at 10-year inflation indexed bonds, there is a minimal 10-15% market implied probability of seeing rates higher than 200bps in the five years to come) does not mean they are right. The point here is that there are mounting intellectual forces challenging traditional thinking. Though they may include some kind of a “bias of confirmation”, right or wrong, they point to potential changes in policy.

The next recession could be the crossover point for a regime shift. A retreat in globalisation, the inflationary effects of protectionism and the politicisation of financial and economic variables could turn the clock back towards the 1970s.

In the following pages, we provide investors with some guidelines for portfolio construction, depending on different inflation scenarios. Implications for investors will be, in particular, in terms of asset allocation, as the expected returns and correlation dynamics change in different inflation regimes. In (hyper) inflationary regimes, in fact, both bonds and equities have not delivered well in real terms and have exhibited higher correlation, while real assets such as commodities, real estate and infrastructure have delivered better risk-adjusted returns. Therefore, we believe it is crucial for investors to rethink their strategic asset allocation, including exposure to real assets, and be ready to adjust to the different inflation scenarios that could materialise in the future.

In addition, as inflation is expected to come back as a consequence of (de) globalization, strategies based on geographical/ regional diversification will be back in focus, while the ones exposed to globalization, which benefited the most in the last three decades, will become less effective.


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