More than a year on, the war between Russia and Ukraine has largely dropped from financial and business news headlines as commentators look for the next reason that can be cited for sending numbers either up or down.
While market movements are now hardly linked directly to the war, a much bigger shift has taken place in geopolitics, which will profoundly impact how markets behave and what investors decide in the coming years.
“The economic and political framework of the past 10 years is gone, leading to a very different investment landscape that calls for a changed approach to asset allocation,” says Alexandre Tavazzi, head of CIO office and macro research at Pictet Wealth Management.
“It is only by looking at the long-term changes that we outline and understanding their implications that investors will be able to make the best of our forecasts for asset-class returns over the coming 10 years.”
Pictet has distilled the challenges for the coming decade into its 11th edition of the Pictet Horizon report, which carries an overarching theme: Scarcity.
According to experts from the Swiss private bank, economies face growing competition for natural resources. At the same time, labour supply is dropping, as population ages. The combination of these trends will help drive higher inflation, and curb the growth potential of economies.
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Investors, having gotten used to easy and cheap funding and stable assumptions of the interplay between economies and countries, have been rudely shaken up by recent developments on the global stage.
“Europe has discovered that they are very, very dependent on Russia for energy, that they have no army,” says Tavazzi in an interview with The Edge Singapore, referring to the reaction following Russia’s invasion of Ukraine.
“Investments that you could see coming for the next 10 years...have been brought forward by the war,” he adds, referring to the big scramble to invest in renewable energy infrastructure.
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And, of course, companies used to more than three decades of relative stability following the end of the Cold War now find themselves unwilling participants in increasingly volatile geopolitics perpetuated by the world’s biggest countries.
Previously almost unthinkable scenarios did happen, like how China could patch Saudi Arabia with Iran, forming their bloc of partnership away from the traditional power bases. The world, says Tavazzi, is becoming more multi-polarised.
At the company level, the operating environment has become much more complicated. “Where do you put your factories? Where do you form your supply chains? Is that place friendly with you?” The new set of priorities will trigger stiffer competition.
Now, companies are operating in a world of energy scarcity because of constraints on how output can reach buyers. There is a scarcity of materials, where key elements used in high-growth industries, such as cobalt, are found only in a few countries. Labour is scarce, and the population is ageing worldwide. “The last 10 years have been pretty easy. The cost of funding was zero. Companies were borrowing at very, very low-interest rates. Your supply chain was seamless; everything was going fine.”
On top of higher operating costs, businesses have to cope with higher financing costs because of higher rates. “And governments are probably going to raise taxes as well because central banks do not want to buy government bonds as much as they used to do. So, you have to find someone else to do it. And maybe the governments will look for new income sources, including higher taxes. So low tax, low interest rates, cheap labour’s gone, and that’s all contributing to bringing inflation to higher levels,” warns Tavazzi.
Inflation
With central banks already waging a coordinated battle to bring down inflation, Tavazzi expects results to be more apparent. For example, on June 13, the US announced that inflation for May had been reduced to 4% y-o-y from 4.9% y-o-y in April. At its peak last June, the rate was 9.1%. Global inflation is seen to trend down to around 3 to 3.5%, which Tavazzi says is a good balance.
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However, for those yearning for 2% or so before the old norm was upended, this is an ideal to be left behind — including the central banks. “At some point, we should expect central banks and governments to implicitly acknowledge that we are not getting inflation down to two. That’s ok.”
Tavazzi candidly admits he was unsure who exactly laid down the 2% inflation target that many central bankers then adopted. However, he can understand why. “It’s not too high. So that is not the target, which is unreachable. But it’s not zero, so it fits everyone’s purposes.”
Private equity leads
Amid this new norm, Pictet has come up with projections of how various asset classes will perform in the coming decade. Of the 56 different asset classes in the study, Pictet projects that private equity is the one that will turn in the best returns of 9%, nominal, over the coming decade, thanks to its certain attributes. “There’s something very specific in private equity, which I think you won’t find anywhere else,” says Tavazzi.
Specifically, private equity investments are made not only with the capital involved. More often than not, the investor will be actively involved in the management of the companies in a bid to improve the profitability and, by extension, the returns that can be enjoyed when the private equity investor exits. “That is something you can never find in public markets,” says Tavazzi.
The nature of these privately-held investments means they are not subject to public scrutiny and quarterly reporting as listed companies. This means the existing shareholders and the managers they appoint have much more flexibility to turn things around with fewer distractions or make significant restructuring.
As a result of active involvement versus passive investing and waiting for returns via dividends or capital gains, private equity investors rightfully expect higher returns versus the stock market.
And, of course, investors and the companies they invest in have the luxury of time to make things work. “That’s unique to private equity.”
While Pictet expects private equity to do well over the next 10 years, the various asset classes had generated better returns in the previous decade. For example, private equity managed to generate 16.8% per year over the past 10 years, versus 9% expected for the upcoming 10, says Tavazzi.
Real estate, meanwhile, generated 11.8% per annum over the past decade but is now seen to fetch just 6% per year for the next 10 years. As Tavazzi explains, the higher returns were because of the generous use of leverage, thanks to cheap, easy funding, and because of the devaluation of asset prices.
Fixed income, balanced portfolio
Naturally, investing in private equity is not something all investors can have access to. Or, they may not want to stomach the potential volatility. As such, for the next decade, Tavazzi advocates for the return of the so-called balanced portfolio consisting of 60% equities and 40% fixed income. “The returns that you don’t get on private equity, you can get them on a fixed income. That’s the biggest change,” says Tavazzi, noting that investors should “rediscover” this asset class that can be built without much volatility.
As recently as four years ago, expected returns from investment-grade fixed income were “close to nothing”. With rates much higher and held steady for a long time, that has changed. “This is the only bucket where you generate more in the coming 10 years than in the last 10 years. I think we should all be happy with that because that means you can reduce the overall risk of your portfolio but still get the same return. I think that’s a big change.”
