Commentary: Preparing for what may lie ahead

Many commentators tend to regard the multitude of crises that we've faced as a series of independent and random developments. When I look at the bigger picture, it is clear to me that these events are symptoms of problems that have been building over decades.

After an unprecedented period of growth and prosperity, the structural drivers of growth have gone into decline across the developed world. This decline is accelerating.

Debt has been a driver of growth over recent decades. This has slowly built up, underpinned by declining interest rates and with an ever-increasing amount of debt needed to prop up each new growth cycle. When interest rates hit zero, or even became negative in some parts of the world, it is likely that the world reached a point of debt saturation. The volume of new debt that would now be needed to sustain another growth cycle has become too large and this driver of growth is exhausted as a result.

Demographics are increasingly a significant drag. Organization for Economic Cooperation and Development working-age populations have stagnated and are set to contract as the baby boomers retire (see Figure 1). Barring an unforeseen productivity miracle, growth is going to be evermore difficult to generate.

Central banks and governments have been active participants, pushing experimental monetary and fiscal policies to their limits.

With a single-minded focus on boosting economic activity, central banks lost sight of their objective, and have been left scrambling to tighten policy as they battle to regain control over the inflationary forces they have unleashed.

The much higher level of interest rates makes me question the sustainability of these debts, which are going to become more and more painful as they are refinanced over time.

As policymakers work to contain these resurgent inflationary pressures, central banks are faced with another problem. Globalization, a force which has underpinned decades of low inflation, has lost momentum, and has gone into reverse. Deglobalization will see higher costs feeding through the entire economic system and makes it difficult for central banks to be truly confident that they are getting inflation under control. This means that rates are likely to stay elevated for longer than many currently anticipate.

To me, it appears increasingly likely that these factors are pushing us toward a tipping point. The number of zombie companies, those unable to generate sufficient cash flow to cover the interest on their debts, has exploded in recent years. It is difficult to see how many of these companies can survive a prolonged period of higher rates.

In the short term, there are some positives for us to be thankful for which may buy us a little more time if they help to anchor longer-term yields.

The supply chain disruptions that followed lockdown are now finally dissipating (see Figure 2), as is the commodity spike that resulted from Russia's invasion of Ukraine. These factors, along with the powerful impact of base effects, should work to bring inflation downward in the months ahead.

However, longer-term forces remain worrying. A shortage of labor is apparent everywhere and vacancies are still at historical highs (see Figure 3). In my view, this shortage of labor is not being driven by a single factor, but by a combination of demographics, a lack of immigration and the emerging trend of deglobalization.Suddenly we are onshoring production, or at least trying to make supply chains more regional, which is creating local demand for labor. No one wants to create new production in China now, and if I had to choose the single most important reason for the low inflation of the last 30 years, I would point to the shift in production to China's cheaper labor force.

This is enough evidence to keep central banks worried, and that is why they are so determined to do whatever it takes to bring inflation down. If inflation shifts to a new equilibrium and a high inflation regime becomes anchored, creating a reinforcing wage-price spiral and unhinging long-term inflation expectations, it becomes extremely costly to undo.

If inflation remains stubbornly elevated over the medium term, central banks may be forced to engineer a more severe economic downturn to achieve their current inflation goals. In that scenario, the combination of higher rates and weaker economic activity would raise the risk of a Minsky moment, a disorderly deleveraging event that could start to tear against the fabric of the financial system.

At that point, central banks may decide to reassess, likely under intense political pressure, and accept that inflation has become more structural in nature. I believe the most likely consequence of this would be an upward shift in inflation targets. Ultimately, why not target inflation at 3% rather than 2%?

Although this may allow central banks some flexibility to deal with the next crisis, higher inflation over the longer term would likely have more subtle consequences. Corporate profits are an obvious area of concern. It seems difficult to believe that corporate profits can be sustained at close to record levels relative to gross domestic product when you consider upward pressure on wages and limitations on cheaper sources of production. Economic pain appears inevitable as the system rebalances to a new equilibrium.

Elisabeth Kubler-Ross, the famous Swiss-American psychiatrist, outlined the stages of grief that patients move through after experiencing some kind of trauma, and I believe that, to a degree, this is applicable to society as a whole given the issues we are facing.

Since the global financial crisis, we have been living in denial — artificially trying to sustain the status quo via zero interest rates and quantitative easing. The consequences of this have now caught up with us, and we have started to move through the anger stage, as standards of living continue to erode. People are probably going to become angrier before we can move forward and start to look for real solutions to the problems we face.

As we navigate this, I come to a very simple investment conclusion — we must value the visibility and certainty of cash flows. This simple principle must be at the heart of any analysis, allowing us to be as prepared as possible for what may lie ahead.

Abdallah Nauphal is the CEO of Insight Investment. He is based in both the U.S. and the U.K. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.