Capital Market Line: A Cycle That Favors Main Street Over Wall Street

In the previous cycle, economic growth was lackluster amid fiscal austerity on top of private sector deleveraging. In a valiant attempt to offset such drags, central banks wandered into uncharted territory with increasingly extreme policies. A handful of developed market central bank balance sheets swelled relative to nominal GDP, pushing real rates down from already near-record lows – all in an attempt to support growth through ever-looser financial conditions. This barbelled approach to balancing fragile growth resulted in massive outperformance of financial assets (“Wall Street”) relative to the real economy (“Main Street”).

Now with the successive shocks of the pandemic followed by Russian President Vladimir Putin’s invasion of Ukraine, the stage is set for bigger government-led solutions to even bigger problems. Similar mixes of growth drivers have historically generated shorter and more inflation-prone regimes than more market-driven mixes. Our Capital Market Line (CML) seeks to anticipate how changing landscapes over the ensuing five years will differ from long-term means – and we aim to ensure that these evolving backdrops are reflected in changes to forward-looking cash flows and capitalization rates.

We conclude that today’s bigger government policy approaches, if successful, aim to reverse the last cycle’s “Wall Street over Main Street” outcome. While faster nominal economic growth is on offer, this growth will likely be less efficient. The scale of today’s fiscal responses to the pandemic has resulted in excess demand teamed with record-high excess savings. Fortified in this manner, excess demand will be difficult to dampen. Today’s record savings rates are also embedded in today’s extraordinarily generous capitalization rates.

After a decade of deleveraging, consumers have pristine balance sheets. While businesses underinvested as their customers were deleveraging, they now find themselves learning to cope with excess demand and are facing capacity utilization levels that are resulting in client dissatisfaction. They must decide whether to sacrifice share or boost investment. So far, we’re seeing one of the faster takeoffs in business investment out of recession. Much needs to be done, with companies reconfiguring supply chains to enhance their resiliency while also seeking to improve their carbon footprints. While Congress appears likely to swing narrowly into Republican hands during the US midterm elections this year, even if it switches sides, a narrow majority will still augur against renewed austerity and would more likely result in higher military and social spending – especially given the air cover inherent in 2022’s shrinking fiscal deficits. Given all of these reversals, we no longer consider the US economy to be fragile.

Meanwhile, Putin’s invasion of Ukraine is likely to go down in the history books as a blunder that unified and galvanized NATO into action. While wars tend to spur stagflationary pressures in the short term, this invasion is igniting a ramp-up in military and climate spending over the medium term. Germany is the clearest example. The invasion put an end to the debate over whether Putin could be integrated into a rules-based global order, or whether Europe was inadvertently financing Russia’s military buildup while boosting its own dependence on Russian gas. In an impressive reversal, German Chancellor Olaf Scholz quickly set Germany on a new course after the invasion, seeking to wean itself off Russian gas within just two to three years. And after undershooting its NATO pledge by 40% for an extended period, Germany will also nearly double its military spending in the years ahead. The required investment will let some of the air out of today’s global savings glut – another force in shrinking today’s negative real interest rates.

Along with the sanctions, over time these efforts should weaken Putin’s seat at the global table while degrading his ability to disrupt and drag down other nations. At the same time, decarbonization has become intertwined with national energy security and will contribute further to commodity demand in the years ahead. These developments add to the deglobalization trends ignited by the US-China trade war and pandemic. Just as the fall of the Berlin Wall led to several decades of expanded globalization, which in turn led to higher returns on investment and lower real rates, a slow and gradual reversal looks likely – the big question is, to what degree?

During the post-pandemic recovery, economic slack has been absorbed at a stunning pace. The output gap has now closed in the developed world, with labor supply growth curbed by retirements, a lack of immigration, changes in workers’ priorities, and lingering Covid supply bottlenecks. While margins spiked initially given pricing power and fiscal- and monetary-financed demand, negotiation power is shifting toward labor in many professions and countries. We may finally see the long-anticipated pendulum-shift away from ever-higher returns to capital and back toward higher returns to labor

By the second half of this year, we expect record profitability to show increasing challenges at the margin. Revenues should see continued tailwinds from both faster baseline real economic growth than in the prior decade (even if slowing from present levels) as well as higher baseline inflation (even if lower than today’s levels). Thus far, companies have been able to pass through higher costs with impunity, given shortages everywhere. Yet in the quarters ahead, profitability should start to fade from current all-time highs as consumers begin to resist higher prices and supply and labor bottlenecks ease a bit, making it harder for companies to pass along higher costs. We expect this trend to come to a head in the second half of 2022, which is one reason we have favored upgrading our equity mix toward names with higher-quality income statements and balance sheets.

We’ve been tracking the reconfiguration of supply chains and reshoring of production capacity. Recent events have amplified these trends – still mostly to the detriment of many emerging markets, but affecting the developed market business model as well. These trends will soon put pressure on profitability, in our view, as companies’ priorities shift from a focus primarily on efficiency (left over from a world in which abundant supply was presumed) and toward ensuring the reliability of supply, along with various ESG considerations.

China, meanwhile, continues to march to the beat of its own drum and is becoming more desynchronized with the global economy. While the country’s 2021 policy crackdowns aimed to shift the balance toward “common prosperity,” its implementation left private businesses in China uncertain about their future, and a swift economic downturn ensued. This was fully baked even before the omicron-induced slowdown. Ever the pragmatists, China’s policymakers are now recalibrating, with stimulus policies emerging. The upswing now expected in the second half of 2022 is in stark contrast to 2021’s policy tightening and will have global consequences, given China’s heft as one of the two global economic bookends while most other countries slow.

We expect such cross-currents to persist at least through 2022, slowing the global slowdown – a downshift that is needed to alleviate today’s inflationary pressures. This year is pivotal for China: President Xi Jinping will, in all likelihood, be elected “leader for life.” Prior to that, in the context of an economy running uncomfortably slow even prior to renewed Covid challenges, President Xi had recently made accommodations that favor market forces and transparency. From a market perspective, this policy shift could bode well for 2023 and beyond if these newly balanced priorities themselves last beyond the Party Congress.

Whether they do or not, China will still pursue greater self-reliance, aiming for a “dual circulation economy” that replaces many higher-tech imports, reducing its dependence on external suppliers, and facilitating stepped-up military buildup. All else equal, this could pose a challenge to many countries and markets that rely on Chinese demand.

This quarter, our Capital Market Line’s inputs continued to evolve toward ongoing adjustments that reflect faster nominal growth, but with incrementally less efficiency – financed by a declining global savings glut and monetary policies that will gradually drain the historic excess that had contributed to prior decades’ extreme declines in real interest rates. This means somewhat higher cash flows (at least for many growth assets) offset by less-generous capitalization rates. The net effect of these changes, along with modest market corrections to date in 2022, is a disappointingly positive upward-sloping curve with elevated dispersion. This signals a low-return world, particularly for those asset classes that benefitted the most from the 40-year decline from extremely high to low real rates.

Despite their recent rise in yields, risk-free bonds continue to weigh on the lower-risk portion of the curve. While the swift repricing of the rates curve is probably behind us, a slow burn higher for longer may still lie ahead. In “Stall Speed” regimes, risk-free rates have historically exhibited their best returns, while teamed with -0.4 correlations to equities. Reflation has eroded their protective power, with correlations to global equities shrinking to -0.2 – validating our reflation thesis. From here, Treasuries will increasingly have to stand primarily on their return potential alone, and much less from their protective powers of the past.

Unlike fixed income, equities should continue to benefit from higher nominal cash flows in the new cycle, yet they must still contend with tighter financial conditions and liquidity withdrawal for years to come. A firmer inflation environment will be more supportive for newer, less correlated segments of the major asset classes. We preview such newfound attractiveness for China property bonds, Latin American local currency debt, commodity carry, and trend strategies.

Capital Market Line as of 31 March 2022 (Local Currency)

Capital Market Line as of 31 March 2022 (USD View, Unhedged)

Please see Capital Market Line Endnotes. Note that the CML’s shape and positioning were determined based on the larger categories and do not reflect the subset categories of select asset classes, which are shown relative to other asset classes only.

Insights From Today’s CML

A moderately sloped Capital Market Line (CML) with a high level of dispersion. The slope of our CML remains moderately positive, and dispersion is elevated. It continues to signal an average reward for selective risk-taking, elevating the importance of sequential improvement in cash flow fundamentals. Equities remain the “least-dirty shirt” within financial assets, while safety assets should continue to struggle; minimal growth in cash flows is paired with initial yield levels that remain below inflation, as liquidity is intentionally taken out of the system in an attempt to take real rates out of negative territory. This status encourages leveraging of the system and higher inflation. We expect the CML to gradually flatten as frontend yields rise and the cycle matures, yet at this point, the risk/ reward is still signaling intermediate-term value in risk assets.

Developed market government bonds remain unattractive. Starting yield levels for DM nominal bonds are arguably the single biggest challenge facing the investment world. The fundamental insights from our CML process point to a higher base level of inflation than in the prior decade, with past monetary policies among the guilty parties. The shift toward a more reflationary regime forces the central banks’ hands to either move the goalposts by raising inflation targets or to begin removing the historic excess created in the last decade. For now, the path of least resistance is committing to a medium- to long-term path of draining excess liquidity. Yet even if yields were to remain unchanged, real returns from safety assets would remain below inflation, destroying real purchasing power. They face even greater challenges if rates, particularly real rates, keep trending higher. While many see a relapse like Bernanke’s and Powell’s prior episodes with quantitative tightening (QT), we caution that those backdrops were marked by slow growth and economic fragility. In the firmer, tighter world ahead, we caution against the consensus expectation of a relapse. Yet to add insult to injury, in reflation, the correlation benefits from safety assets are diminished, and their hedging efficacy is thus more muted. We believe that the benefit of safety assets has shifted from a secular buy-and-hold asset for strategic asset allocation strategies to a cyclical tool to be used in dynamic or tactical strategies. Otherwise, the returns just cannot keep up with inflation and essentially ensure destruction of capital preservation.

Seek uncorrelated, idiosyncratic market opportunities. Given the headwinds to assets most correlated with and driven by the prior decline in real rates (including core equities and developed market government bonds), we have shifted our focus to identifying relatively uncorrelated, idiosyncratic opportunities. In hindsight, one should have maintained high equity and bond betas while real rates were declining. Should they rise, one needs lower betas to equity and bonds. European carbon credits are one example of a more idiosyncratic growth asset than global equity. Our research points to a structural tailwind for these assets, as climate change remains a priority for European governments. As the supply of such credits deliberately shrinks relative to demand, we see high-single-digit returns for the next five years with a low correlation to global stocks and developed market rates. Another example is commodity carry, which currently benefits from a favorable curve structure and high-single-digit roll yield, with the potential to release value upon adverse demand shocks. In this environment, we believe commodity carry could be a substitute for developed market government bonds. A third example is trend-following strategies that can benefit from inflationary environments and higher macro volatility. We think investors should consider diversifying into relatively uncorrelated opportunities with reasonable return prospects until monetary headwinds have subsided – a process we expect will take years, not quarters.

Equities will be challenged by less-generous capitalization rates, while still benefiting from higher nominal cash flows. The policy mix of this cycle should support higher nominal cash flows as excess capacity is absorbed, with a healthier private sector ramping up its investment. Equity risk premiums (unlike depressed credit, term, and illiquidity premiums) remain in the middle of their historical range. The equity risk premium could stabilize or improve, rather than continue to rise, as it did during the 2009-2019 “Stall Speed” regime, as reflation relieves fears of weaker growth. This likely will prevent a sharp de-rating in most equity markets should rising rates be partially offset by declining equity risk premiums. Our ongoing lukewarm outlook for emerging market (EM) growth, dragged down by China’s slowing along with deglobalization trends, leaves EM equities looking relatively middling despite years of underperformance. Commodity producers within EM may be an exception, but ESG considerations mean that a highly selective approach is needed to access this slice.

Commodity prices already reflect a demand boost. The developments over the first quarter added to incremental demand for commodities in the years ahead, via higher private sector investment and military and decarbonization spending. Resumed slowing of demand in China after this year’s expected Party Congress would offset much of these new sources of demand. Yet we find that much of this incremental demand has already been reflected in the sharp rise in commodity prices. On the other hand, we see commodity prices well supported by the lack of supply growth, as global producers remain disciplined in adding capacity.

The Fundamentals Driving Our CML

A cycle that favors Main Street over Wall Street. In the previous cycle, economic growth was lackluster as a result of fiscal austerity and private sector deleveraging. Extraordinary monetary policy was needed to offset these drags, resulting in an outperformance of financial assets (Wall Street) over the real economy (Main Street). The current cycle will likely reverse these outcomes. Stronger economic growth is on offer, supporting higher consumption growth and inflation, while monetary withdrawal acts as a persistent headwind for financial assets.

A reflationary, more volatile macro regime takes hold. The previous cycle featured below-target inflation and extraordinary monetary policy designed to reflate the economy and achieve target inflation. Liquidity gushed in, dampening macro volatility. The current cycle will be spent mostly above target on inflation and will challenge monetary policy to walk the tightrope of tightening conditions to bring inflation to target levels without causing a recession. Such regimes are inherently more volatile. The result may be shorter cycles that reset macro conditions via short and shallow recessions.

A new iron curtain and arms race. Regardless of its final resolution, Russia’s invasion of Ukraine has erected a new “iron curtain” and set off an arms race after decades of declining military spending. The implications are higher demand for commodities and a further inflationary impulse. The freezing of Russia’s central bank assets will now motivate the development of a financial payment system independent of the US dollar. This decoupling, which is likely to be sponsored by China, will reverberate across sectors and shape the financial system.

Acceleration of decarbonization. Europe is set to accelerate its decarbonization plans as it works to reduce reliance on Russian energy, with Germany bringing forward its net-zero plans by 15 years. This should lead to a sizable rise in investment activity globally, creating an important tailwind for growth and job creation over our forecast horizon, particularly in years three to five. The annual investment gap to meet net-zero is estimated at $2.9 trillion. That said, recent spikes in energy prices give a glimpse at how difficult it may be to assess and manage the knock-on effects of these policies, and commodity prices may become a de facto determinant of the “speed limit” on these initiatives. Higher macro volatility may be part of the cost.

Reshoring and the restructuring of supply chains. The combination of the US-China trade war and the Covid pandemic cemented the need for companies to restructure their supply chains to avoid costly disruptions. Developments in the recent quarter have added a strategic, geopolitical dimension to this issue and will accelerate the trend toward “regionalization.” Companies will be willing to pay a premium to secure supplies in a less globalized world. This will require substantial investment and will leave the system less efficient than in the past few cycles. Regionalization will be less supportive of EM economies overall, and decisions will be more forcefully influenced by political alignment.

China pivots to strategic priorities beyond economic growth. This year is important politically in China, where a reacceleration in policy now appears necessary to reinforce the pivot toward “common prosperity” in 2023 and beyond. However, this trend bears watching and will depend to a great extent on the remixing of the CCP’s power centers during the upcoming Party Congress. Thus far the strategic focus on sustainable and inclusive growth has come with slower overall growth. The real estate market, historically the biggest driver of China’s growth, is the largest of the “three mountains” of housing, education, and health care burdens and is thus in the crosshairs of this strategic shift, more than any other sector. Policymakers will continue fine-tuning fiscal and monetary policies to avoid too much disruption, yet the impact of the “common prosperity” push and its impact on growth is likely to be felt globally. In parallel, the pace of changing regulations across several sectors has already dented private sector confidence. The gains for China in the longer run could be more sustainable growth with more equitable distribution of wealth, yet the transition to date has led to increased market volatility. China’s political decisions on the global stage will be paramount.