Capital Market Line: The Global Savings Glut Is Poised to Disappear

In the post-financial-crisis era, a lingering balance sheet recession led to rising savings as households deleveraged and investment remained tepid. Savings/investment imbalances led most regimes to meaningfully higher/lower rates. Economic growth would have been lackluster even without the fiscal austerity that surfaced, with an attempted offset through ever-looser monetary policy in the form of Chair Bernanke’s crisis-oriented helicopter money followed by Chair Yellen’s perpetual crisis-level monetary settings. This period was an extreme outlier, one in which interest rates fell to the floor.

Today, the backdrop couldn’t be more different, and in many ways it represents a revenge of the old normal. Savings now are dropping rapidly, and even lower savings rates lie ahead (why should households save when they’ve become accustomed to getting bailed out?), and the backdrop for investment is very strong, with supply chains reshoring (a reversal of the outsourcing of capital intensity to China that had become the norm since the country’s 2001 entry into the World Trade Organization); moreover, climate urgency is heating up, Gen Y-ers are attempting to buy their first homes, and the US government is meeting China with its own investment-led industrial policy. This investment impulse is very strong, certainly in comparison to anything we’ve seen since China’s WTO entrance, but also in relation to today’s tepid savings impulse.

Meanwhile, the policy mix has also flip-flopped toward tighter monetary and looser fiscal policy. Fiscal deficits nearly always contract in late-cycle periods, yet 2023 overthrew this precedent with a substantial widening. Now that the bond market has been forced to acknowledge that policy easing isn’t right around the corner, these pressures need to be absorbed by rates and currency movements. The “dark side” of a first-in-50-years, top-of-the-cycle fiscal thrust is tighter financial conditions that pressure valuations while raising legitimate concerns about debt sustainability.

While we are finally observing a meaningful decline in inflation, the risk is that it proves to be temporary, owing largely to the rapid unwinding of transitory supply disruptions. Causal medium-term structural factors (like a tightening labor market, escalating climate change impacts, and deglobalization) all carry the potential to reaccelerate inflation once these transitory declines run their course. The International Monetary Fund (IMF) just reminded policymakers that the historical odds of reacceleration are quite high, making the case for thoroughly stomping out inflation before letting their guard down. In response, the Fed aims to hold rates where they are now. Lower nominal policy rates will only happen well into 2024 if core inflation doesn’t rebound, and to prevent a continuous rise in real rates if disinflation continues. Either path will be accompanied by continued quantitative tightening (QT) into 2025 until the Fed’s supersized balance sheet (which has been flooding markets with too much liquidity for over a decade) comes back down to 7%-8% of GDP. We are in a new regime, marked by a return to a pre-financial-crisis real rate structure, although this one needs to contend with a much worse fiscal picture and stepped-up Treasury issuance.

Growing fiscal demands for higher defense spending, age-related expenditures on pensions and health care, and subsidies in the energy transition are leading to a burgeoning debt stock. Coupled with projected higher real rates, this is set to augment the interest service burden and escalate the debt-to-GDP ratio as far out as the eye can see. The current yield, with the 10-year approaching 5%, heightens concerns about debt sustainability, signaling a looming debt spiral if the economy cannot achieve the real growth rates needed to support these higher financing rates. This concern is echoed by Fitch, which has downgraded US long-term government bonds, anticipating fiscal deterioration and a heightened interest burden amid diminishing government credibility in repeated debt limit standoffs and last-minute resolutions. Ultimately, a fiscal sustainability fight lies ahead. This adds to the significance of US and UK elections in 2024, as we see how societies vote on these issues.

China’s policy mix creates a different dynamic. While most of the world adopted extremely loose monetary and fiscal policies during the pandemic, China’s approach was notably austere, and further restrained by even more austere regulatory levers. Such restraints eroded private sector confidence along with private investment and employment for several years leading up to November 2022.

China’s policy is now gravitating toward less restraint on the monetary, fiscal, and regulatory levers – yet its emphasis this time around is on relaxing the regulatory levers as the primary tool, not going back to the old formula of ramping fiscal thrusts. Beyond ending zero-Covid and reaching a detente with the major technology platforms, China has more recently relaxed down payments to buy homes and lowered existing rates on mortgages to support consumption. Despite these developments, the Chinese authorities’ response to economic downturns this time seems more cautious to those searching for the old playbook with its rapid fiscal stimulus, like the RMB4 trillion economic package rolled out immediately after the Lehman Brothers collapse in 2008. While incremental regulatory relaxation keeps coming, delays risk postponing a return of the private sector confidence that was hit so hard in 2020-2022.

So too is the country’s approach to monetary easing on the cautious side. National security remains the top priority for Chinese officials, which is evident when it conflicts with measures to boost economic growth. This priority is on display in efforts to support and encourage the Global South to trade in the yuan. Rapid adoption would reduce the risk arising if the US were to block China from using the dollar-based banking system. China’s trade flows have already shifted quite noticeably toward the Global South, although this could be further accelerated with a more common currency facilitating trade. Reducing Treasury holdings in favor of gold lessens China’s risk if the US freezes its currency reserves, in a repeat of the Russian situation.

It remains to be seen whether stabilizing the yuan to pull forward its adoption by the Global South will work. While a rapidly falling currency would clearly raise alarm bells in the Global South, allowing the yuan to drift into overvalued territory, further weakening China economically, could also give the country’s newly important trading partners pause. We suspect most, when considering adopting the yuan for trade purposes, would prefer a slightly undervalued currency attached to a country gaining economic strength. Meanwhile, further monetary accommodation is needed to stabilize the appetite for homeownership in this important store of value, with all its impacts on confidence. Slow-walking monetary accommodation raises the odds of a slow slide into a balance sheet recession.

Despite these risks, China’s lighter regulatory touch is producing green shoots. Meanwhile, geopolitical uncertainty continues to push many Western countries and corporations to diversify their supply chains away from China to countries that are closer to home or more politically aligned, like Mexico, India, and Vietnam. Strategic industries such as semiconductors, industrial automation, and batteries are at the forefront of national security-oriented potential restraints. Increasing factory automation to combat labor shortages is boosting related suppliers, including IoT (Internet of Things) and machine vision technology providers, enhancing automation and plant efficiency. Generative AI platforms like ChatGPT could also feed into these trends.

Elsewhere, geopolitical risks are once again manifesting in oil supplies. Oil prices have surged on the back of reduced supply from OPEC+ (including Saudi Arabia and Russia), rejuvenating inflation concerns. One may wonder about the implications of this for countries like China and India, which still buy oil at 20% discounts from Russia. It underscores the lesson from Russia’s invasion of Ukraine last year on the importance of reliable domestic energy sources. The rising global focus on renewables reflects this shift. Increased spending on decarbonization will continue to force investment. Alongside central banks draining liquidity (after surging it for most of the last decade), Western companies are no longer capable of outsourcing capital intensity to the same extent. All of these measures also appear poised to drain the global savings glut, creating a medium-term trend of less-generous capitalization rates, particularly in developed market (DM) countries.

In sum, the current Western mix of tight monetary and loose fiscal policy, along with escalating debt levels at prevailing high rates, is sounding alarms about debt sustainability. The end game could be a fiscal contraction amplifying any number of other cracks, from small businesses that borrow short-term needing to shed workers to offset such interest rate pressures, to expiring office real estate leases in 2025 triggering a raft of nonperforming loans for US midsize banks. Geopolitical risks can also magnify existing cracks in the system. The West begins this process with risk-free rates that are shaking loose from suppression faster than risk premiums. Emerging markets never took on nontraditional monetary policies and have no payback ahead as these unwind in the West.

For the first time in nearly a decade, our valuation analysis highlights the enhanced attractiveness of emerging markets compared to developed markets. The growth gap is also shifting. After many years of EM nominal GDP decelerating toward the DMs’ pace, this growth gap is reaccelerating, again favoring EM. This is also where policy restraints are lessening, while they are tightening in the West – and slowly beginning to bite.

Capital Market Line as of 30 September 2023 (Local Currency)

Capital Market Line as of 30 September 2023 (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 relatively flat Capital Market Line (CML) with a high level of dispersion. Our CML continues to flatten compared to historical levels, due to deteriorating liquidity resulting from an acceleration of Treasury issuance, coinciding with quantitative tightening. Demand-side props from too much fiscal stimulus will wear off. This landscape continues to pose a significant, broad-based headwind for both valuations and cash flow growth. On the flip side, a noticeable level of dispersion in the market highlights the importance of careful asset class selection.

Developed market government bonds have largely shaken off their suppression. Investment needs and Treasury issuance have begun to surface, while QT removes the tremendous excess liquidity that markets have become accustomed to (except in Japan, for now). While real rates are becoming attractive again, Treasuries no longer offer the extraordinary hedging benefits they did during most of the post-GFC period. Insights from our CML process indicate a structural increase in inflation (from 50 basis points below targets to 50 bps above) owing to sticky factors such as tight labor markets and deglobalization. A major shift in the savings-versus-investment balance is taking shape, along with an unsustainable fiscal balance. Central banks are communicating their intent not to become driven by the latter, and intend to keep policy rates elevated for a longer period, lowering nominal rates only to prevent the continuous rise of the real rate. The Fed also intends to persist with QT and to sustain a sufficiently restrictive real rate until either a recession transpires (to which the Fed increasingly attaches low odds) or its inflation target is met. In this context, expected returns for DM bonds have improved.

Credit becomes more attractive relative to equities. Although credit spreads have not widened significantly, higher starting all-in yields make credit attractive relative to equities whose price/earnings ratios have adjusted less to the new rise in real rates. This is particularly true of US high yield (HY), which has a much-improved risk profile relative to previous cycles. Asia HY also offers a longer-lasting opportunity to earn high carry with very low duration, after sustaining a significant shock in the form of China property sector defaults, which have raised spreads in sympathy.

Western equities are challenged by stretched risk premia and peaking DM profitability. Corrections can be in price or time. While AI holds promise for boosting margins and profitability over time, at present a narrow list of companies are benefiting. Meanwhile, Western equities are challenged by cresting margins, rising capital intensity (much of the outsourcing to China has either ended or is partially reversing), and tougher labor conditions that lie ahead, even if they’ve recently come off the boil. Although equity risk premiums are expected to remain on the low side, which they normally do as real yields rise, the S&P 500 began September with no equity risk premium. Stretched levels coupled with tightening credit conditions signify that valuations are likely to remain a headwind. That said, investments related to productivity and climate change are our highest convictions, capable of powering through a general slowdown. We favor Japanese banks and the health care sector, with the former benefiting from rising interest rates in Japan and the latter outperforming in a market slowdown, with structural upside from an aging population. We also hold a constructive view on specific emerging market equities, anticipating a cyclical recovery in China and a secular opportunity in India.

‘Green commodities’ are structurally attractive, despite short-term headwinds. Higher military and decarbonization spending, as well as the rebuilding of energy infrastructure, support the continued demand for “green commodities.” Research indicates that the supply of many minerals and metals, like nickel and dysprosium, essential for key lower-carbon technologies, will face a shortage by 2030. However, in the short term, prices have been hurt by China’s slowdown and a goods recession in developed market economies.

The Fundamentals Driving Our CML

A reflationary, shorter cycle but a more volatile macro regime. The past cycle, characterized by below-target inflation, saw exceptional monetary policies aimed at an economic boost and attaining target inflation. The current cycle is likely to experience above-target inflation, posing an ongoing irritant to monetary policy. The necessity to tighten conditions to curtail inflation, while averting a potential recession, contributes to this regime’s inherent volatility. This results in shorter cycles, longer recessions, and modest upcoming policy support due to enduring inflation. “Goldilocks” requires a central tendency in which rebalancing the economy appears effortlessness, with long, expanded cycles one consequence. Markets became accustomed to this as governments stepped back and let markets and economies play a more decisive role. This began in the 1980s, led by Deng, Thatcher, and Reagan. Of course, market systems rebalance more easily, and left to their own devices, cycles grew longer. Now, with big intermittent crises (the GFC, the pandemic, global warming, rising geopolitical tensions), the US is expanding its industrial policy to meet China head on. Central banks have beaten governments to the punch and are already dominant and intrusive. With mega fiscal and monetary policies having become the norm, we see cycles shortening, leading to more volatility.

From a lack of demand to a scarcity of supply. While Covid-related supply disruptions are now behind us, continued tightness in labor, energy, and capacity appear to have structural roots, differing from the last cycle. Continued weakness in labor market participation may sustain inflation. Contrarily, demand remains robust, supported by healthier private sector balance sheets and positive real wage growth. The peak-of-the-cycle fiscal thrust has further boosted economic strength. This scenario is likely to lead to a sustained withdrawal of surplus liquidity, challenging most financial assets. In contrast to a long disinflationary backdrop with inflation and rates secularly dropping, allowing markets to outperform economies, we may be in for a stretch where economies do better than markets.

Generative AI may boost productivity. Demographic and labor trends can be counterbalanced or amplified by technological advances and increased human capital and investment. Notably, generative AI technologies like ChatGPT are causing a significant shift in the tech landscape, potentially leading to substantial labor savings, new jobs, and enhanced workforce productivity. It is projected that AI automation could impact two-thirds of existing jobs, with generative AI replacing a quarter of current work. This change could significantly increase annual US labor productivity, transforming work and stimulating business innovation and productivity.

Near-shoring and reshoring are gaining traction. Geopolitical tensions have pushed Western companies to diversify supply chains away from China and closer to consumers and more politically aligned regions, like the US, Mexico, India, and Vietnam. Despite lower labor costs in many EMs, total costs could be higher than in China. In a less globalized world, companies will pay more to secure supplies, leading to significant investments and less efficiency. Overall, China’s decoupling from DM economies across key sectors will likely slow supply growth, intensifying inflation due to demographic patterns and societal shifts compared to the previous cycle.

The energy transition contributes to growth while draining savings. The energy crisis sparked by the Russia/Ukraine conflict has accelerated the green energy transition, prompting initiatives like the US Inflation Reduction Act (IRA) and the EU’s Green Deal Industrial Plan to increase low-carbon energy investments. Increased spending on decarbonization and defense will contribute to growth, keeping some product markets structurally tight, but will also contribute to draining the global savings glut. This, along with central banks, will tighten the supply and demand for funds and create a medium-term trend of capitalization rates becoming less generous.

ESG 2.0. Trends may be pointing to an ESG approach (perhaps more common outside the eurozone) that emphasizes a company or industry’s improvements in ESG as the primary investment consideration, rather than cutting off industries based on their current state. This “ESG 2.0” approach provides an incentive for companies in “ESG-unfriendly” industries to “clean up their act” to attract investment. Many of these high-emitting industries have prodigious cash flows and have initiated new processes that are much cleaner. These improvements are needed to address the $2.9 trillion net-zero funding gap, and ESG 2.0’s “carrot versus stick” approach bears watching.