Capital Market Line: With Free Money Behind Us, What Lies Ahead

After more than a decade of monetary policy that would have been viewed as extreme in the past, the era of free money is finally unwinding.

The post-financial-crisis monetary experiment was implemented only in part through negative real interest rate policy, with the balance coming from quantitative easing (QE). Normalization of this second policy lever had barely begun when several regional banks failed. All were outliers, with narrow and fickle depositor profiles and faulty asset-liability management, as well as regulatory supervision. Rushing in with temporary support, the Fed quickly unwound 60% of its quantitative tightening (QT). Meanwhile, since December 2022, the Bank of Japan (BOJ) also surged its balance sheet to preserve yield curve control well past its useful life. These actions helped equity risk premiums and credit spreads stay calm as danger drew ever nearer.

Nonetheless, these last balance sheet surges should be viewed as one-offs. The long journey of ending the free-money era is a two-step process that is now past the halfway mark. Central banks appear committed to finishing the job, barring an immediate recession or financial instability. QT will continue well after a policy rate pause. Policy rates that linger at their highs while QT continues to drain liquidity will expose economies and capital markets to more frequent and significant cracks. It’s hardly a pause that refreshes. This, coupled with unsustainably inflated earnings and margins in the aftermath of Covid stimulus, means markets remain asymmetrical to the downside.

The rapid increase in rates has claimed its first victims: special-purpose acquisition companies, the venture and crypto ecosystems, Silicon Valley Bank, and Credit Suisse – all beneficiaries (and then casualties) of the excessive liquidity force-fed into the system for too long. Far more have been propped up and have yet to reveal themselves as the tidal wave of money recedes. Commercial real estate was also puffed up by excessive liquidity creation and is subject to substantial refinancing risks as liquidity thins out.

Yet given the resilience of US households and businesses and the preponderance of very well capitalized bank balance sheets – and with ample liquidity remaining in the system – we believe central banks can take a surgical approach to address the handful of cracks that appear, without needing to abandon their monetary objectives. If so, the resilience of the system likely rules out a balance sheet recession (characterized by lengthy workouts that suppress demand and inflation for extended periods as deleveraging takes place). Instead, a milder cyclical income statement recession is expected, which could still yield a deeper profit recession given today’s record profit margins, which are still artificially high due to rampant inflation that is now unwinding.

While most large public firms and individual homeowners termed out their debt and aren’t feeling the policy rate hikes at present, small firms borrow primarily floating-rate loans from the regional banks. Too little regulatory supervision is historically followed by too much. We now expect stress-testing to incorporate interest rate moves and extreme shocks in deposit betas to rates. These moves combined will force asset-liability mismatches to shrink to safeguard the system, hampering the regionals’ competitiveness in the process. Stepped-up supervision will also lead regionals to hoard liquidity and to become quite conservative in extending loans. This lending will ultimately move mostly to private credit. Meanwhile, net margin pressures are cascading on small businesses, whose financials are not public, creating a blind spot in an area that has accounted for most of the hiring in the past few years. A profit squeeze here, where nobody is watching, is what may finally result in job cuts, pushing excess demand below supply – and also marking the onset of recession.

After 40 years of disinflation, structural supply scarcity has emerged due to the war in Ukraine and the escalating US-China rivalry (which has partially reversed globalization), and societal shifts influenced by inequality – exacerbated by the pandemic, which has shifted many workers’ focus away from maximizing income and toward a better quality of life. This is contributing to decreased labor participation and productivity. Collectively, these trends create supply obstacles that are likely to outlast and outweigh any drop-off in demand after the pandemic stimulus packages and supply-side constraints wear off.

In the post-pandemic era, transitory shortages in a quarter of the economy have now come and gone, creating meaningful ramp-ups and then ramp-downs in goods prices; what’s left are slowly growing, yet stubborn, secular inflationary forces that touch about half the economy and look poised to settle higher than during the post-financial-crisis period. This is the Fed’s primary focus, which is why it will be slow to cut policy rates (until after it’s too late). Until then, the Fed will also stick firmly to implementing the second policy lever through ongoing QT, which will last long after the pause in policy rate hikes.

But not all is dark. As labor participation declines, the recent introduction of generative artificial intelligence (AI), such as ChatGPT, may help alleviate some workforce pressures. It has the potential to increase overall labor productivity at levels comparable to the surges following transformative technologies like the electric motor and personal computer. Of course, going in the other direction is the end of Moore’s Law, which postulates advances in semiconductor power within the same space on a wafer, and climate change urgency, requiring massive investments to produce the same quantum of (cleaner) power.

Then, there is China. Beyond its reopening, there is a growing recognition that the nation’s aspirations for military superiority require a much stronger economy; thus its more pragmatic approach to economic issues. Policymakers everywhere are recognizing the need to fuse national security and economic policy. As widely reported, positive signals are emerging from China which highlight this new pragmatism, including Alibaba’s restructuring accompanied by Jack Ma’s return to the country, Tesla’s planned build of a Megapack battery facility in China, and Airbus’s expansion of an assembly line there. We are also seeing early signs of a recovery in China’s real estate sector, in both prices and transactions, as policy restraint gives way to accommodation.

After seeing the US freeze Russia’s currency reserves and devalue its own reserve currency through a decade-long surge in the Fed’s balance sheet (at multiples of nominal GDP growth), China is also orchestrating a de-dollarization campaign, promoting trade with and among countries like Saudi Arabia, Brazil, Iran and others in local currencies, bypassing the US dollar. We expect this to be a slow-moving phenomenon that points to a gradual weakening of the US dollar’s preeminence.

Decarbonization has emerged as a crucial driver in Europe’s energy strategy. “ESG 1.0,” associated with the eurozone, emphasized cutting off entire industries from financing based on their current state of environmental, social, and governance practices. This approach revealed its Achilles heel in 2022 as capital misallocations steered by ESG 1.0 led to massive reductions in nuclear and coal power in Germany, which had not yet been replaced by increases in clean energy. As a result, the natural gas price in Germany surged long before Russia’s invasion of Ukraine (and may even have been an emboldening sign of vulnerability).

Now the invasion of Ukraine has accelerated renewable energy timelines, which have been elevated to a matter of national security. Germany itself pulled forward its net-zero plans by 15 years, with the annual investment gap to achieve net-zero now estimated at $2.9 trillion globally according to our estimates. 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, which, along with central banks, will tighten the supply and demand for funds and create a medium-term trend of capitalization rates becoming less generous. This does not end when the Fed pauses rate hikes. It’s barely begun.

Rather than signaling the end of ESG, we see this episode paving the way for ESG 2.0 – an approach we view as more common outside the eurozone, which emphasizes a company or industry’s improvements in ESG as the primary investment consideration rather than cutting off entire industries based on their current state. This 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 funding gap, and ESG 2.0’s “carrot versus stick” approach bears watching.

In sum, 40 years of disinflation, during which central banks were able to rush to the rescue when needed, has programmed many to expect the last rate hike to be quickly followed by the first cut and the onset of new bull markets. This time will not necessarily be different; just more typical of inflationary backdrops when central banks are much slower to come to the rescue. Once economies gain downward momentum, it’s harder and takes longer to reverse this. The end of free money (which unfolded over a decade) has not yet been addressed with respect to right-sizing central bank balance sheets. This will take much of the next five years, during which capitalization rates should become less generous, with market returns lagging cash flow growth (note that during disinflationary periods historically, market returns have often exceeded cash flow growth). Valuations favor areas that avoided monetary excess. This time, the excess was concentrated in developed markets, and the fundamental progress of growth is most visible in emerging markets – which are also more attractive in our CML framework. Go East.

Capital Market Line as of 31 March 2023 (Local Currency)

Capital Market Line as of 31 March 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 flat but steepening Capital Market Line (CML) with a high level of dispersion. The slope of our CML ticked up slightly this quarter due to price actions following the failure of two US regional banks and Credit Suisse. Nevertheless, the CML remains relatively flat compared to historical levels, as the withdrawal of liquidity remains a particularly challenging headwind for valuations on a broad basis. Additionally, the level of dispersion remains high, making asset class selection all the more important.

Developed market (DM) government bonds are becoming slightly less attractive. As disinflation has become more evident alongside slowing growth and rising risk aversion, yields have fallen from their highs in fourth-quarter 2022, making DM government bonds slightly less attractive. Nevertheless, even at current yield levels, the relative value of DM government bonds has improved significantly relative to the previous cycle. The fundamental insights from our CML process point to persistent higher inflation and yields compared to the last cycle, resulting from a tighter labor market and a splitting of global supply chains as companies address rising geopolitical tensions – a clear headwind for fixed-rate safety assets. Yet current yields finally provide a positive real yield, and a fading of inflation from current (high) levels will create a more attractive risk/reward profile for bonds.

Credit assets have become more attractive relative to equities. Credit spreads have widened, and along with higher yields, they have made credit assets more attractive than many equity markets in both absolute and risk-adjusted terms. US high yield stands out, supported by much better credit quality and lower default risk. Asian investment grade bonds also appear attractive, with spreads having widened in sympathy with broader credit markets while the bonds retained one of the most robust fundamental profiles.

Equities face higher equity risk premiums and peaking DM profitability. The main challenge to equities is higher equity risk premiums as excess liquidity is mopped up and profit margins decline amid a partial reversal of globalization, along with the recognition that the inflation spike went hand-in-glove with the profitability spike. Increased capital intensity from client urgency also is not favorable for valuations. Some countries – e.g., Mexico and India – may benefit from reshoring and nearshoring, and commodity producers could benefit from decarbonization buildouts. However, ESG considerations mean that a highly selective approach is needed to access this slice.

China’s zero-Covid pivot boosts growth. As China pivots away from its strict zero-Covid policies and moves in part toward renewed pragmatism, the country is expected to bolster domestic growth and benefit its equity sectors. However, beyond the next nine to 18 months, Chinese equity fundamentals may face ongoing challenges from the decoupling of US-China technology, supply chains, and currency blocs.

‘Green commodities’ are structurally attractive, but with very high dispersion. Higher military and decarbonization spending, as well as the rebuilding of energy infrastructure, support the continued demand for commodities, particularly aluminum and lithium, which are geared to the energy transition. Accelerating domestic growth in China offers a positive outlook for commodities, but a potential recession in the US and Europe may dampen prospects for commodities broadly. Within “green commodities,” we observe a high dispersion of expected returns. We think aluminum and cobalt screen as very attractive, while lithium screens unattractively. The key factor driving this dispersion is the large divergence in supply growth projected over the coming five years, with less attractive markets suffering from a high level of supply coming onstream due to prior investments.

The Fundamentals Driving Our CML

A reflationary, more volatile macro regime. The previous cycle featured below-target inflation and extraordinary monetary policy settings designed to reflate the economy and achieve target inflation. The current cycle will be spent mostly above target on inflation, challenging monetary policy to walk the tightrope of tightening conditions to bring inflation down without causing a recession. Such regimes are inherently more volatile. The result may be shorter cycles, with longer recessions, and less forthcoming policy support due to persistent inflation.

From demand deficiency to supply scarcity. Recent supply constraints around labor, energy, and capacity appear to be structural, unlike in the last cycle. Weakness in labor market participation will, if it continues to languish, provide a stubborn floor for inflation. Demand, on the other hand, remains robust as a result of stronger private sector balance sheets. This combination will induce ongoing withdrawal of excess liquidity, challenging most financial assets.

Generative AI may boost productivity. Generative AI harbingers a potential revolution in the labor market, automating tasks and leading to cost savings and increased productivity. Adoption of AI could add 1.5 percentage points to yearly growth in labor productivity, similar to past technological advancements. The widespread adoption of generative AI is expected to change how work is done and offer opportunities for new businesses to innovate and for existing businesses to become more productive.

Supply chains diversify away from China. Companies are actively diversifying their supply chains away from China and toward countries that are closer to end markets and more politically aligned. India and Mexico stand out as key beneficiaries. This restructuring will lead to shifts in growth rates, particularly within emerging markets, and will have implications for inflation; labor costs in many EMs are now lower than in China, yet all-in costs may prove higher. Companies will be willing to pay a premium to secure supplies in a less globalized world, but this will require substantial investment and result in a less efficient system. Overall, the decoupling of China from DM economies across strategic sectors will likely curb the growth of supply, adding to demographic trends and societal changes that will elevate inflation relative to the previous cycle.

Energy supply will drive the geopolitical calculus and contribute to inflation. Russia’s invasion of Ukraine triggered an energy supply crisis after a quiet geopolitical period that had lulled politicians into taking energy supply for granted. The noble drive to combat climate change was also mismanaged via ESG 1.0-era policies, which drove down conventional energy investment faster than new sources of energy could come onstream, leading to overreliance on unreliable renewable energy in tandem with a capital misallocation. We expect the rebuilding of energy networks to take several years, with Europe incurring substantially higher energy costs across the entire economy. Profitability will be challenged, with the currency only being a partial offset in terms of global competitiveness.

Acceleration of decarbonization. Decarbonization is a crucial driver in Europe’s energy strategy due to the need to reduce dependence on Russian energy and tackle climate change. Germany has advanced its net-zero plans by 15 years to emphasize the transition away from fossil fuels, which is expected to increase investment, growth, and job creation. We estimate an investment gap to reach net-zero of $2.9 trillion globally, highlighting the significance of decarbonization in shaping the new economic cycle. That said, commodity prices may prove an important de facto determinant of the “speed limit” of these initiatives. Higher macro volatility may be part of the cost. ESG 2.0 – which focuses on improvement in ESG metrics – may help avoid exacerbating the energy crisis. Elsewhere, we sense the onset of “ESG fatigue” but expect the continued pursuit of decarbonization, perhaps at a more sustainable pace.