“Economic history is peppered with sudden and unexpected regime shifts. Most of the time, they have far bigger consequences than initially thought.”
Our long-term expected returns are rooted in a deep belief that underlying macroeconomic factors – and particularly GDP growth and inflation – are the main drivers of asset prices. Since the correlation between financial markets and the economy strengthens over time, a top-down view that moves from a discussion of macroeconomics to asset classes over a 10-year horizon makes sense.
We think the right approach to economic and market forecasts involves identifying economic ‘regimes’, keeping in mind potential ‘regime shifts’ (changes in regimes). Understanding ‘regimes’ is made complicated by cyclical movements in the economy. Dissociating the cyclical noise from structural signals is not easy, but it is vital in order to make apposite projections.
Regime shifts occur, with varying degrees of probability, in parallel with changes in the interaction between inflation and growth. We like to look at regimes through a matrix, taking into account three different phases of inflation and three types of growth. This means there are nine main economic regimes that result from their interaction.
Regimes and regime shifts have implications for our forecasts for long-term asset returns. First, our economic regime analysis will strongly influence the path of expected returns: getting this analysis wrong will distort our return projections. Second, and perhaps even more importantly, regimes are not stable in the long run. In fact, economic history is peppered with sudden and unexpected regime shifts. Most of the time, they have far bigger consequences than initially thought. In hindsight, it could be argued that the election of Ronald Reagan and Paul Volcker’s appointment as Federal Reserve chairman in the early 1980s constituted a major regime shift, as they led to a sharp decline in inflation and acceleration in inflation-adjusted growth.
End economic regimes in main economies, central scenario
|Country||Real GDP growth||Inflation|
Source : Pictet WM-AA&MR, February 2019
A base scenario based on the spread of innovation
Some economists posit that the US is currently in ‘secular stagnation’, characterised as an era of negligible or zero growth, partly due to ongoing low business and federal investment. In the secular stagnation view of things, low investment is due to insufficient savings. By contrast, our base scenario is that over the next 10 years we will be in a regime influenced by three main drivers: the continued spread of innovation, the growing role of emerging markets and global monetary policies that remain market friendly.
In our view, innovation will be a particularly crucial driver of asset return expectations. We think the proponents of the secular stagnation thesis may have underestimated the ongoing wave of innovation and its continued spread throughout the economy. We are also inclined to believe that innovation bringing more upside than downside surprises.
We foresee an end regime of 2.25% GDP growth in the US, 1.3% in the euro area and 4.6% in China over the next 10 years. Our forecast for the US is higher than the Congressional Budget Office’s since we make greater allowance for innovation – and particularly its diffusion –, resulting in higher total factor productivity. Our euro area forecast is similar to the EU Commission’s. Meanwhile, our core scenario is that China will not experience a ‘hard landing’ (a major financial crisis). Instead, we expect Chinese GDP growth to continue to decline gradually. This view reflects structural change in the Chinese economy, which is becoming older, less investment driven and more oriented towards the domestic consumer.
Regarding inflation, we think that ongoing technological progress will continue to significantly dampen price pressures. We believe that inflation will average less than 2% per year over the next 10 years in the US in our base scenario. At the same time, we think a structural shift towards more domestic consumption will lead to higher inflation in China. On top of the innovation factor, we think the build-up of debt throughout the world may also have disinflationary consequences, which could be particularly acute in countries where the population is ageing rapidly, most notably Japan.
The negative scenario of a populist regime shift
Alongside our base scenario, we remain aware of possible negative scenarios. One in particular we choose to highlight in this edition of Horizon is populism. Further populist breakthroughs in major economies could well disrupt the structural drivers of growth, inflation and monetary policy, thus upsetting our central forecasts.
“Our forecasts are based on a blend of our base scenario (70%) and our negative one (30%).”
From an economic point of view, populist policies tend to try to stimulate growth in the short term, usually through demand-driven policies that disguise a sharp deterioration in the supply-side picture. Such policies often inflict irremediable damage to confidence in policy making and their credibility. Thus, our negative, ‘populist’ scenario sees the innovation boost to growth being hurt and policy credibility being severely eroded, leading to higher inflation.
However, even though we have drawn up two clearly delineated scenarios – innovation in our base case, populism in our alternative negative scenario – the reality might turn out to be some shade of grey. Therefore, we prefer to base our forecasts on a ‘blended’ version of our base and negative scenarios, with a 70% probability assigned to the former and 30% to the latter. The next two years could turn out to be pivotal for populism, with a lot of electoral deadlines approaching. The central scenario in next year’s Horizon may be very different.