Four Strategic Risks that are Colliding as the Low-Rate Era Ends

Four Strategic Risks that are Colliding as the Low-Rate Era Ends

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By Blu Putnam, Chief Economist, CME Group

With the debt ceiling debate now thankfully behind us, investors everywhere are breathing a sigh of relief. Averting the catastrophe of a US default is undoubtedly cause for celebration, but a number of critical risks in the marketplace still remain. Looking ahead, successful investors must turn their attention to navigating four key, long-term factors that will impact their portfolios as well as further shape this new age for the global economy.

  1. Capital is more expensive.

With the old world of near-zero short-term rates and quantitative easing in the rear-view mirror, new strategies are required. The practice of finding yield by taking risks, further encouraged by super-accommodative monetary policy and inexpensive capital, is over. The new mantra will be “disciplined employment management” with a focus on maintaining profit margins in a difficult economic environment.

For the US government, higher rates mean that interest expense in the federal budget will start to grow rapidly. As the low-rate debt matures, replacement borrowing at higher rates will constrain fiscal spending. A new era of both restrictive fiscal and monetary policy is at hand.

  1. Inflation isn’t easily returning to 2%.

Inflation may not easily or quickly return to the 2% target of the Federal Reserve, because the medicine of higher rates must contend with new headwinds. 

Trade and geo-political tensions are re-writing the globalisation playbook, making supply chains more costly and removing a former source of downward pressure on inflation. In the golden era of globalisation, supply chains were optimised for only one criterion – the lowest possible cost.  In the new era of heightened trade and political tensions, resiliency and diversification of sources has become paramount, and it comes at a price.

The price reduction gains from technological and social media advances have been a key element of empowering consumers to comparison shop, resulting in more competition and downward pressure on inflation. Unfortunately, this trend has largely run its course.  Developments in artificial intelligence are more likely to be focused on labor-saving advances, providing more support for maintaining profit margins than helping to depress inflation by further empowering consumers.

  1. Demographic patterns are rewriting how our economy will function.

Many underestimate the economic realities of slowly evolving demographic patterns.  The retirement of the boomer-generation and the lack of growth in new workers entering the labor force suggest steady upward pressure on wages and slower growth in real GDP. The arithmetic of real GDP is that faster growth can be attributed to gains in labor productivity or to rapid growth in the labor force. Labor will hardly show any growth in the coming decades, and labor productivity is notoriously difficult to measure. Yet over the long run, productivity gains averaging 1.5% to 2% would be a typical outcome, unless technological advances provide a great leap forward.

  1. Changing climate changes investment risks.

Beyond the fossil fuel transition, climate adaptation, particularly related to migrations caused by weather change, is going to become an increasingly important economic and political challenge in the next few years. For example, a multi-year, very strong La Niña (cool waters along the equator in the Pacific Ocean) is giving way to what could be a very powerful El Niño (warm water along the Pacific equator). The La Niña/El Niño cycle overlays trends in global warming. The challenge is that the recent La Niña mitigated warming, while the oncoming El Niño is likely to accelerate it. This means more excessive heat spells, larger storms, and faster melting of glaciers in Antarctica and Greenland, all of which will have an impact on economies near and far. 

Bottom Line

It’s a new world now that the economic super-cycle of low rates, low risk, and high returns is over. This next fiscal and monetary regime will make capital more expensive and policy seriously constrained. How investors adapt to this emerging environment, respond to the uncertainties it creates and, most importantly, manage the risks it presents will be key to protecting portfolios and unlocking new opportunities.

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