The world is entering an era of higher interest rates, weaker economic growth and hence, less abundance.
The macroeconomic environment this year has been a continuing saga of last year’s narrative around geopolitical tensions and tightening monetary policy. Russia and Ukraine are still at war while US-China trade relations remain hostile. As a result, the global economy is shifting away from hyperglobalisation, where supply chain bottlenecks are bound to restrict growth. On monetary policy, inflation remains sticky, and the impact of tighter monetary policy and credit markets are materialising.
We are seeing trends that previously reigned deviate from the norm. Commodity prices now move with in tandem with the US Dollar (rather than against it), hence a stronger Dollar will amplify the negative terms-of-trade impact on commodity importers. Financial cycles (both global and domestic, typically 8 and 15 years long, respectively) are also tightening concurrently.
The last 15 years of near-zero interest rates have been an anomaly, and markets are now starting to price in higher real yields. The economy is now more resilient to higher rates: home vacancy rates are at record lows, the European banking sector is in much better health, the competitiveness gap between core and peripheral European countries is closing, and many of the secular forces that drove deflation are dissipating (e.g. de-globalisation, political populism, demographic aging). This is countered somewhat by opposing forces such as the artificial-intelligence-led productivity boost and China’s economic weakness.
Macroeconomic regime transitions are difficult to navigate, leading to heightened volatility in financial markets.
The “most anticipated recession in history” has yet to arrive, but recessions often happen when investors least expect it. Thus far, market anticipation of rate cuts and strong government demand (due to the green transition, supply chain diversification, etc) have kept the economy afloat. However, monetary policy acts with long, variable lags, and structural changes in the economy (e.g. stronger corporate investment after a decade of US deleveraging) compound the difficulty in estimating the neutral rate, hence policymakers are moving cautiously.
Higher rates mean less liquidity in the system, and therefore more tactical volatility. Higher yields will lead to lower equity risk premium, which would lower expected equity returns to 2-3% in nominal terms rather than 6%. The sharp public markets correction in 2022 did not immediately filter through to the private markets, but the private markets have re-priced this year.
The geopolitical splintering between the US and China is one of the fundamental driving forces in the region. The outcome could be either further fragmentation of the world economy along geopolitical blocs, which the IMF is warning us about, or deeper and broader reintegration in supply chains and emerging economies, which the WTO is championing. In the former situation, the APAC region would suffer the most; the IMF has forecasted an 8% drop in output.
A new macroeconomic regime requires new investing approaches. However, there are also pockets of opportunity.
Investors (LPs) are looking for new asset classes for portfolio diversification and income, including infrastructure, real estate, and commodities. The classic 60:40 portfolio of bonds and stocks may not work well anymore because the negative correlation between bonds and stocks has diminished. Infrastructure also benefits from demand tailwinds like green transition, supply chain reshoring and friendshoring, and reindustrialisation in ASEAN. Besides that, private credit has outperformed in an environment where banks’ lending standards have tightened despite resilient economic growth and therefore demand for credit.
More volatile markets means it is more difficult to generate returns from beta, so investors need to either take a more tactical approach, or look for alpha (illiquidity premium). In private markets, this entails generating returns from operational improvements, business expansion, and value creation rather than just valuation mark-ups. That said, many companies will have to restructure to survive in an environment with higher rates, so there are opportunities in transactions such as carveouts and take-privates. Furthermore, structural economic reforms in some APAC economies that have seen relative political stability (e.g. Japan, India, and China) are now bearing fruit, hence there are investment opportunities here too.
ASEAN as a region will benefit from preparing for either scenario of increased fragmentation or reintegration of global supply chains. This would entail developing domestic competitiveness to attract investments (as seen in reindustrialisation in Vietnam and Thailand), expanding trade in services especially leveraging on digital technology, expanding and further diversifying trade (both imports and exports), and tackling cross-border challenges, e.g. climate change and local currency payments systems, together.