By Magdalena Polan, Head of Emerging Market Macroeconomic Research, PGIM Fixed Income
A changing US-China relationship, the regionalisation of global supply chains and the reemergence of industrial policy in the West are bringing fundamental change to the macro landscape, making it imperative for investors to both manage risk and capitalise on new opportunities that emerge in this era of change.
While a full decoupling is less likely, globalisation will take a different path in the next decade than it did in the last, reflecting the regionalisation of trade and the benefit of subsidies to key industries. Investment opportunities will continue to present themselves but in different regions and sectors, as supply chains are redirected, and fiscal support incentivises domestic growth. Savvy investors with dry powder will be poised to capture these unexpected opportunities.
In order to manage risk, it is crucial to anticipate industrial policy’s potential shortcomings.
Policymakers aim to simplify supply chains and limit exposure to geopolitical turmoil by encouraging manufacturers to take up roots closer to their own borders. But there is a risk that today’s economic interventions fall short of their objectives over the long haul.
A corresponding increase in government spending adds to bloated public debts worldwide, and managing this debt burden will become trickier in a higher-rate regime. Domesticating supply chains threatens to raise the risk of inflation, supporting the case that central banks will hold interest rates higher for longer as they fight to bring down underlying price pressures. Investors have already observed liquidity challenges across global markets, particularly in bond markets and in regions such as Japan, as a normalisation in monetary policy takes shape. Higher interest rates may also crowd out private investment and dent industrial policy’s potential benefits to growth.
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Government policy shifts bring with them another possibility: picking winners that turn out to be misses. China may serve as a cautionary tale given its recent economic struggles, showcasing the limitations of infrastructure investments and diminishing returns over time.
Unintended consequences may also arise. Rather than encourage cooperation among strategic allies, there’s a risk that US industrial policy pushes some trade partners closer to China, especially those that rely on Chinese demand (such as Germany) and inputs (such as India). This may in turn create new geopolitical tensions. Furthermore, geopolitical strife threatens to put a greater strain on government budgets, potentially leaving less money to spend on economic development or other stimulus programs.
A different path for policy and growth, from an industrialisation drive to global economies taking unexpected and divergent trajectories, thus portends a new economic era that will alter the investment outlook.
With the world seemingly changing at a quicker pace, investors must avoid thinking of risk within a narrow spectrum. Managing risk today means finding the right assets and strategies that can mitigate downside risks from both high- and low-probability events—and even provide upside potential in an otherwise volatile market.
Active managers who have experience investing through a variety of cycles can help build portfolio strategies that cut across public and private markets to meet investors’ risk-management objectives.
A world that is shifting faster and more dynamically will compel investors to create more robust portfolios that can withstand volatility. This calls for diversification and more sophisticated strategies, such as systematic macro strategies, that can be long but also go short as risks develop. For instance, while an allocation in commodities can be used as a hedge against inflation, agile investors need to plan for an unexpected or sudden softening in price pressures.
When managing risk, reducing risk ahead of known events such as elections is a natural part of the investment playbook. Investors can prepare for “unknown unknowns”—and hard-to-predict geopolitical risks—by building agility into their portfolios, thus reducing reaction times when a new regime takes hold.
One thing investors have going in their favor is technology and quantitative models make it possible to quickly detect shifts in the correlation between asset classes and macro trends, allowing market participants to be much more responsive. By processing large amounts of data, quantitative managers can assess performance drivers and help optimise portfolios to not only capture excess returns, but account for expected and unexpected performance detractors.
Key takeaways for investors:
Keep dry powder: Have dry powder on hand to capture unexpected opportunities in different regions and sectors as supply chains are redirected and governments extend fiscal support to domestic industries.
- Monitor liquidity risk: Be aware of liquidity challenges across global markets with inflation supporting the case for central banks to keep interest rates higher for longer.
- Mitigate downside risk: Find the right assets and strategies that can mitigate downside risks from both high- and low-probability events—and even provide upside potential in an otherwise volatile market.
- Experience across market cycles: Seek active managers who have experience investing through a variety of cycles and can help build portfolio strategies that cut across public and private markets.
- Nimble strategies: Use diversification and more sophisticated strategies, such as systematic macro, that can be long but also go short as risks develop in a dynamic, fast-changing world.
- Flexibility: Leverage quantitative models that make it possible to quickly detect shifts in the correlation between asset classes and macro trends.
