The re-opening of economies after Covid sparked a phenomenon investors have not experienced in decades.
Strong demand met limited supply, causing inflation to rise sharply. Central banks were slow to react, blaming transitory factors such as the war in Ukraine for temporary spikes in energy and agricultural prices. However, healthy economies and low unemployment meant that these shocks prompted higher domestic inflation, and central banks were left with little choice but to play catch-up.
Higher interest rates are the most conspicuous result – and they are likely to persist – but they are just one facet of the five key macro trends we expect to define the coming years as we move into a new economic regime:
1. Central banks will prioritise controlling inflation over growth
Since the global financial crisis, central banks have always stepped in with support for the real economy and financial markets at the first sign of a downturn. Interest rates cut to record lows, even below zero in some countries, with trillions of dollars worth of quantitative easing, were all seen as necessary to fight the risk of deflation.
Now, with inflation at its highest levels in some 40 years, political pressure has risen and central banks have shifted their response and are now actively trying to slow growth to lower inflation – even if that means causing recessions.
The scale of inflation means that interest rates have to rise further in the short term and remain higher for longer, with central banks unlikely to loosen policy to support growth for some time.
The probability of this scenario is apparent in 'real' (after-inflation) policy interest rates. These became very negative in recent years, contributing to higher inflation, but for most countries are now rising again.
2. Governments will respond with more active fiscal policy
Because central banks’ actions are set to bear down on growth, we expect governments to become more active in their tax and spending decisions. They will try to support households and firms through the economic downturn. These fiscal measures could conflict with the actions of central banks, and cause heightened uncertainty.
Government balance sheets have yet to recover from the costs of the pandemic, and rising interest rates are putting pressure on governments to apply austerity. Yet populist political movements, which are strong in many countries broadly oppose austerity measures and gather their support on platforms of increased spending.
Governments could use redistributive policies and impose higher taxes on wealthy individuals or on companies viewed as beneficiaries of current circumstances, as a way to maintain or increase certain spending. But any fiscal stimulus risks stoking inflation, opposing the actions of central banks.
There is scope for disarray elsewhere as governments, central banks and financial markets fall out over policy direction. The independent role of central banks, whose objectives do not include providing low-cost funding to governments, is already facing hostility. Central banks may come under further fire as politicians’ sensitivity to higher interest rates becomes more pronounced.
3. New world order will challenge globalisation
The relationship between China and the West has been strained from some years, in particular around issues of trade and technology. The pandemic brought a new, physical dimension to these existing political risks, as severe Chinese lockdowns caused widespread blockages. This has added to inflation.
Separately, but with related outcomes, the war in Ukraine has widened geopolitical fault lines which are now re-shaping the global energy landscape. These threaten a greater divergence between China and the West, potentially leading to more protectionism on both sides.
In response to the disruption and these wider developments, companies are planning on diversifying their production – and relocating it nearer to home. Our analysis of the text of US companies’ earnings reports highlights a striking increase in firms’ talk of 'reshoring'.
This means one of the great deflationary forces of recent decades, the growth of low-cost production in China is weakening and may have run its course. Globalisation can still play a role in lowering costs as production moves to new countries, but the easy gains are over as firms place increasing weight on security of supply.
4. Companies will respond by investing in technology
Companies are not only facing rising production costs due to higher commodity prices, but also higher staffing costs.
Labour shortages, which are stemming from the demographic factors, as well as political causes such as curbing migration, have tilted the power in wage negotiations back towards the workforce. This is allowing workers to demand bigger pay increases in response to the rising cost of living. Offshoring as a way of limiting these costs is becoming less attractive, as described above.
Elsewhere regulatory costs are rising, as is taxation. These factors will drive up costs and prices in the near term. Overall companies’ share of economic growth is under threat, meaning a squeeze on profit margins.
To protect profit margins, companies have one clear route to increase productivity: technology. This means investing and adopting greater use of robots and artificial intelligence where feasible, rather than an over reliance on labour.
In recent years use of robotics has grown strongly in Asia and Australia, but there is impetus now for a catch-up in Europe and the US. Likewise some sectors, such as auto manufacturing, have been major adopters while others, like agriculture, have lagged.
5. Response to climate change is accelerating
The long-term economic impacts of unchecked climate change would be unavoidably huge. In the near-term, the actions being taken in an effort to cap global warming are also proving disruptive. Governments have been slow to coordinate and act in response to the climate emergency, and so companies have taken the lead.
The transition to renewable energy will drive inflation structurally higher in several ways. First, there is the cost to create the needed capacity. This is not a linear path as there are shortages of rare earth elements and other key materials. Second is the higher initial cost of switching to a more expensive source of energy. Third will be the costs imposed through regulation to force the switch, as individual countries and blocs accelerate their policies.
Regulatory measures will include carbon pricing (where environmental harm is captured in the prices consumers pay) and carbon border adjustments. The latter – which involve 'taxing' imported goods based on the emissions or other harms involved in their production – serves as a form of protectionist policy. There is a risk that this could be used as front to serve other political objectives as mentioned earlier.
The threat from climate change will likely prompt greater investment in technological solutions, which if successful, could help lower the inflationary impact, and improve the outcome for economies worldwide.
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