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Point of View · 09.13.22

3 Investment Trends Driving Portfolios in the Coming Years

What inflation, evolving central bank policies and threats to the green energy transition mean for investors

  • Portfolio Construction
  • Green Energy
  • Outlook
Format
Article
Executive Summary

Key Points

What this is

Investors manage their portfolios with long-term trends in mind. We examine three of those trends.

Why it matters

Investment trends related to inflation, central bank policy and the transition to clean energy may move markets over the next five years.

Where it's going

The worst of inflation probably has passed, the flood of monetary support likely has ended, and the slowdown in green energy looks to be temporary.

Potential Investing Threats and Opportunities

 

Over the next five years, we think investors must navigate economic, environmental, and political threats and opportunities to achieve their goals. As part of our Capital Market Assumptions Five-Year Outlook research, we identified those threats and opportunities through broad investment themes we believe will drive portfolio risk and return. We explore three of those themes.

 

 

Inflation Recalibration

 

No economic variable has changed more rapidly or created more volatility for investors over the past year than inflation, leading to . Just as investors thought inflation caused by pandemic-related supply disruptions would eventually settle down, the war in Ukraine triggered soaring commodity prices and forced investors to recalibrate their inflation assumptions. High inflation has sparked aggressive responses from central banks globally, increasing interest rates and volatility for stocks and bonds.

 

The war has primarily increased inflation through higher commodity prices, which may last for years. Before the war, Russia supplied 12% of global oil and 17% of global natural gas exports. Russia and Ukraine combined supplied 29% of global wheat and 19% of global corn exports.* This supply is at risk of disruption — both in the short term because of disruptions to planting, harvesting and exporting and the long term with potentially persistent Russian boycotts in reaction to economic sanctions by the U.S. and Europe. Russian boycotts will more likely influence the five-year horizon more, as it further entangles a global supply chain already snarled by the COVID-19 pandemic. The war has also notably widened the already-growing “West-East” divide, jump-starting a dramatic rebuilding of energy and technology self-sufficiency to lessen dependence on imports from political adversaries.

Exhibit 1: THE END OF AN ERA

 

The end of persistently low inflation means investors must recalibrate their invesment assumptions. 

Exhibit 1: The end of an era

Source: Northern Trust Asset Management, Bloomerg, Data from 3/31/2017 to 3/31/2022. All regions use headline Consumer Price Index as the inflation metric. Historical trends are not predictive of future results.

Automation and digitization still produce powerful disinflationary forces, but these forces need some time to overcome the shocks of stressed global supply chains, tight commodity markets and depressed labor supply. While inflation may take years to return to normal, we believe the worst has passed.

Monetary Drought

 

To fight inflation, central banks have decisively shifted their focus from supporting the pandemic-damaged global economy to fighting global inflation. This has created a Monetary Drought, in which central banks have increased interest rates, cutting to a trickle the previous flood of monetary support. Investors must adjust for higher interest rates when making investment decisions, such as valuing equities, and no longer depend on central banks to come to the rescue if the economy falters.

 

 

The “terminal” forecasts found in Exhibit 2 represent where we believe policy rates will be at the end of the five-year period, which can somewhat obscure our year-by-year policy expectations from start to end. For instance, we expect the Fed will end the five-year period at 2.5% but will push rates up over the next year before slowly coming down. The average (green bars) takes into account our forecasted trajectory (2.8% in the case of the Fed), providing a better indication of the average monetary policy environment expected over the five-year horizon.

Exhibit 2: CENTRAL BANK PIVOT

 

Central bank policies and the resulting short-term rates are taking a more restrictive turn, and we think investors will need to adjust for higher interest rates in the coming years.

Exhibit 1: The end of an era

Source: Northern Trust Asset Management, Bloomerg, Data from 6/30/2022. Historical trends are not predictive of future results.

Green Transition Still a Go

 

Russia’s attack on Ukraine has brought forth a new political landscape alongside new security concerns, and the sits right in the middle of it all. Russia’s cutback of its energy supply to Europe has forced politicians to ensure that energy demand can be met — whatever the source.

 

We believe the approach to the green transition will diverge by region. Europe and Asia in the short term are seeking to fulfill their energy needs any way they can. They are importing liquefied natural gas and increasing production at coal-fired power plants. At the same time, however, the high prices of fossil fuels have encouraged massive public and private investment in renewable energy, such as solar power, and conservation. Even more, governments are signaling they understand the role renewable energy and nuclear power must play in achieving energy security. As a result, despite the short term pullback, investors should expect a bolstered green transition in the medium-term.

 

In the more politicized U.S., some use energy security as the justification to commit more deeply to “made in America” fossil fuels instead of renewable energy. Opposition by the Republican party to green energy threatens the pace of the green transition. However, with fossil fuel prices likely to stay elevated, we think the U.S. will naturally shift toward green alternatives such as wind and solar as well as electric vehicles.

 

While we believe the urgency to source energy in today’s political climate will slow the pace of the green transition in the short-term, war in Ukraine has also pushed fossil fuel prices higher and spurred a renewed focus on energy security. This potentially drives private and public investment in renewable energy and energy conservation, for reasons beyond their clean-energy merits. We expect this to accelerate the green transition — and green investment opportunities — in the medium- to long-term.

Explore more investment themes in our Capital Market Assumptions Five -Year Outlook.

*Brookings Institution, 2020

Main Point

Inflation, volatile interest rates and the green transition likely will impact investors’ portfolio decisions for years.

These global trends may spark turbulence for equities and bonds as central banks calibrate for economic changes and surprising political turns. While investors may frame this uncertainty as threats to their portfolios, we think alert investors can uncover plenty of opportunities.

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