The global community is facing a public health crisis, an economic crisis, and financial turmoil all at once – an unprecedented combination in modern times. The crisis has brought to the fore market vulnerabilities and accelerated shifts in the global investment landscape.
Prior to Covid-19, GIC’s view was that asset prices were not providing adequate compensation for risk, given our mandate ‘to preserve and enhance Singapore’s international purchasing power’. This led us to reduce the overall risk in the GIC portfolio, a helpful cushion during the first-quarter 2020 market volatility. While the low growth, low productivity, and fraught geopolitical environment is expected to persist, there are several major shifts that are likely to lower future returns and increase market volatility.
Pre-crisis, long-term interest rates globally were already at their lowest for at least 140 years, reflecting central bank policy as well as longer-term trends such as slower population growth, weaker productivity growth, and an excess of savings over investment. The low interest rates contributed to steadily increasing debt as companies were increasingly incentivised to restructure balance sheets away from equity and towards debt.
The future aggregate debt burden will be higher still. Companies will have to borrow even more to weather revenue declines. The large and rapid official response has sharply increased public debt and shifted risk onto government balance sheets. Elevated debt limits the extent that interest rates could rise without causing a significant economic slowdown.
The rapid policy response and fall in interest rates have helped boost asset prices and reduce the likelihood of a deep financial crisis. Central banks have resorted to increasingly unconventional measures. Not all countries can afford such large-scale stimulus. Concerns over how these programmes are financed are likely to weigh on debt markets, particularly in lower-income economies and those that are reliant on foreign capital flows.
There is greater implicit or explicit co-operation with monetary policy in leveraging up fiscal programmes, increasing purchases of government debt, or maintaining low government financing costs. These coordinated policies have been critical in supporting the economy. Yet they may prove difficult to calibrate and reverse once the economy normalises.
These shifts have the potential to change the investment environment in two ways. First, the medium-term risk of higher inflation has increased. If central banks deliberately keep rates low as economic activity increases, economies could overheat, resulting in upward price pressure. This risk is likely to materialise only over the medium term given strong current disinflationary forces. If this happened, it would change the investment landscape. In particular, the correlation between equities and bonds could become positive, making it difficult for asset allocators to achieve diversification.
Second, currency moves could play a larger role in asset returns for a global investor. As the effectiveness of the interest rate channel for monetary policy decreases, more emphasis will be placed on increasing purchases of government debt and potentially capping interest rates, which could lead to capital flight and currency depreciations.
A further major theme is increasing corporate emphasis on resilience. Companies are rethinking global supply chains to increase reliability and reduce complexity. They are likely to accelerate the adoption of technology such as advanced robotics and additive manufacturing as well as digitalisation of content. This will help shorten supply chains and reduce the exposure of goods production to trade.
Companies will diversify their production geographically, or bring production closer to home. National security concerns have led to pressure to reshore supply chains for products such as pharmaceuticals, medical equipment and technology. Restrictions on movement of labour and capital could tighten to protect domestic interests. US-China strains will remain a significant headwind ahead of the US presidential elections. There could be further restrictions related to technology, with the US already excluding Chinese firms from its information and communications technology supply chains, and limiting China’s access to US-origin technology and materials.
Strategic sectors such as healthcare and defence are likely to see more reshoring to the US. In response, China’s strategy is to globalise in sectors such as healthcare, substitute local suppliers for US IT sector suppliers, and get closer to large end-markets like the US by producing in Mexico. In some ways, these shifts will lead to a more robust system. Companies are diversifying their suppliers, and standardising parts and processes to make them more modular and easily replaceable. These shifts will help ensure a more secure and stable supply of goods and products.
Beyond the crisis, GIC retains belief in Asia’s resilience. This reflects not only the region’s improving institutions and macroeconomic policies, but also growth in exports and intra-regional trade. However, capabilities to deal with the pandemic differ across the region, which could imply a less synchronous recovery. Economic recovery will take time as supply normalisation will be gradual, precautionary savings will stay high, and external demand will remain subdued.
Investment in healthcare systems will increase, with positive effects in terms of preparedness for future pandemics, higher life expectancy and improved quality of life. Over the longer term, Asia can continue to benefit from urbanisation and middle-income growth, investments in infrastructure and human capital, and deeper regional integration. These factors should continue to generate self-sustaining growth in Asia, including China, and drive longer-term outperformance. Given the challenges, governments need to remain steadfast in introducing structural reforms supporting potential growth and adaptability to an ever-changing global economic landscape.
Prakash Kannan is Chief Economist at GIC, the Singapore sovereign fund. This is an edited version of an article, ‘A Changing Global Investment Environment’, in the GIC 2019-20 annual report.