By Jayson Forrest
Deanne Baker (Lonsec) and Lin Ngin (JANA) consider some key structural drivers that will impact portfolios over the long-term.
Alan Logan - Perpetual Private.
Deanne Baker - Lonsec
Lin Ngin - JANA Investment Advisers
When looking at the current economic environment, long-term equity returns and many growth investments are lower than they have been for quite some time, which has largely been driven by both valuations and earnings receding back to an equilibrium level. Yet, despite this, markets are still not cheap.
According to Lin Ngin — Senior Consultant at JANA Investment Advisers — when excluding the ‘Magnificent 7’ tech stocks, JANA sees the S&P 500 as roughly neutral, the MSCI World at about 18x forward price-to-earnings (P/E), and Australia at 17x forward P/E.
“These figures suggest there aren’t any areas where markets can be considered cheap,” says Lin. “They’re either expensive or in-line.”
Against this backdrop, when considering long-term portfolio returns, Deanne Baker — Deputy Chief Investment Officer and Portfolio Manager Multi-Asset at Lonsec — believes it’s important to think about structural thematics that will drive future earnings and growth expectations.
Lonsec has identified a number of key structural thematic drivers — which it terms the five Ds: demographics, deglobalisation, disruption, decarbonisation, and debt — that it believes will continue to evolve and shape the macroeconomic outlook over the next decade and beyond. These drivers are expected to have a significant impact on portfolio returns in the years ahead.
“These are the type of drivers we think about when we’re setting out our capital markets assumptions, which we do on a biannual basis,” says Deanne.
Deanne used the 2024 IMAP Portfolio Management Conference in Melbourne to explain that while some of these thematics have been around for some time — like ageing populations and the high indebtedness of governments globally — since the COVID pandemic, a number of significant shifts to these thematics have taken place. She believes it’s important to understand these shifts as part of the portfolio construction process.
With a rise in global tensions, we’re seeing an increasing emphasis on national security, as well as supply chain resilience, particularly in sectors like technology (artificial intelligence, computer chips, and quantum computing) and mining (critical minerals). As countries and corporates prioritise supply-side security, this is ultimately leading to increasing costs
1. Deglobalisation: A changing world
After 30 years of relatively stable diplomatic relations following the end of the Cold War in December 1989, the world has returned to heightened geopolitical uncertainty and tension, as geopolitical risk rises globally.
According to Lin, this rise in geopolitical risk is leading to what JANA calls a ‘multi-polar world’, where there are many important global powers and not just a few superpowers. This can be seen by growing U.S./China rivalry and resurgent ambitions amongst major regional powers, like Iran and Russia.
“The impact of deglobalisation is enormous,” says Lin. “That’s because geopolitics directly influences global trade and capital flows along geopolitical lines and alliances. With a rise in global tensions, we’re seeing an increasing emphasis on national security, as well as supply chain resilience, particularly in sectors like technology (artificial intelligence, computer chips, and quantum computing) and mining (critical minerals). As countries and corporates prioritise supply-side security, this is ultimately leading to increasing costs.”
He points to the COVID pandemic and Ukraine conflict as stark reminders of how fragile and unreliable both the energy and commodity markets can be, and highlights just how vulnerable global supply chains are.
“Being part of an economic system that relies on the free flow of goods and labour, when geopolitical events like these occur, demonstrates just how vulnerable markets are and the risk they present to inflation,” says Lin.
Deanne agrees the world is progressively moving into a period of deglobalisation, as clear trading blocks emerge, as well as a noticeable shift to ‘friendshoring’ and ‘onshoring’.
“We’re seeing China and Russia beginning to forge an alternative trading system outside the reach of U.S. sanctions,” says Deanne. “We’re also observing a general decreasing reliance on global trade and global institutions and instead, we’re seeing much more localised and nationalistic approaches being adopted across the world. This is a trend that portfolio managers need to be aware of.”
We’re seeing China and Russia beginning to forge an alternative trading system outside the reach of U.S. sanctions. We’re also observing a general decreasing reliance on global trade and global institutions and instead, we’re seeing much more localised and nationalistic approaches being adopted across the world
2. Demographics: The challenges of an ageing population
When considering demographics as a structural theme, JANA looks closely at the ‘old age dependency ratio’. This is the proportion of people at retirement age, divided by the number of people at working age.
According to JANA, by 2027, most advanced countries will be above 30 per cent, and by 2075, all of these countries will be either at 50 per cent or above. This is a noticeable increase in the number of retired people living in these countries.
“With declining birth rates in developed countries, an ageing population implies a slowdown in productivity and economic growth. The only ways to combat that slowdown is through higher immigration, workplace participation, and growth in productivity through the likes of artificial intelligence (AI),” says Lin.
“The other aspect of having an ageing population is the pressure it puts on a range of areas, including healthcare, the Age Pension, and associated pressures on tax revenues.”
However, unliked developed markets, JANA maintains reasonable expectations for growth in emerging markets, due to the younger demographics of these countries. Unlike developed markets, emerging markets are not typically faced with the same age-related issues.
We see interest rates being higher, and with ageing populations in advanced economies, there will be a major shift from saving to spending. Ageing demographics will continue to challenge the sustainability of government debt
3. Decarbonisation: A target of net zero
According to the International Energy Agency (IEA), in order to hit the Paris Agreement target for net zero emissions by 2050, the world needs to triple its capacity of renewables by 2030. This is a massive undertaking and will require significant investment over the next decade, including in areas like: energy efficiency, transmission, and storage.
Lin acknowledges there is currently a large ‘green’ financing gap, with investment flows into this space not matching what’s required to meet the 2050 target. However, in order to reach net zero emissions, a significant ramp-up of investment is required, which JANA sees as being inflationary.
Deanne acknowledges that decarbonisation does have huge economic, societal and political implications, as the world transitions its entire energy system away from fossil fuels towards renewable energy. She accepts there is the potential for ongoing supply disruptions, as markets source the enormous amount of raw materials needed to build-up the infrastructure for this energy transition.
We believe structurally higher inflation, less liquidity and higher volatility are likely to feature in the years ahead. Regime shifts in inflation, growth, liquidity and volatility need to be factored into long-term risk/return expectations, as portfolios designed for the next decade will look decidedly different from those in the post-GFC era.
4. Disruption: Technology changes status quo
Another area where Lonsec is seeing a significant structural shift is within technology, particularly in relation to artificial intelligence (AI), automation and cloud computing. Deanne believes technology will increasingly disrupt traditional channels — like agriculture, mining, and healthcare — and have wide-ranging implications for productivity growth going forward.
“The application for AI outside of areas you traditionally think of, like ChatGPT or taking meeting notes, is growing,” says Deanne. “We believe the capacity for AI to be implemented in other sectors of the economy is enormous. It will significantly help improve productivity.”
5. Debt: Governments, households, and corporates
Debt is another structural driver identified. With JANA not predicting a return anytime soon to pre-COVID economic conditions, Lin believes with central banks focused on managing both growth and inflation, more of the heavy lifting will increasingly fall on government fiscal policy.
“However, the government debt of advanced economies is very high and interest costs are rising,” says Lin. “This makes it challenging for existing debt levels to remain sustainable. Over time, this may also mean that investors will look for additional compensation for the risk they take with their investments.”
Deanne agrees, adding that highly indebted governments, households, and corporates are a definite structural driver over the next decade and beyond
Looking long-term
Considering these structure drivers and their impact on the macroeconomic environment, JANA’s outlook for long-term portfolio returns is below average. It bases its view on: inflation remaining sticky; high energy prices; costs associated with the energy transition; costs associated with de-risking global supply chains; increasing fiscal spending; and continuing geopolitical tensions.
“We see interest rates being higher, and with ageing populations in advanced economies, there will be a major shift from saving to spending. Ageing demographics will continue to challenge the sustainability of government debt,” says Lin.
Deanne agrees: “We believe structurally higher inflation, less liquidity and higher volatility are likely to feature in the years ahead. Regime shifts in inflation, growth, liquidity and volatility need to be factored into long-term risk/return expectations, as portfolios designed for the next decade will look decidedly different from those in the post-GFC era.”
She says the macro environment has evolved significantly post-GFC, from a period of low inflation and ample liquidity, to a post-COVID state of structurally higher inflation and declining liquidity, as central banks undertake quantitative tightening.
“Prior to the pandemic, central banks had difficulties hitting the lower end of their inflation targets, primarily because of long-standing structural drivers, like: ageing demographics, high debt levels, technology disruption, and globalisation. All these drivers exerted downward pressure on prices.
“However, rolling forward to today, we believe the inflation scales are more balanced now. The energy transition and reorganisation of global supply chains have now placed upward pressure on prices,” says Deanne. “So, with longer term inflation risks now symmetrical — where we’re going to see upside surprises to inflation, as well as potentially downside risks — we believe the era of ‘free money’ is likely over. Policymakers are much more constrained in how much money printing they can do.”
Against this backdrop, Lonsec believes that for an Australian investor in a 60/40 balanced portfolio, long-term (10 years) return expectations look to be in-line with long-term average returns. However, it has lower return expectations for U.S. and global equities, which have been offset by higher expectations for cash, fixed income and some bond proxies.
About
Lin Ngin is Senior Consultant at JANA Investment Advisers; and
Deanne Baker is Deputy Chief Investment Officer and Portfolio Manager Multi-Asset at Lonsec.
They spoke on the topic ‘Are long-term portfolio return outlooks below average?’ at the 2024 IMAP Portfolio Management Conference in Melbourne.
The session was moderated by Alan Logan — Investment Director at Perpetual Private