Mega Forces: Why They Matter Now

Transcript

Mega forces, structural forces, including geopolitical fragmentation remain the right lens through which we look at what’s happening in the economy and also what’s happening in markets.

1) Hedging for geopolitical risk

In this new geopolitical regime where risks for escalation are persistently higher compared to before. Instead of immediately fading the market reaction, actually thinking about having exposures in portfolios that give some geopolitical risk hedging or reasonable valuation makes sense, like energy, like the dollar, for example, and inflation-linked bonds.

2) AI to ease supply constraints

Moving over to AI which is a key mega force that we have identified that we have been overweight for a while now. This week’s earnings reporting continues to show that there is more runway for this theme to play out.

But we’re not looking at the obvious kind of just the tech sector and the magnificent seven, but also secondary beneficiaries of the AI mega force. We’re looking at data center, infrastructure, energy as well. You think about energy needs in the context of AI analytics all of that creates, actually represents lots of opportunities both in the public market as well as in the private market.

3) Aging and labor markets

Aging population is another mega force. And if you think about aging populations it does represent slower productivity and demand representing in turn lower trend growth. But if you look, for example, the last two years or so in the U.S., 3 million immigrations. That actually has helped partially offset some of the labor constraints from aging population. But it has helped, but it has not alleviated the constraints and we do expect this to bite going forward. And that’s a key theme population changes and what that means for overall investing and also demand, overall productivity growth.

We have long viewed the world through the lens of mega forces, or big structural shifts. They help explain macro and market outcomes not only long term, but right now. Geopolitical fragmentation is one of five mega forces we track. The strikes between Israel and Iran – and the market response – are one example of how mega forces impact returns now. Most of these mega forces create supply constraints. Yet a productivity boom from artificial intelligence could ease these constraints.

Taking the long way round

Daily transit trade volumes, 2023-2024

We see escalating tensions in the Middle East as a sign we’re in a new geopolitical regime. The first direct strikes between Israel and Iran structurally raise risk in the region, in our view. The strikes come as Iran has used proxy attacks by the Houthi rebels on ships in the Red Sea as a response to the war in Gaza. These attacks upended supply chains, diverting swathes of goods from the Suez Canal to the Cape of Good Hope. See the chart. Since the attacks began, shipping costs from China are still up about 75% from the end of last year, LSEG Datastream data show. Persistent supply constraints that keep inflation and interest rates above pre-pandemic levels are an upshot of our mega force view. The International Monetary Fund’s recent discussions on the growth impact of structural challenges – like geopolitical risk and other mega forces – reflect similar thinking to ours.

Since we rolled out our mega forces framework last year, we have seen more evidence that these forces are a useful investment lens. We think the geopolitical turmoil in the Middle East has lowered the bar for escalation in the region – upping the chances of persistently higher oil prices. Commodity shocks reinforce why governments are prioritizing energy security and affordability alongside decarbonization. The recent events show traditional energy still has its place, even in the low-carbon transition – and can be a buffer against geopolitical risk.

Supply constraints at work

Population aging is another example of supply constraints playing out in real time. Shrinking working-age populations in developed markets are limiting productivity and output. An unexpected jump in immigration in the U.S. and other major economies offsets the impact of a dwindling domestic workforce for now. Yet we find this effect must persist for some time to outrun adverse demographics. We look to this week’s U.S. payroll data for signs immigration is still supporting labor markets.

A resilient U.S. jobs market marked by persistent wage gains is keeping services inflation elevated. Markets now expect fewer than two Federal Reserve rate cuts in 2024, down from seven earlier this year. Higher-for-longer rates could keep squeezing bank deposits, where interest rates have lagged the Fed policy rate – unlike yields on money market funds. Plus, banks face stricter regulations. We like private credit – where default rates have fallen three quarters in a row – over public on a strategic horizon of five years and longer. Private markets are complex, with high risk and volatility, and aren’t suitable for all investors.

One mega force that could ease supply constraints? AI. We think AI could deliver strong efficiency gains across sectors. We watch for AI adoption to broaden beyond tech – into sectors like healthcare, communication services and financials, and into applications like data centers and infrastructure. We see a high bar for Q1 mega cap tech earnings to beat lofty expectations. Early results have skewed positive – yet any signs of weakness could trigger a change in our U.S. stock view.

Our bottom line

Mega forces provide a useful investment lens now, not just in the future, we think. We like energy stocks as a buffer against geopolitical risk. We prefer private credit over public on a strategic horizon. We stay overweight the AI theme.

Market backdrop

The S&P 500 broke a three-week losing streak last week and rose 3%, while U.S. 10-year Treasury yields hit new 2024 highs. The Federal Reserve’s preferred inflation metric rose more than expected in March, supporting our higher-for-longer interest rate view. U.S. mega cap tech led a strong start to Q1 earnings – we think sticky inflation raises the bar for earnings to keep delivering and supporting sentiment. The Bank of Japan kept rates steady as expected, driving the yen to a new 34-year low.