By Chris Redmond, Global Head of Manager Research, Martin Jecks, Senior Director and Multi-Asset Strategist and Chris Mansi, Chief Investment Officer, Europe and International, WTW
Understanding what that shift means for capital markets, portfolio construction and the clients we serve is the defining investment challenge of our time. The transition to “The New Paradigm” presents challenges, but also opportunities.
From neoliberalism to mercantilism: A structural rupture
The neoliberal order gained prominence in the late 1970s and was built on globalization, liberalized capital flows and expanding trade, supported through the integration of emerging markets, fiscal discipline and the widespread introduction of independent central banks focused on price stability. Success of this model was underpinned by the exceptional performance of the U.S. economy and its singular role as the world's geopolitical hegemon, effectively creating “a peace dividend” that has supported global growth.
Over several decades, we have observed a growing number of challenges to the neoliberal paradigm – the return of China as a true global superpower and transition to a multipolar world, the displacement of parts of the labor force through globalization, waning trust in established institutions – although these slow-moving changes can get lost in the noise. But much like the fault line between tectonic plates, the surface may appear calm for extended periods belying the maelstrom of pressure building beneath. But after a while that tension becomes too great and we experience a rupture, an earthquake. We are now dealing with that earthquake as we transition to The New Paradigm.
In a world where the U.S. is no longer willing to underwrite the “global order” as it once did, and geopolitical risk remains structurally elevated, the role of the state is changing. We increasingly see countries seeking to provide greater support and investment to local energy infrastructure, strategic minerals, domestic supply chains and resource security. This reflects a motivation to align economic activity explicitly to national power and resilience.
How this changes investment approach and portfolio construction
The investment implications of this transition do not all point in the same direction. That complexity is, itself, the challenge. Things are pulling us in different directions. We need to prepare for different scenarios, but we also need to be careful not to interpret elevated geopolitical risk, or elevated risk more generally as a signal to become defensive too early. The instinct to reduce equity exposure when there is bad news aplenty and valuations look stretched on conventional metrics can be costly if applied too simplistically. We believe there are several implications for portfolio strategy and approach, as reflected in the “three Rs”
Reactivity: What we are experiencing is not episodic volatility but higher systemic risk. These episodes are linked, and their frequency is likely to increase over time. More scenario testing, greater use of pre-mortems and a clear-eyed view of mission failure for each client are required. Portfolios and governance structures must be capable of responding quickly to new information, through high-quality data flows, clear decision-making processes and sufficient liquidity to act when circumstances change.
Resilience: In a world where equity-bond correlations may remain positive for longer, the traditional equity-and-bond portfolio loses a core structural advantage. Downside protection needs to be rebuilt on different foundations. Longer-horizon investors also need greater openness to high-volatility, high-skew strategies that can deliver the sustained returns required to meet long-run missions.
Renewed belief in active management and alternatives: The new environment also renews the case for active management. Alpha generated through manager skill is likely to become a more valuable component of portfolios than it has been in recent years, when all you needed to do was put money in equity markets. Infrastructure, hard assets and private markets carry renewed importance, both as sources of structural return and as assets harder to erode through inflation or geopolitical disruption. We also see a number specific portfolio-relevant implications, including:
Two-sided risk for inflation and interest rates
Large trade shifts are here to stay, but their inflationary impact is uncertain. China's continued success in growing high-value exports, now accounting for around 40% of global electric vehicle exports, for example, illustrates that deglobalization does not automatically mean higher prices everywhere. We see similar phenomena to the downside, as prior disinflationary forces appear to be weakening, all of which support our view that we need to prepare for more two-sided outcomes for inflation and interest rates going forward, rather than the largely one-way path lower over the last 40 years.
There are strong tailwinds for real assets and some commodities
There is an almost existential need for greater investment in defense, energy and resources by many countries – a structural, multi-decade opportunity. Whether some nations go further by restricting or redirecting foreign capital remains uncertain, but it's got to be higher risk than it was.
Technology and artificial intelligence (AI): Opportunity, uncertainty and recalibrated risk
The other structural transition in the world comes from technology, where AI is reshaping the productive potential of the global economy at a pace and scale that demands serious attention. Based on McKinsey estimates, we consider it plausible that between $5 trillion and $8 trillion of AI-related capital expenditure is deployed over the coming years, equivalent to between 15% and 25% of U.S. GDP
The implications for capital markets and investment strategy remain complex, however in our mind there are clear conclusions and opportunities:
Technology sector equity valuations are elevated, reflecting a combination of strong growth and future expectations. We do not believe this is currently in “bubble” territory, however as strong earnings expectations stretch far into the future, this effectively increases sensitivity to interest rate changes compared with recent decades.The significant capex spend is reflective of race towards recursively self-learning artificial intelligence, growing market share and significant revenue growth. The result is winner-takes-all dynamics and an urgency of investment that have few historical precedents, but nonetheless an environment where active management is likely to be well rewarded.Our view is that AI will ultimately be deeply disinflationary and that productivity gains will be significant and lasting. But the path there is uncertain, the near-term capex surge may prove inflationary before that dividend is realized. Combined with geopolitical forces, this reinforces a central conclusion: inflation and interest rate risks are now genuinely two-sided.
The opportunity in uncertainty
The newsreel can make it easy to reach a negative conclusion. Most articles in the financial press are about the next bubble, the next crisis. But that's not our central view.
The structural transition underway creates genuine opportunities, in infrastructure, active management, private markets and the new choices available to clients.
Navigating them requires portfolios built for resilience, informed by clear analysis of what is knowable and what is not, and grounded in an honest reckoning with what risk really means for each investor.
The paradigm has shifted. The task now is to thrive in it.
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