Demographics and geopolitics – investing through structural change

Interest rates are at levels not seen in over a decade, and debt and profit margins are near record highs. Meanwhile, a war rages in continental Europe, tensions over Taiwan continue to simmer and globalisation has been replaced by deglobalisation, friend shoring and nearshoring.

So, it’s not surprising that many investors focus on the near-term and overlook the structural shifts occurring globally that are likely to impact where capital is invested in the decades ahead.

ANZ Private’s Chief Investment Officer, Lakshman Anantakrishnan was joined by Group Head of Geopolitical Risk, Cameron Mitchell to discuss these longer-term trends at a recent ANZ Private Insights series.

Mitchell’s presentation focused on his ‘UNTIDI’ geopolitical outlook. You can read more on this in his recent article.

Everything comes in waves

There was a distinct undercurrent of apprehension amongst attendees at the Melbourne event, as the significance of the seismic change unfolding across the globe dawned on many. That the change is likely to transpire at the same time as the largest intergenerational wealth transfer on record wasn’t lost on anyone in the room – most of whom would be navigating the handover of significant family capital throughout this period of uncertainty.

So, it was reassuring to hear the current global dynamics aren’t necessarily new. Rather, the change afoot is something markets and economies have navigated previously – albeit under slightly different circumstances. In fact, it was the premise of cycles – both long and short – that underpinned Anantakrishnan’s presentation on structural change across demographics and the potential impact for investors.

Cycles, as he explained, occur everywhere across markets and economies – showing up in labour forces, the accumulation of debt, inflation dynamics and corporate profit margins to name a few. In fact, it’s often the cumulation of smaller cyclical changes that lead to larger structural shifts.

For investors, the long-term nature of this transformational change means it’s often an after-thought – particularly when stock markets are oscillating daily with such ferocity. But ignore this change at your peril, as the non-linear pace of structural change tends to sneak up on investors – the AI surge a recent example.

Because of this, Anantakrishnan notes, “ideally portfolios should hold exposure to investments that are exposed to short-term, cyclical and structural change”.

The first cycle Anantakrishnan focused on was debt and its importance for global growth. As he succinctly explained, “in its simplest form, economic growth is the transformation of human capital into productive output using financial capital”.

Debt cycles occur on both a cyclical and structural basis, with numerous short-term cycles sitting inside a longer-term cycle. And although difficult to pinpoint exactly where we are in the current cycle, Anantakrishnan was quick to highlight the incredible debt levels that corporates and consumers have accumulated across the globe.

This extreme leverage hasn’t been as dangerous in recent years due to the low inflation and low-rate environment, as “lower rates can enable higher debt levels to be sustained for a period. However, when combined with weak income growth, this makes households and corporates more vulnerable to changes in economic conditions,” he said.

And with the long-term disinflation trend potentially turning despite the normalisation of monetary policy, according to Anantakrishnan, investors should “expect volatility to remain elevated for some time”. 

The Fourth Turning

It’s not just financial capital that moves in cycles. The chart that generated most interest related to the “The Fourth Turning”, a 1997 study on generational cycles that have shaped Western history.

Anantakrishnan noted that historically, a major crisis for humanity has developed every 80-100 years. He pointed to the Civil War almost 80 years ahead of WWII, the American Revolution some 80 years before that, and the Glorious Revolution 80 years earlier, preceded by the Armada Crisis some 80 years prior. The most salient point? It’s now almost eight decades since the conclusion of WWII; and, according to some, the next great crisis could be upon us.

Humanity moves in cycles

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Sources: The Fourth Turning, thegenxfiles.com, ANZ CIO

Like the debt cycle, this longer phase of 80 odd years is typically interceded by shorter cycles punctuated by a new generation entering adulthood. What drives the tipping point in the longer-term cycle, Anantakrishnan explained, is a sudden change in the priorities and ideologies of society as a new generation enters adulthood. These priorities are typically formed during the period each generation is exposed to prior to adulthood. Depending on these lived experiences, significant structural change to government policies, human behaviour and corporate conditions may occur.

On this occasion, the structural change is inextricably linked to the debt cycle.

“This new generation – call it Gen-X and beyond – have arguably not benefitted from massive asset appreciation fuelled by low rates,” Anantakrishnan said, noting that growing wealth inequality has already led to a significant rise in populism since the turn of the millennium.

With Millennials and Gen-Z forecast to control the voting power in the US by mid-2030, Anantakrishnan expects this change and reprioritisation of ideologies to accelerate across Western democracies over the next decade.

An example of past reprioritisation, was the sharp increase in the top US marginal tax rate following the last crisis (WWII) to more than 90 per cent – something the audience was none too pleased to hear. And although Anantakrishnan was quick to reassure this was unlikely to happen again, he still expects policy change to focus on solving for these inequalities in society – something seen in Australian politics more recently.

And this disparity links to a current point of contention – the share of income between corporates and employees. As Anantakrishnan highlighted, in Australia, the share of GDP going to workers is at record lows. In the US, corporate profit margins have recently experienced all-time highs, and the share of income going to labour has been trending lower since the 1970s – accelerating markedly since 2000. 

The share of Australian GDP going to workers is at record lows

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Sources: Centre for Future Work, Australia Institute, ABS, ANZ CIO

Reversing course

This income disparity is something Anantakrishnan expects to rebalance in the decade ahead. He notes the current trend has come about as disinflationary tailwinds including globalisation, the removal of trade barriers and favourable demographics – across developed markets and China – all assisted corporates in retaining heady profits.

He points to forecasts, including the total dependency ratio (which  shows the number of dependents relative to the working age population), increasing markedly across most developed nations in the decades ahead. Conversely, except for China, the supply of human capital isn’t expected to be a concern for most emerging and less-developed economies as workforce percentages are set to remain strong for some time.

This may allow humans to have greater bargaining power in developed countries, while higher working populations across less developed nations should provide opportunity for better growth outcomes and could possibly transform many working-class economies into consumption-led powerhouses – a phenomenon that’s transpired across many emerging market economies over the prior two decades.

The downside? Corporate profit margins, particularly across developed markets, look susceptible to these waning disinflationary forces and demographic headwinds. Structurally higher inflation and elevated borrowing costs, combined with declining working populations and a new generation of voters seeking to shift power back to workers could leave corporate margins vulnerable. 

Emerging markets have transformed from working-class to consumption led economies

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Sources: FactSet, ANZ CIO

Emerging more and more

Another factor that has Anantakrishnan nervous – particularly when it comes to US equities – is the significant proportion of the American population’s wealth that is tied up in shares. His analysis highlights that a higher allocation to equities has historically led to lower 10-year forward returns for share markets and vice versa. And while this has occurred in the past, one factor that could exaggerate any drawdowns this time is the potential coincidence with an ageing population that is actively looking to de-risk portfolios as they approach retirement.

Perhaps unsurprisingly, Anantakrishnan expects his portfolios to have lower allocations to developed market shares and higher allocations to those regions less encumbered by such demographic headwinds in the years ahead, noting, “we’ve begun increasing emerging market equity exposure and it’s likely to become a more structural overweight across portfolios in time”.

Alongside a higher allocation to emerging markets, Anantakrishnan pointed to increased exposure to alternative and private market assets as being necessary in future, as traditional drivers of portfolio returns are challenged, and higher structural inflation leads to more persistent and elevated volatility.

The other factor that is becoming increasingly important for investors “is diversified exposure to companies or assets that are positively exposed to this structural change”. In this case, that change relates to ‘demographics’.

The wild card

According to Anantakrishnan, the one wild card that is yet to be played is technology and the potential disruption it might bring – unsurprisingly another ‘theme’ his team considers in its portfolio construction process. If this technology – which includes AI and robotics – can be harnessed in a manner that allows productivity to lift and inflation to remain modest, then the good times for corporates could continue. And potentially the bargaining power of workers may continue to be compromised.

Of course, according to Anantakrishnan’s thesis, when it comes to AI and robots the question must be asked – is this simply the next generation rising to power?