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The current shortage of labour in the service sector is likely to be short-lived. The accelerating pace of automation in the next five years is likely to trigger increasing generational inequality. Underemployment and lagging income levels of younger employees will have a strong deflationary impact of up to 3% annually in Europe, causing negative yields, high equity returns, even greater inequality and social unrest.

The rapid and accelerating pace of automation in the past two decades did not render people jobless. Instead, it drove about 10-15% of working population from very productive industries to mostly low-wage service industries, such as restaurants, hotels, health care services and education. This migration resulted in overall sluggish productivity growth rates, lower demand for products and eventually – lower interest rates. Better margins in highly productive industries combined with lower interest rates provided for stellar equity returns.

The next round of acceleration in automation is currently taking place in the social, commercial and professional services industries, particularly replacing jobs traditionally held by younger inexperienced junior employees. Due to the fast pace of this transition, the markets are unlikely to adjust appropriately and in time with new job creation. This will lead to increasing generational income gap and lower consumption demand.

To be clear, we do not claim that our assumption for the pace of replacement of young people is accurate. Merely that it is probable, given what we observe in everyday life in shops, restaurants, movies, sales and marketing businesses, legal or accounting firms. If these assumptions are close to reality, it is likely to result in interest rates that are ~300 basis points below average for the last decade, low inflation or possibly deflation and strong equity returns (an upside of ~50%).

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Macroeconomic theories do not determine prices. Companies and individuals do. We examine several theories supporting a regime change towards a higher inflation environment in the long-term and find all of them lacking evidence from the ground. We then propose firm-level reasons for persistent inflation and highlight indicators that could point at the direction of prices in various industries going forward.

• There is little doubt that a combination of lower capacity utilisation due to Covid-19, higher income due to the fiscal stimulus in the US and temporary shift in the consumption patterns away from services and into food and products triggered the first bout of inflation starting with food prices in April 2020. The war in Ukraine has added more pressure on energy and food prices in 2022.
• Capacity utilisation and the supply chain functioning have nearly recovered to the normal levels, and the spending patterns have returned to the pre-Covid structure. However inflation levels persist, prompting the need for more long-term explanations, among them the demographics (shortage of labour), wage-price spiral, raw materials (resource) limitation theory and de-globalisation.
• Upon closer look, neither of these explanations for long-term inflation is supported by data, at least for now.
• Looking at the firm level, persistent inflation can be explained by the combination of a very large disruption due to Covid and the very slow repricing reaction by companies that often takes up to 18 months or longer.
• The key to the question of whether the price hikes will continue lies in the volume response by consumers: large volume declines would mean that it may be more optimal for firms to cut prices. There is significant evidence of volume declines across food, transport, housing and recreation industries, suggesting that at least in some of these industries, price cuts are likely to be the norm going forward.
• Although record high local energy prices in Europe due to the war in Ukraine may add additional inflationary pressures, energy intensive industries in Europe still enjoy very high margins and it will be suboptimal for them to continue increasing prices in the face of falling volumes. An additional limiting factor will be the “imported deflation/stabilisation” from the US.

Figure 1: Capacity utilisation, personal income (% of the level in January 2020) and Consumer Price Index component change from the date of the first above trend level to June 2022. Source: US BLS, FRED, LINKS calculations

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We introduce new energy transition scenarios focusing on the distribution of the financial burden. The results suggest that even if different scenarios have the same target temperature limit, the outcomes for financial asset returns and interest rates can be very different, depending on the distribution of the costs of the energy transition.

 

In 2019 we introduced energy transition scenarios in Mira ABM – our strategic risk management, stress testing and scenario analysis platform. At the time, our focus was the frontier of achievable change and how the economy (and the underlying asset classes) would perform if all the industries and regions transitioned to low- (or no-) carbon technologies realistically available at the time or in the very near future.

In this issue of Risk Wire we introduce the new, expanded energy transition scenario set that focuses additionally on the required investments to achieve the well-publicised climate targets, but also elaborates on the distribution of effort and burden between regions, governments, consumers and industries – a granular analysis that can be meaningfully accomplished in Mira ABM. Our broad conclusions are:

• the distribution of transition burden has a major effect on the asset returns and interest rates even for the same level of target temperatures,
• irrespective of the regional distribution mechanism, EM equities will have major performance issues even if there is a per-capita adjustment of fossil fuel consumption targets; interest rates tend to be negatively affected in all scenarios
• depending on how much of the burden is passed on to the public, the energy transition is likely to exacerbate the trend of labour moving to lower productivity and lower income jobs, causing major social and economic tensions

The complete scenario options have been introduced in Mira ABM and subscribers may already carry out customised comparative analyses on their portfolios in Mira ABM or reach out to LINKS Analytics for help. In this report, we focus on the impact of four broad generic scenarios – all scenarios cover the +1.5 °C case, but with different regional distribution and public burden policy choices.

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We have carried out a systematic review of global risk sources using our five-step structured risk assessment approach. Part one and two of the review published earlier covered the inflationary risk concerns and the risk of accumulating government debt. In this part three of the review, we focus on the risk of global trade war.

 

The Covid-induced disruptions to supply chains and the ensuing inflationary episode have been at the forefront of the public attention lately. It is very likely that the concerted effort of the governments, logistics and transport businesses and manufacturers will eventually succeed in removing the bottlenecks. However, the noise created by this temporary “technical” challenge masks a potentially bigger and more structural challenge – the risk of a reversal of globalisation and acceleration in trade barriers.
On the surface, specific trade-related “quarrels” between various nations may appear to be episodic and related to very particular political issues between two countries. However, the totality of many such episodes combined suggests that the world is on the way to more isolationism due to the absence of a strong and concerted global support for free trade. In other words, just like democracy, free trade requires constant effort of activist countries to be sustained – effort that has been mostly absent after the great financial crisis.

The practical implications of de-globalisation are sharply lower asset prices for countries and regions with smaller internal markets and greater dependence on global trade. European equities, for instance, will suffer more than equities in the US. Another likely outcome is a substantial negative impact on pension fund balance sheets. Based on the assessment of Mira ABM*, a typical pension fund is likely to experience a drop in the funding ratio of more than 30 points, which makes this by far the most impactful stress scenario currently included in our framework.

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We have carried out a systematic review of global risk sources using our five-step structured risk assessment approach. Part one of the review issued earlier covered the inflationary risk concerns. In this part two of the review, we focus on the risk of global government debt crises.  

Investors concerned about the sustainability of government debt often quote the two major economic crises in the past two decades, when governments were forced to step in and maintain the continuity at the expense of long-term sustainability of government debt. The concern is not about the governments’ active stabilisation policies during the crises per se, but rather the subsequent lack of effort to cut down the debt level. In this line of thought, there are no structural economic policy issues, but only lack of political will to discipline government spending during the economic expansion.

We do find indeed that in terms of traditional fiscal sustainability metrics (budget surplus vs. stock of debt, growth and interest rates) the degree of concern should be higher than usual (Figure 1). However, contrary to the traditional interpretation of fiscal sustainability, our real concern is not that the major governments will become insolvent and the resulting economic chaos, but rather the likely round of fiscal austerity that would be triggered by debt levels that appear “frightening”.

A round of austerity caused by the optics of high levels of debt could pose risk to economic growth rates and result in marginally lower interest rates. For a number of structural reasons though Mira ABM indicates that the impact on asset prices would be limited, while the balance sheet impact on pension funds would be driven by somewhat lower interest rates.

We regard the likelihood of the “debt Armageddon” as in collapse of trust in the major governments’ ability to honour their debt as sufficiently low (for reasons elaborated in this report) not to merit a Mira ABM scenario of its own.

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We have carried out a systematic review of global risk sources using our five-step structured risk assessment approach. Although global inflationary concerns are often quoted as the most pressing risk source, our assessment suggests otherwise. A more significant potential damage to pension fund balance sheets can be expected from a possible global trade war and more lasting consequences of the Covid-19 pandemic.   

The significant and rapid shifts in the economy due to the political and social transition in the population of major economies and the response to Covid-19 pandemic have increased the volatility of financial markets, product prices and relative strengths of industries. Unsurprisingly, these changes have also resulted in new sources of investment risks, while at the same time deflating some existing ones. Although our approach to identifying and managing sources of risks has always been a continuous (ongoing) one, the sheer pace of change over the last year required a complete review of risk sources in Mira ABM – our scenario analysis and stress testing agent-based framework.

The aim of the series of Risk Wire issues is to give the reader an overview of the impact of the five main risks on the financial assets as assessed by MIRA ABM. The five main risks are:

• Supply-driven Inflation (covered in this report)
• Global Sovereign Debt Crisis (part II)
• Global Trade War (part III)
• Residual Covid-19 impact (part IV)
• Oil Price Collapse (part IV)

Supply-Driven Inflation

Sharp price increases, such as these, raise a question of sustainability. Prices in mid-supply chain that are 40-50% higher than six months before mean that further downstream (closer to the consumer) companies experience lower margins, unless of course they are able to increase the end-consumer prices.

The real question is whether the prices increases are temporary, driven by a supply-demand disbalance, or they are more permanent in nature. To answer this question, we need to understand the key causes of the price increases. Of course, Covid-19-induced supply chain disruption could be blamed for all of the price hikes, which would mean that the price hikes are definitely temporary. But how do we explain then price increases in many industries that have not experienced any supply chain disruption?

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The changing environment for growth option pricing in the last decade, namely, higher economic uncertainty and lower cost of innovation, has caused the underperformance of factor portfolios.

Factor portfolios promised to deliver stable and easy-to-predict excess return at no additional risk and relatively low cost – an attractive promise for institutions that are starved for return. Just when the pension funds and endowments successfully built internal capacity for factor investing –the mainstay of quantitative hedge funds in the prior decade or two, the factor portfolios “suddenly” started to underperform the broader markets.

“Factor investing is not about what is included in the portfolio, but rather, about what is excluded from the portfolio – the option value of growth.”

There are of course several “technical” reasons for this underperformance. We rely on several academic studies to examine some of these reasons, including errors, overfitting, crowding out and “fake” diversification. However, the technical reasons are only a part of the story, explaining only up to half of the performance shortfall.

A significantly larger part of the perceived underperformance, in our view, is due to misunderstanding the source of expected returns from factor investing in the first place.

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Institutional investors increasingly notice that the results of an ALM study become irrelevant almost immediately or shortly after the ALM exercise. Why is that?

Traditional statistical models use historical relationships to create future scenarios. If there are no comparable historical precedents (think of Brexit, Covid-19, demographic developments, blockchain, etc.), a future scenario based on an extrapolation of the statistical past, however intelligent, becomes nothing more than a guess. It is therefore not surprising that most of you have had the frustrating experience of ALM results not being very realistic or useful. Yet you continue working with them, having no other viable alternative.

It is not an ideal situation and that is why we – Triple A – Risk Finance in collaboration with LINKS Analytics, have worked on a solution to achieve a better ALM process.

“BpfBOUW has been using deterministic scenarios in the ALM studies for years to map out the consequences of various possible developments. In the “traditional” approach to ALM studies, long-term equilibrium values are assumed based on historical averages and relationships. Various probability calculations then follow from the stochastic analysis and, of course, sensitivity analysis can also be performed on specific variables. The question, however, is whether and to what extent historical averages can be applied to the future. It therefore helps us enormously to gain insight into the outcomes of specific integrated scenarios that we consider plausible and / or regard as high risk. A well-founded and consistent “storyline” of those scenarios helps to better understand the outcomes and sensitivities.” – Linda Teer, Manager Investments, bpfBOUW

LINKS and Triple-A provide all the required supporting information for the Board to form and articulated the scenario inputs during the workshop. At the end of the workshop the fund will have defined the reasonable inputs for the scenarios. Following the workshop, fully worked out return expectations – Scenario Sets are introduced to the Board.

The Scenario Sets contain the full development of the average expected return per year for all investment categories and the yield curves for discounting the liabilities under different scenarios.

LINKS Analytics and Triple A – Risk Finance help pension funds and insurers conduct consistent scenario-based ALM studies.

LINKS Mira ABM is a strategic risk and return management tool that translates world views into consistent scenarios. Mira ABM is fully integrated with the ALM model of Triple A – Risk Finance, whereby scenario triggers and policy sets are included in the assessment as standard. With this integration, the scenario-based ALM management process can be successfully implemented.