Secular theme: Balanced risks, but beware golden ages

Our 2023 Secular thesis, “The Aftershock Economy,” argued that the early 2020s disruptions would create an enduring new reality. We saw a world of elevated macroeconomic volatility and sluggish growth. We predicted that central banks would do whatever it takes to return inflation to “2-point-something” percent.

While this thesis broadly continues to hold, our outlook for the next five years must incorporate and assess major developments since our May 2023 forum:

• A war breaking out in the Middle East and a war in Europe dragging into its third year
• Rapid and – so far – painless disinflation to “2-point-something” percent in most DM economies
• Material divergence of inflation and growth trajectories between the U.S. and other DM economies
• An unforeseen doubling of the U.S. budget deficit in an economy with near record low unemployment
• An October “Treasury tantrum” triggered by worries that the unsustainable U.S. fiscal trajectory will worsen in the years ahead
• Continued bank retrenchment amid tightening regulations for capital and liquidity

Our secular views also build upon our latest Cyclical Outlook, “Diverging Markets, Diversified Portfolios.” That outlook sees central banks breaking ranks to follow varied rate-cutting paths, with relative U.S. strength persisting while many large DM economies slow. That has produced a “re-risking” theme in U.S. financial markets, as well as questions about whether these trends are short-term or more enduring.

Central banks have maintained flexibility …

The sharp post-pandemic cyclical adjustments that rippled through the global economy are now giving way to more lasting secular trends and with important implications. While we continue to expect sluggish global growth and more volatile business cycles over our secular horizon, the risks around that outlook appear better balanced than they did a year ago.

That’s partly due to the quick return of inflation in most advanced economies to “2-point-something” percent levels. Rapid policy tightening brought the inflation spike under control and did so without medium-term inflation expectations rising.

The better balance of risks is also due to central banks’ tacit adoption of an “opportunistic disinflation” strategy to navigate the remaining journey toward target levels. This strategy allows policymakers some leeway to lower rates to support growth at times when inflation appears subdued.

Concerns we had last year about tight monetary conditions triggering financial instability have not materialized. Systemic risks to global banking and nonbank financial markets appear contained.

That said, regulatory trends are clearly moving toward stricter bank capital and liquidity requirements. Banks’ inability to provide balance sheet capacity in certain markets will likely further push many lending activities to private capital.

We see a growing window for investors to step in as senior lenders in areas once occupied by regional banks, such as consumer lending, mortgage lending, and equipment finance. CRE will also present opportunities for flexible capital, as bank retrenchment exacerbates challenges posed by declining real estate prices and a more than $2 trillion wall of maturing loans^Footnote1 over the coming years.

… But fiscal space is constrained

While the monetary policy backdrop has improved, the fiscal outlook has not. The global fiscal trajectory was a focus of this year’s Secular Forum, especially the path of U.S. federal debt.

It remains to be seen whether cyclical U.S. economic strength is durable or merely fueled by pandemic-period government support and a rising debt-to-GDP ratio. If the U.S. eventually faces a fiscal reckoning, debt consolidation through entitlement spending reforms and higher taxes is likely. However improbable it seems in the current political environment, even the seemingly untouchable may have to evolve.

The massive stock of sovereign debt relative to GDP hanging over advanced economies (see Figure 1) will likely cause yield curves to steepen over our secular horizon, as investors continue to demand more compensation on longer-term bonds. There is evidence – for example, forward inflation-indexed yields or estimates of the Treasury term premium – to suggest that markets have already priced in some of this adjustment, even before central banks start to cut rates (to learn more, see our recent piece, “Will the True Treasury Term Premium Please Stand Up?”).

Figure 1: Fiscal space likely to be limited

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Authorities will almost surely face more constraints when looking to discretionary fiscal policy to limit the damage from future business cycle downturns. Our baseline is not a sudden financial crisis, but recurring episodes of market volatility when focus shifts to fiscal issues.

Despite these fiscal pressures, we believe that the U.S. dollar will remain the dominant global currency, in no small part due to the lack of a viable challenger. A U.S debt reckoning could eventually come about, but it’s not likely imminent given U.S. advantages in immigration, productivity, and innovation; U.S. Treasuries being a global reserve asset; and the general dynamism of the U.S. economy. An elevated demand for U.S. Treasury securities as a “safe haven,” liquid store of value has, to date, limited the bond market’s concerns about fiscal sustainability. That suggests the timeline for fiscal reforms may be super-secular.

The U.S. may still be the “cleanest dirty shirt” compared with other economies. China’s outlook is challenged by property sector recession, an aging population, and less-open export markets. In Europe, fragmented politics will make it difficult to build a comprehensive growth strategy in the face of regional conflict, energy insecurity, and more direct competition from China on higher-value manufactured goods.

Moving to a multipolar world

The geopolitical landscape is increasingly defined by tensions between a dominant superpower (the U.S.) and its rising rival (China). Both China and Russia have clear long-term visions that are at odds with Western ideals. The peace dividend realized over the past three decades is becoming a conflict outlay.

This underscores a shift toward a multipolar world order, where cooperation seems limited and new middle powers may emerge. The shift will likely also lead to changing correlations across markets and increased divergence in potential growth and policy responses. Business cycles will likely also be less synchronized. We expect the underlying forces will lead to greater macroeconomic and financial market volatility than pre-pandemic.

Risks to financial stability have also increased and could become problematic should these conflicts begin to materially alter cross-border financial flows or create conditions for capital impairments. We believe the risk premium for credit investment in China is too low to be attractive given potential risks.

We expect China’s growth to continue slowing without stalling. Notably, China is re-globalizing. Its new growth model, focused on production and infrastructure to counterbalance a property sector collapse, is driving a rise in manufacturing exports. This pivot requires reevaluating China’s role in the global economy, especially its impact on commodity markets and inflation, as well as its integration into the global financial order.

Major emerging markets (EM) have displayed remarkable resilience this cycle. The typical combination of factors that often trigger EM crises – capital flight, tighter financial conditions, and a collapse in commodity prices – is not currently evident, nor does it appear likely to emerge over the secular horizon. Debt levels in EM countries are increasing but so far remain at sustainable levels compared with DM.

Roughly 60% of the world by GDP weight will be voting in a major election this year. With early signs of populist parties gaining support – particularly in Europe – global elections have scope to change both economic and geopolitical policy priorities. We see risks that elections increase trends toward fragmentation, multipolarity, and protectionist measures, favoring friend-shoring investments. Countries such as India, Indonesia, and Mexico are positioned to benefit.

Turning to the U.S. presidential election, we believe trade, tax policy, immigration, regulation, and environmental policy have the greatest scope for disruption. U.S. fiscal deficits are likely to remain near historic highs regardless of the election outcome. Both political parties are also focused on remaining tough on China.

AI effects coming into focus

Generative AI has the potential to transform labor markets and democratize access to decision-making tasks, enabling more of the workforce to make informed decisions.

But many organizations will face challenges as they seek to leverage AI effectively. Dramatically enhanced productivity and efficiency may not be evident in the macro data over the next five years. This is because maximizing the payoff from AI at the macro level will require not only adoption of the technology itself, but also the reconfiguration of work streams and the rethinking of production processes at the micro level of individual organizations.

Similar to the experience with other new technologies over the past few decades, there may not be much of an incremental impact on productivity from modest enhancements of existing work practices. But there is a chance of breakthrough changes that could have a larger impact on productivity growth in certain specific areas, such as healthcare and science.

While our base case is that the full impact of new AI large language models manifests gradually over the secular horizon, it’s possible that disruptions may occur more quickly. The capital spending boom in computing, data centers, and green energy technology increases availability of these resources for applications beyond AI, while AI investment makes AI-supported breakthroughs in other fields increasingly plausible. Downside surprises are possible as well, especially if misuse of AI models for surveillance, manipulation, or security threats results in innovation-stifling restrictions.

For now, capital spending can lead to a shorter-term sugar high. Ultimately, efficiency gains will be needed to generate longer-term sustainable growth.

The demand for chips, data centers, and the generation capacity that will power them is expected to be explosive, and these trends will have immediate sectoral consequences.

Neutral policy rates to remain low

Today’s elevated policy rates are the result of cyclical forces, namely an inflationary spike. Once inflation stabilizes near central bank targets, we expect neutral monetary policy rates in advanced economies will likely settle at levels below those that prevailed before the global financial crisis.

We believe the neutral nominal policy rate in the U.S. over our secular horizon will likely remain in the range of 2%–3% (implying a long-run neutral real rate of 0%–1%). By contrast, current pricing indicates markets expect the neutral rate may not fall far below 4%. That can present further opportunities for bond investors, as yields today already embed cushion in the form of positive real rates and term premium.

We expect central bank balance sheets, which are currently contracting under quantitative tightening (QT) programs, will remain substantially larger than before the era of quantitative easing (QE). DM central banks will likely continue to use asset purchase programs to ensure the smooth functioning of sovereign debt and repurchase markets, and to act as lenders of last resort. Examples include the U.S. Federal Reserve’s 2023 Bank Term Funding Program and the Bank of England’s 2022 operation to support the U.K. gilt market.

However, we think it is less likely that central banks deploy open-ended QE asset purchase programs in response to future economic downturns. The financial strain of maintaining large securities portfolios, where the costs of funding exceed the returns from these assets, has become increasingly apparent.

Monetary and fiscal puts – or expectations of government relief in the event of downturns – are further out of the money today. That constrains the government’s ability to stimulate flagging economies and provide support to dampen shocks. We expect additional volatility as markets trade more on fundamentals and less on the expectation that governments will come to the rescue.