The global economy and financial markets are at a crossroads.

After a year of grappling with rampant inflation that spurred central banks to embark on their most aggressive tightening campaign in decades, some investors are starting to see the possibility of a soft landing that avoids a brutal recession. But policymakers warn that they haven’t yet finished the job, and that prematurely declaring victory would only cause more pain down the line. 

We asked three prominent investors, who collectively oversee almost $2 trillion, about the next big risk they see coming over five to 10 years: Henry McVey, chief investment officer of KKR & Co.’s balance sheet; Saira Malik, Nuveen’s CIO; and Karen Karniol-Tambour, Bridgewater Associates’s newly named co-CIO.

Their comments have been edited for length and clarity.

Longer, Deeper Recessions

KAREN KARNIOL-TAMBOUR
Co-chief investment officer, Bridgewater Associates

The next big risk is recessions that are deeper and longer than what we’ve been accustomed to.

Everyone investing today has had their whole career over a period of significant disinflation and where every time there was any downturn in the economy, central banks could just hop right in and reverse it. They didn’t face any kind of trade-off, and we saw it the most in Covid.

When the economy’s going down, reversing it is a win-win for everybody because growth is a disaster and there’s no inflation. Just ease everything. That means recessions could never be deep and long. They were quick and shallow because there was always a savior. And we’re going into a world where that’s just not what it’s going to look like anymore. Every time the economy slows, it’ll be painful because central banks will want to ease, and at the same time will be struggling with sticky inflation.

Covid was a turning point because for the first time you had fiscal policymakers get deeply involved in solving the problem. You didn’t just have money printing like you did coming out of 2008. You had policymakers basically come in and direct the money to people. Now you’re getting it directed towards environmental outcomes in the Inflation Reduction Act. So to me, the dam has been broken where fiscal policymakers are now part of the story and can try to solve the problems.

Recessions are going to feel really different because now suddenly political actors are part of the solution. They’ve experienced what happened in Covid and realize they can impact the outcome. So they’re much more likely to step in with big fiscal expansions.

Monetary policy on the one hand will be less important because fiscal will be doing what it’s doing. On the other hand, they’re going to be in an even tougher spot because they’ll have much more entrenched inflation because of secular inflationary pressures and fiscal policymakers stimulating at the same time.

So they’ll be forced to tighten a lot more than they would’ve otherwise wanted — or ease a lot less. Those become recessions that are much more difficult, much more painful. And how difficult and painful they are will depend a lot more on what fiscal policymakers end up doing.

I’m fundamentally very concerned about a political system that is stuck and can’t step in and influence the things that matter the most for individual households, for people, for the environment. Because we’ve lived through decades where, honestly, policymakers could do very little and outcomes were still great because you had an economy that was humming and delivering for everybody, and that’s changed. And we’re in a place where to solve a lot of our most important problems, you can’t only rely on market forces, you need political forces to work as well. I always say the environment’s the best example of this.

These risks are exacerbated by how fast the pace of de-globalization is going to be. You had decades where the world came closer and closer together — a very powerful deflationary force. You were constantly taking goods and services that were being produced and moved them to the cheapest possible place, and it made the whole world cheaper, constantly brought more and more labor online, and that was one of those big deflationary winds that allowed central banks to keep coming in and easing when things were tough.

The biggest wild card here, of course, is how difficult the relationship gets with China, because China’s so deeply embedded in supply chains. There’s a big difference between having to modestly cut them out or actually decoupling from China. That could be a very inflationary event that exacerbates this whole environment significantly.

Where Are the Workers?

HENRY MCVEY
Chief investment officer of KKR’s balance sheet

The biggest risk, what’s changed, is around labor — and that’s a global statement.

What’s happened since Covid is we’ve seen a lack of people come back into the workforce, and it’s probably been most pronounced in the US. But even countries like China, their population actually shrank in 2022. That has huge implications for not only society, but also for companies and how they’re valued. If you have less people in the labor force, you probably will have more government subsidies for those people who are out of work.

But there are actually a lot of success stories around labor. A lot of countries, particularly in Europe, are doing a lot more on worker retraining. That hasn’t really taken place in the US.

The US right now spends about one-sixth of what Germany does and about one-twentieth of what Denmark does on labor. Over history, the best economies, the best societies are when laborers are engaged, working, bringing home pay and feeling good about their job.

GDP is labor force growth times productivity. In the 2000s, US labor force growth was 1.2%. Today it’s less than half of that. That’s a huge drop-off. And so if you only have two variables that you can control, it really puts a massive emphasis on productivity.

Ultimately, it’s a slower growth world. It’s a world where you have more tension, where workers feel disenfranchised, and ultimately that puts more burden on the government and you probably have more political angst. Those are all huge implications.

The more immediate risk is not a populist uprising. We’ve been living in a world where corporate profits have exceeded GDP. We could enter a phase where corporate profits lag GDP if companies don’t figure out how to address this labor issue. Because ultimately labor is your No. 1 input in terms of margins on your cost side. So even if you have the revenue, if you can’t have costs work properly, you’re not going to have any free cash flow. So that’s a huge issue.

We’re rooting for inflation to come down and real wages actually go back positive so employees can buy more groceries, they can pay more for education, they can do things for their households that they want to. That hasn’t happened despite the fact that wages have been growing 5-6% at the household level. That’ll enable companies to have greater visibility on what they’re paying their employees and hopefully extend the duration of their employees. Right now, the switching costs are huge for employers because people are changing jobs at a record clip.

We need to end up in a spot where we have rates up a little bit higher and real wages are positive. It’s one of the reasons this is the big tension, because this is not going away. It’d be one thing if you said the participation rate is going to go back to 68% and there are going to be lots of eligible employees. That’s not what we’re predicting. We’re saying this phenomenon is going to continue with us, not just in 2023, but clearly for next five, 10 years where employers, investors, employees, everybody needs to think about getting to the proper mix.

Climate Risks Fueling Inflation

SAIRA MALIK
Chief investment officer, Nuveen

I’m worried about climate change and the path we’re taking to lower emissions. It’s going to impact three key areas: Real assets, the economy and inflation.

We’re worried about real assets because they’re part of the problem and the solution. Farmland, agriculture and real estate are some of the biggest producers of emissions. Infrastructure is part of the solution as we electrify the grid.

When you take a look at inflation, there’s going to be tight supplies of inputs into clean energy and traditional energy that should add even more to inflation going forward.

The economy will be impacted by climate change volatility as well as geopolitical conflicts, as some countries may not agree on the path to lower emissions. There’s also shareholders voting with their feet and how companies think about capital spending.

The bridge from traditional energy to renewable energy is going to be long. We’re still going to need oil. We think prices remain higher than the past $60-$80 per barrel range, and even with upside to $100. That’s inflationary.

Metals that go into solar, wind, the grid infrastructure and hybrid vehicles and batteries are cobalt, copper, lithium and nickel. In the last 25 years, US production of copper has dropped by about 50%, but we expect demand to double by 2035 because of demand for renewable energy. From discovery to production of a copper mine takes 16 years. So inflation in metals and oil prices should continue to exacerbate the already high inflation problem we have.

We have a lot of positive things, like the Inflation Reduction Act, which was the single largest piece of climate legislation in history, and the Paris Agreement, which targets net zero carbon by 2050. But to reach net zero carbon by 2050 requires a complete transformation of our economy. And there are a lot of areas where we’re not prepared.

Farmland and real estate are important because they’re the biggest producers of emissions. Farmland is responsible for 20% of greenhouse gases and it’s the No. 1 employer in the world. Real estate is responsible for about 40% of worldwide emissions. And 80% of buildings today are going to be the ones in existence in 2050. So this is about transitioning your buildings to lower emissions rather than just building newer green buildings. For real estate companies to do that, it can cost up to 20% of the net asset value of a building to move it to low carbon.

I look at the risk of what companies will lose if they don’t keep up with this. This is about companies transforming and continuing to modernize so they can bridge that gap. These will be the winners — the ones that don’t do that will end up with higher funding costs, stranded assets and get left behind.

This article was provided by Bloomberg News.