RATES,
RECESSION
AND RESILIENCE
2023 Winter Roundtable in La Jolla, California
INSIGHTS
The Pacific Pension & Investment Institute (PPI) kicked off its 30th Anniversary year with the Winter Roundtable in La Jolla, California, on March 1-3, 2023. Over 130 participants joined in person for discussions addressing resilience in the context of persistent inflation, geopolitical risks, and the lingering effects of the pandemic. The program also featured business site visits, offering a new experiential learning element. Despite the unseasonably chilly weather in Southern California, participants imbued the program with unparalleled enthusiasm and a healthy dose of optimism. The following captures some of the insights exchanged during the week.
Inflation, Rates, and Recession
The U.S. Federal Reserve (Fed) now has sufficient data to conclude that the current bout of inflation in the U.S. is primarily driven by overstimulated consumer spending due to generous fiscal programs during the pandemic rather than supply disruptions. This is encouraging news to the Fed, as central banks are typically better equipped to solve demand-pull inflation. Indeed, the Fed’s Flexible Average Inflation Targeting (FAIT) framework, adopted in August 2020, is consistent with the Taylor rule, which suggests that a central bank should increase interest rates in situations where inflation exceeds the target level or when excessive gross domestic product (GDP) growth surpasses its potential.
However, there is usually a one- to two-year lag before the full effects of monetary policy changes are felt in the real economy. While some might argue that the lag is shortening in the modern economy due to the Internet and social media, it is nevertheless present. It could result in the Fed overshooting its tightening target. The timing of the so-called Fed pivot depends entirely on inflation data, which continues to be a function of fiscal policy and economic globalization.
To the disbelief of some market participants, the Fed does not care about the U.S. stock market (or asset prices in general). Despite the heavily inverted Treasury yield curve, the looming recession is expected to be short and shallow. In other words, a soft(-ish) landing could still be achieved, primarily if job vacancy rates are appropriately managed.
The Protracted War in Ukraine
Russia’s invasion of Ukraine passed the grim one-year milestone on February 24, 2023. Conservative estimates put the number of lives lost at over 200,000. Militarily, Russia has grossly underperformed in what has become a war of attrition. Russia controlled 51 square miles of Ukraine’s territory at its peak, but now it only holds 40 square miles. Approximately one million Russians have fled their country to avoid military conscription. The war has also resulted in a 60 percent loss of battle tanks and an astonishing 80 percent loss of military personnel on the Russian side due to casualties and desertions. Russia underestimated the resolve of Ukraine, NATO, and Central and Eastern European nations to defend their freedom. Observers believe neither side can win the war, neither is prepared to lose, and both believe that time is on their side.
Russian industries, except oil and gas, were down 15-20 percent in 2022, and the Russian economy contracted by more than two percent. Russian oil and gas exporters may have permanently lost the European energy market. Politically, this war has also proven costly to Putin, as there are indications that his popularity among Russians is declining. Regardless of the manner of his exit, Putin’s successor will likely have to dial back the belligerent nationalist rhetoric. It is worth noting that Russia and Ukraine will hold elections in 2024.
This war has significantly impacted the global energy and agricultural commodity markets. Europe, first and foremost, went through a challenging period during which many countries saw their energy prices spike to cost-prohibitive levels. However, that energy crisis has largely subsided thanks partly to a milder winter. More than ever, Europe is fully committed to clean energy transition and security.
There are also (perceived) net economic beneficiaries of the war, such as the liquefied natural gas (LNG) producers in North America, which have increased their exports to Europe; the same can be said about U.S. grain and food exporters. Having abstained from joining the economic sanctions on Russia, India benefits from cheap Russian oil for domestic consumption and increased refining capacity for Europe and Southeast Asia. Similarly, China is buying oil, gas, metals, and minerals from Russia at significantly discounted prices.
In late February, China announced its attempt to broker a ceasefire on conditions that it would not support Russia’s deployment of tactical nuclear weapons. It is unclear, however, whether China will supply Russia with lethal military aid at the expense of its international standing. The Chinese economy has far more to gain from the global economic order than slowdowns and conflicts.
China Emerges
In late 2022, China abruptly abandoned its controversial zero-COVID policy following civil unrest in major cities. By the first quarter of 2023, post-Lunar New Year, traffic patterns in most urban areas had returned to pre-pandemic levels. But the biggest upside surprise came from China’s manufacturing purchasing managers’ index (PMI) data, which hit 52.6 in February 2023, an 11-year high. There are also signs of a strong comeback in Chinese consumer spending, particularly in luxury items and the service sector, including travel. However, some are concerned that this post-lockdown “revenge spending” is unsustainable. Nonetheless, the International Monetary Fund (IMF) predicts that China’s economic rebound will account for about one-third of global growth in 2023.
Looking further down the road for China, a rapid change in its demographic profile spells concerns for long-term investors. Official data released by China’s National Bureau of Statistics showed a decline in the country’s population in 2022 by roughly 850,000 people to a population of 1.41 billion. This bucks the trend of continuous population growth in China since 1961 (the end of the great famine).
Although demographers had expected a turning point of this nature, its arrival was sooner than previously anticipated. China has tried but largely failed at planning its population through policy directives, and timing has compounded the failure. For example, the one-child policy between 1980 and 2015 followed China’s remarkable fertility rate decline in the 1970s.
Global Demographic Assumptions Challenged
The world has entered a very different era in terms of demographics. One significant trend is universally low or declining fertility rates. Another is the extension of life expectancy, especially in developed economies. Both trends contribute to the prevalence of aging societies around the world. As a prime example, in Japan, the proportion of the population aged 65 or over is projected to rise from 28% in 2018 to 38% by 2050.
Southern European and East Asian countries have recently seen the most significant fertility drop. The clash between traditional family cultures and modern economic realities may have significantly affected young people in these regions. For example, 40-60 percent of women in their 20s are unmarried in many countries.
To slow the decline of fertility rates (let alone reverse them), supportive public policy must be accompanied by shifts in societal and cultural perceptions and acceptance of non-traditional gender roles in childcare, household chores, and work. In other words, men may need to shoulder more of the responsibilities of raising children.
Despite recently surpassing China as the world’s most populous country, India’s fertility rate is only at the replacement level of 2.1. African fertility rates are also declining due to persistently high infant mortality rates and malnutrition. The fertility rate in sub-Saharan Africa was 4.6 in 2000 but is expected to fall to 2.5 by 2050.
Opportunities in Climate Finance
It is estimated that over ten gigatons of carbon must be removed from the atmosphere by 2050. The most effective way to achieve this is through investing in carbon trapping or sequestration assets. In addition, it is also crucial to prioritize the containment of methane, which is over 80 times more potent than carbon dioxide as a heat-trapping gas. Funding and financing such projects would be highly effective in slowing down climate change.
To achieve global net zero, policy incentives from governments are necessary. One such example is the Inflation Reduction Act (IRA) of 2022 in the United States, which provides a promising opportunity for clean energy investments. However, offshore institutional capital is the primary beneficiary of this legislation, with many U.S. pension funds entangled in politicized debates over environmental, social, and governance (ESG) issues.
Some investors are embracing the “radical middle” approach to the energy transition, prioritizing pragmatism. This involves directly investing in various renewable energy projects and companies, such as modular fission and fusion. Often fully or well-funded, these investors can make “moonshot” investments in the energy transition process. They focus on escaping political posturing, virtue signaling, philosophical debates, and other distractions from real progress.
Frontier Markets and Development Finance Institutions (DFIs)
Some of the best investment opportunities are found where local banking systems are weak or access to bank lending is limited, which is the status quo in most frontier market economies. These economies are often under-levered in currency-denominated debt, making them attractive to private debt investors. However, access to long-dated (15 years or more) infrastructure financing remains a significant challenge in Africa and other frontier markets. Raising capital beyond seven years is often extremely difficult for projects in these parts of the world.
This may very well be a case of irrational market behavior as there is data that suggests loan default rates in emerging and frontier markets are, in fact, lower than those in G7 countries. When defaults do happen, the recovery rates are often higher as well. While governments in frontier markets have defaulted on their sovereign debt in the past, utility companies in those jurisdictions could usually continue servicing their debts. Many of these individual projects have successfully insulated themselves from the country and macroeconomic risks by providing essential utilities to local communities.
There are now over 500 development finance institutions (DFIs) worldwide. Collectively speaking, their bureaucracy is disproportionate to the capital they have deployed in frontier markets. The creditworthiness of some of these banks has also been questioned. The DFI space can only consolidate a little because these institutions are often the product of bilateral or multilateral treaties. That being said, DFIs are still a net positive for the development of frontier markets and sometimes play critical roles in areas such as loan guarantees. Private debt investors could potentially mitigate DFI inefficiencies in under-served markets.
Biotechnology Investing
Biotech, which primarily focuses on developing new drugs and therapies, remains one of the most resilient industries amid the current capital market downturn. While some listed biotech companies did see their market capitalization decline, along with the rest of the public equity market in 2022, most private biotech ventures weathered the storm quite well. Insatiable interest from the pharmaceutical industry for mergers and acquisitions largely shields biotech ventures from market cycles. Semi-mature companies and product-focused technologies are the most sought-after acquisition targets. The sector is also witnessing a new trend in which biotech firms co-create with big pharma to leverage the latter’s experience and resources in taking drugs to market.
Nowadays, early-stage biotech companies often focus on ideation, indication, and modality, which collectively pave the way for the emergence of regenerative medicine, precision medicine, and gene therapy. Researchers continuously explore new and innovative ways to treat illnesses such as autoimmune diseases, infectious diseases, obesity, and oncology. Artificial intelligence (AI) provides researchers access to vast amounts of data, enabling them to analyze and interpret data more effectively and efficiently, leading to cost savings throughout the drug development cycle. AI is also revolutionizing the discovery of new drugs by helping researchers validate new compounds and develop new drug delivery systems.
Another significant opportunity for the biotech industry is the animal or veterinarian medication market. This market has similar drug discovery processes to human medicine and represents a potentially important revenue stream. For example, diabetes among the pet dog population is a significant problem that could be addressed with new therapies and treatments.
The La Jolla-San Diego region is a well-known life science and biotech research hub. A small PPI delegation toured a world-class research institute whose faculty has won multiple Nobel, MacArthur, and Wolf Prizes. Concurrently, another PPI delegation visited an early-stage biotech venture discovery engine featuring its lab space, equipment, and a team of scientists.
Real Estate Investing
There is a glaring disconnect between public and private market real estate valuations. Real estate investment trusts (REITs) saw a drop of 27 percent in 2022. On the other hand, private real estate data showed much milder declines, and some properties even increased in value.
The real estate market is decidedly bifurcated, with the best times for some and the worst for others. The best-performing property types include multi- and single-family rental housing, vacation resorts, industrials (including warehouses), and specialty office space (such as labs for life sciences tenants). On the other hand, downtown office space, retail malls, and business travel hotels are under significant stress.
Commercial mortgage-backed securities and collateralized loan obligations markets are seeing increased defaults and price dislocations, which are expected to intensify this year. These markets would be particularly vulnerable to a deeper recession or a hard landing.
Real estate is a levered asset class susceptible to interest rates. The outlook for the next 12-18 months on real estate valuation is still unclear due to central banks’ resolve to tame inflation through continued rate hikes. There could still be pain ahead, and some may be forced to sell or foreclose for liquidity.
Long-term investors should consider exploring less-saturated areas of real estate, such as more opportunistic types of assets, beyond core and core plus segments. They should also pay attention to technology adoption, such as climate tech (for building energy efficiency), blockchain (for smart contracts in real estate documents), and various forms of artificial intelligence. Finally, overseas opportunities, especially those in emerging Asian economies, should not be overlooked.
A third PPI delegation traveled to downtown San Diego, donned hard construction hats and high-visibility vests, and toured one of the most extensive urban redevelopment or adaptive reuse projects in the United States. This project contained many next-generation energy management designs and other sustainability features, spanning 10 acres, seven city blocks, and 1 million square feet.
Asset Allocator Perspectives
Investing sometimes requires imagination beyond risk-adjusted returns and other established performance metrics.
Heightened volatility may persist due to inflation and elevated short-term interest rates.
Alpha has become more significant than ever as beta is expected to fall far from return targets.
Active strategies are preferred over indices when investing in emerging markets.
Private equity markdowns are anticipated in the coming months and quarters.
Opportunities are becoming increasingly available for those who are not liquidity constrained.
Exposure to commodities is still mainly achieved through indirect investments, such as owning shares of mining companies and/or investing in stock indices of commodity-producing economies.
While U.S. investors find investing harder and harder in China, others from the Middle East, Europe, and Asia see many opportunities there.
Not all investors are convinced that the looming recession will be short and shallow.
Fixed income as an asset class has become attractive again.
Investors are now getting paid handsomely for being in cash, which is also a form of optionality.