Beyond Bulls & Bears


PODCAST: Potential Longer-Term Effects from Current Economic and Investment Challenges

Franklin Templeton’s Sonal Desai, Martin Currie’s Alastair Reynolds, and ClearBridge’s Pawel Wroblewski join our Kim Catechis to assess the possible investment impacts of major global challenges, including the ongoing pandemic, growing income inequality and climate change.

Listen to our latest “Talking Markets” podcast to hear more.


Kim Catechis: One of the key things I’d like to start us off with, and I’m going to pick on you, Sonal, to help me with this is, you know, what COVID-19 has done is it has exacerbated the existing socioeconomic polarisation, inequality—word you’d prefer to use—across virtually every country around the world. And, as countries have grappled with policies—in many cases, unorthodox ones—to try and address that and cushion the population from the worst impact of forced stoppage of the economic activity. We’re now coming out to a point where I guess the question is going to be, will there be a number of countries there who perhaps feel tempted to keep this unorthodox policy going further, or may even step further away from what we consider normal policy?

Sonal Desai: So, if I look at what we’ve seen over the past, it’s redundant to say that these were unprecedented times, and so on. But, I do think that there is a common perception that these unorthodox policies that we’ve seen both monthly and fiscal, as we continue to see them today, while we are well on path to recovery and, in some cases, we have fully recovered that somehow they have the ability to reduce social inequities, as you pointed towards them.

Let me start with monetary policy and I’m going to use the US as an example, but this could be applied to many countries in the world. In the US, if I look at one of the impacts of extraordinarily easy monetary policy, which has been in place, frankly, since the global financial crisis, but clearly, we went another step again, over the course of COVID, it has had an enormous impact on asset prices, financial asset prices. Something which we all know, for a fact, is financial assets largely tend to be concentrated in the hands of the wealthy; therefore, a large part of the positive impact from this very loose monetary policy actually increases that wealth inequality, which we started off with.

Let me take it to the next step now and see what’s happened over the course of COVID, where we not only had extraordinarily easy monetary policy, we have had extremely loose fiscal policy. I want to make clear, both sets of policies were exactly the right thing to do in March of last year when the US economy, for example, was on the verge of contracting by a third in annualised terms. But looking at where we are today, though, the question starts becoming much more interesting. If we get even a reduced fiscal package through the US, this year’s fiscal spending will be on track to be close to US$5 trillion. It’s a big, big number. It won’t all be spent this year, but it’s a huge number. And this fiscal and monetary policy together has had an impact on inflation.

Inflation, I would note, is the cruelest tax of all. It impacts the wealthy, almost not at all. It impacts those who are less well-off enormously because in their basket of goods and services, you have things which are essential: food, gas, rent and this takes a large part of their incomes. Those who are on fixed incomes, and those who are on the lower ends of the income bracket. So, you put the two together, the wealthy do get wealthier, and via inflation, those at the lower end actually suffer more. You tell me, what does this do to the inequities that we see in the world today?

Kim Catechis: Absolutely, right. I think that’s a brilliant point you’ve raised Sonal, the inequality and the harshness of the impact of inflation on those that are less well-off. There’s really no options for them. Wealthy people have plenty of options to get around that.

You know, the issue of debt as a byproduct, necessary by-product, of the unorthodox policies that we’ve seen to get us out of COVID-19’s first year. How do you see this playing out? What’s your base-case scenario and what do you think we should be looking for?

Sonal Desai: I would say that debt sustainability is a very interesting question because frankly, in every case debt is sustainable until it isn’t. Now that might sound really facetious, but it literally is that, because you have the question of liquidity issues and sustainability issues. Countries can face short-term or near-term liquidity issues. After all, look at various advanced European countries during the eurozone debt crisis. So, these issues are not limited or restricted to only emerging markets. That’s number one. However, sustainability is a different question. If your liquidity issues last for long enough, they can potentially become sustainability issues. So, a government which is running larger and larger fiscal deficits, the concern is always that the debt stock becomes much more sensitive to longer-term interest rate changes. This in turn can constrain appropriate monetary policy making. And separately, the government’s own fiscal policy can become hostage to who the purchaser of last resort is.

I think certainly advanced economies have an advantage here. I’d say Japan is a particularly special case because over 90% of the debt, Japanese debt, is held domestically. Why this matters is actually very straightforward. Governments have multiple ways of working their way out of a massive debt stock. I always think about it as three or four ways. One way is the way we would all like, which is, a country grows in real terms, doesn’t have massive inflation—grows in real terms, productivity increases, and the debt-to-GDP [gross domestic product] ratio shrinks because the denominator i.e., GDP, is growing faster than the debt. That’s a very good outcome.

The other ways are of course going the way that several countries have done, certainly in the emerging market space, which is to just default. And not just emerging markets, depending on where you’re standing, we’ve seen Greece do it, we’ve seen multiple defaults across the history of economies, and that clearly is not something we would anticipate for the larger advanced economies like the US. But then you have more interesting ways, which one of which is, certainly inflation because that GDP denominator con grow either because of real growth, which is a good thing or inflation, not so good, either way your debt stock in real terms will shrink.

And, I do think that inflationary impulse, I know I keep coming back to inflation factors right now, to me it seems to be at the heart of many of the constraints, which appear for both the fiscal authorities and the monetary authorities looking forward. So, this is something that I am focused on as an investor. We have to be because, of course, as a fixed income investor, as I look further forward, if you have inflation, if you’re anticipating larger fiscal deficits and inflation, you need to anticipate that long-term yields will go up. Or in other words, you will make capital losses. And this is something which of course we are very focused on.

Kim Catechis: Now, moving to another, kind of, global challenge. Climate change is unavoidable. I think in many ways, it’s finally getting the attention it deserves, at least in the investment world. Now, we are seeing now firsthand the impacts all over the world of climate change with droughts and wildfires and hurricanes and flooding. And, although we could say that some countries are more accustomed to extreme weather, it doesn’t really make it any easier. And obviously, if you’re talking about developing countries, populations are growing faster and the government’s institutional capacity to deal with it are often limited. So, given the polarisation of policies, in terms of how to deal with these things in the developing world and developed world, what should investors be thinking or looking for as far as policy and regulatory interventions from say, government bodies? Alastair?

Alastair Reynolds: Yeah. Well, I expect to see some parallels with what we’ve seen with COVID so far. And, let me explain what that is. That’s a common global need, but it will be met very much by self-serving solutions from national governments with very much the afterthought being what’s going on in the developing nations and even below what we class as the emerging markets.

Now, I don’t expect there to be an obvious developed/emerging line that we can observe, but more a hierarchy of solutions that are going to prioritise the interests of the most consuming countries first, going right down to the least consuming.

So, what that means, I think, I would expect Europe and the US to push for a faster transition and expect that the big consumers from the emerging world, China, India, Russia, they will, to some extent, resist that. And, you know, each of those nations, whether developed or emerging, will build their own justifications around how the effect of cleanup costs of a world polluted by CO2 [carbon dioxide], how the costs of that should be allocated. So in emerging markets, I’m expecting it will be necessary for an industry to decarbonize. That way, they’ll remain competitive in the face of carbon taxes that I expect will come in, in their export markets.

So, the focus in these emerging markets is likely to be the removal of coal from power generation, and that’s going to require both government policy and government spending to make that happen. And what that, I think, will start to crystallise around is that we’re in a world where there’s going to be more fossil fuel in the earth than is likely to be needed. And, I expect we’re going to see much more nationalist policy around fossil fuel sourcing. So, buy local, rather than transferring wealth over to other nations. So, we’ve seen that already, for example, with coal from Australia. But elsewhere, I think, let’s say in, the US and Europe, I expect much more of the focus will be on the de-carbonisation of transport infrastructure on their home turf, whilst at the same time levying those carbon taxes that will impact the already outsourced manufacturing. So, I just, I see it being almost a different subject but like a repeat of COVID. Lots of tension, lots of different vested interests, as countries, try to take a very self-styled view of this problem.

Kim Catechis: Yeah. I think that’s an excellent point. Now, one of the topical issues is obviously supply chains and linking up to what you were just mentioning there, we’ve seen a change in trade patterns. So, you know, I don’t want to call this the death knell of globalisation, but certainly we’re seeing a rise in more inter-regional trade. And we know that there’s a recalibration going on of global supply chains, partly due to geopolitics, but also partly due to practical issues experienced through COVID-19. So, where do you think this fits in terms of, you know, you mentioned lower carbon emissions, Alastair, you know, where do you think emerging markets maybe fit there?

Alastair Reynolds: In the short term, I think that move into a more regionalised world, it’s going to require additional investment, and that’s coming at exactly the same time as the world is going to try and make this transition away from carbon.

I saw the IEA [International Energy Agency] put out a figure saying that they expect it’s going to be required, the transition, the carbon transition itself is going to require somewhere in the region of US$5 trillion per year over the transition phase. And if we couple that with a move from “just in time” to “just in case” tight supply chains, as we’ve been talking about, you know, you’re starting to really see a double, increase in demand.

You know, you’ve got to put the investment in place to drive this regionally distributed supply chain. It’s just not set up today to do that. And that’s going to be good for capital goods providers, for building materials, for industrial property, for warehousing, suppliers of intermediate goods, as we go through this venture-built period. But it’s going to put huge pressure through our systems, as we’ve been seeing already with the recovery from the COVID period. So, it’s likely to be, I think, quite inflationary in the short run. That’s a heck of a lot of demand being put into a pretty strained system.

Now, we’re going to have to live through that first before we get to what is going to be a more regionalised world. And, I do think that regionalised world could see long-run benefits with transport distances shortening, and the energy that’s going to be used to move those goods around is going to be much more renewable than it is today. So, in the very long run, we get this wonderful deflationary period where energy, the transition, has already taken place. But, that’s not overnight. I think there’s a five-year period where we’re going to go through this real investment for the first time behind that transition and the regionalisation of supply chains, and, that’s going to be an exciting area for us to watch.

Sonal Desai: On this fact, it is so true and it’s something which I think, you know, that interplay between a certain degree of economic nationalism together with a certain view that regionalization, localisation is needed in the eyes of this last year, when everything was disrupted the way it was. It takes you to a quite interesting point because the reason people offshored and outsourced and created global supply chains in the first place was because, clearly, economically it was the most efficient thing to do, which resulted in lower prices, which of course benefitted consumers around the world. And we are going to be moving exactly as Alastair said through a period, if this continues, where prices are almost an inevitable point of sensitivity, because something has to give. I don’t think companies created global supply chains out of anything other than a desire to create efficiencies. And when you decide to unwind those in those efficiencies, there are going to be consequences.

Kim Catechis: I think that’s a point well made, Sonal, because as we know, time and again, the corporate motivation to keep efficiencies improving will lead potentially to a recalibration of supply lines, but not necessarily a long-term increase step change in costs. And perhaps, Pawel, talk to us a little bit about how you see the situation, particularly in the issue of, you know, technology playing a role, perhaps in supply chains and low-carbon economies, et cetera.

Pawel Wroblewski: Yes, so innovation, across many technologies is, in fact, incredible. It is shaping societies in developed markets, in emerging markets. I think what’s very important to recognise is also the pace of adoption of many new technologies is accelerating everywhere and that clearly creates opportunities for companies in all markets and maybe, quite often, even more in emerging markets to really leapfrog some legacy systems. Also, in the power markets, in renewables, companies can almost bypass, kind of, generations of obsolete technologies. And what we see quite often is that adoption of innovative solution is actually driven more by local, young entrepreneurial companies locally than some large multinationals.

One example of this trend is innovation we see, for example, in the fintech space in Latin America, where, you know, for example, penetration of traditional banking was quite low. Many people had no access to bank accounts and that created an opportunity for, you know, local fintech companies to really lead with innovative solutions. So now, we have booming mobile banking services, mobile world services with QR [quick response] codes. All these things have really brought more consumers to participate in big segments of the economy, like banking and e-commerce.

Another innovation that is really reshaping societies is innovation logistics. One example there comes from Eastern Europe where we see these automated parcel machines, which are adopted at a much faster rate in other parts of the world. And they really had a big impact in reducing the cost of delivery of parcels and really accommodated for growing volumes of online shopping.

Kim Catechis: Yeah. So, Pawel, can we talk a little bit in terms of renewable energy, tech and how that comes together?

Pawel Wroblewski: I think, yes, it’s true that many solutions are still not ready. They need to improve for kind of large-scale adoption, if you’re thinking about solutions like green hydrogen, that still requires a lot of technological improvements. But, if you look at other technologies that we already have, like solar photovoltaic, like wind power, like lithium-ion batteries, I think it’s true that they are not only, kind of, commercially available today, but they are competitive.

If you look at the last decade, solar batteries they all have improved much faster than we expected, which is good news. I mean, costs have come down anywhere between 80%, 90%, it’s amazing. And they will probably continue to improve rapidly as we see more companies invest in research, invest in manufacturing scale. So, when we look around the world or even right now, renewable power, wind and solar are quite competitive right now with fossil fuel, without any subsidies. And then when we look at electric cars, with modern batteries, I think already, or very soon they will be cheaper to own than combustion engine cars. We are already starting to see that the electric powertrain has many economic advantages. It can last longer, it doesn’t require a lot of maintenance, it is cheaper to charge, and all these economics do matter, especially for commercial fleets. Right? So, I think the good news is that this transition away from fossil fuels, away from the combustion engine could actually happen mostly for economic reasons over the next few years.

Kim Catechis: Electric vehicles, Pawel, talk to us a little bit about your expectations for the adoption across different geographies.

Pawel Wroblewski: I think adoption of electric cars, the rate of adoption, will really be driven by the rate of improvement in battery technology. It’s one of those, as we can describe them, exponential technologies where every year as we increase the scale, we see costs coming down. But also adoption of those barriers because of the different regulatory environments and kind of local differences in terms of things like urban density and miles traveled, and so forth. Looking in the recent past, we know that because of very aggressive regulation, China was leading early on with adoption of electric cars. China is a big oil importer; they are coping with of course pollution problems in cities. So, they were much more aggressive than the West in promoting electric cars. In some cities, for example, you were even not able to kind of get a registration card if the car was not electric. So by now, of course China has quite well- developed charging infrastructure and they do have a vibrant ecosystem of manufacturers of batteries and EVs.

If we move to Europe, there, the regulatory environment varied by regions, the Nordics, especially Norway, was very aggressive with tax incentives for electric cars right now, the last few months, we have seen that in Norway sales of electric cars account for 60, 70, 80% of new car sales, which is pretty amazing. But the whole European continent is becoming more and more supportive through more stringent emission regulation, the grants for battery research and so forth.

So I think that sales in the whole continent will continue to grow. Here in the US, we’ve been lagging a little bit in terms of adoption of electric cars. We do have some specific issues like lower taxes on gas than in other parts of the world. We do drive larger cars. We do drive larger distances, but I think as the battery technology improves, the private sector will be again, aggressive investing in electric cars and sales will continue to grow also in the US.

Alastair Reynolds: The challenge, I guess, will be, how do you get this to be a mainstream product? And that’s going to take a few years. Two areas I think that really need to catch up in that are the nationwide charging infrastructure, and then in time, the recycling industry that will come around the end of the life of these vehicles. But I think it provides a real opportunity if you think about taking China, for example, where, used to be a less-indebted nation, has just gone through an incredibly debt fueled period of growth, driven by corporates, and as we’re seeing the property sector played a large role in that.

And I think there’s a real challenge in terms of within China to try and redirect that domestic pool of capital in favour of some of these renewable technologies. So electric vehicles would be a key one; obviously, the country is already at the forefront of EV battery development. But I think, when I look back at my experiences in the auto sector in China, clearly, it became the biggest market in the world, but clearly missed the boat in terms of technology transfer. And I think that there is a real opportunity here still to be taken for the likes of China to step up and become technology leaders in the renewable energy space. And that way that there’s an enormous global need for these technologies, it’s going to have to be funded by more debt, but it could be a highly productive form of investment. So that could be one way that ties together, what do emerging markets do with this demographic and borrowing headroom that they potentially still have going forward and tying that in with the themes that we’ve been talking about here, in terms of de-carbonisation and climate change. I think there is a role and a linkage there where they could apply that debt to real productivity increasing technologies to grow out to what would be a global industry.

Kim Catechis: I do think there’s a fantastic opportunity set in front of us, just need to keep our eyes open. Thank you very much, everyone.

Host:  And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about any other place you listen to your podcasts. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.

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