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Tuesday, March 5, 2024

Robeco Comes Down From The Mountain Warning About Three Big Risks

Robeco Comes Down From The Mountain Warning About Three Big Risks


Robeco might be the most interesting asset manager you’ve never heard of. The European investment house is a quiet one – while most of its peers publish updated economic forecasts four times a year, Robeco goes to press just once every five years. But when it does put out an update, it’s a hefty tome (the latest is 132 pages) that makes for some pretty compelling reading.

In its most recent outlook, Robeco lists three major power struggles around the world that will impact economies and markets everywhere over the next five years. Here’s what the firm sees happening and how you might position for it…

What are the three big power struggles?

The rise of labor versus capital. Companies have grabbed an increasing share of the financial pie in recent years. They’ve steadily undermined the bargaining power of their domestic workforces by shifting manufacturing work to overseas countries with plenty of inexpensive labor and fairly cheap shipping costs. But, Robeco says firms are going to see the labor side of things transform, driven by a reshoring trend and climate concerns.

That transformation could lead to a boost in bargaining power for labor, but it might not. See, the benefits of the AI revolution are falling disproportionately into the laps of businesses, not individuals. And that is likely to continue if manufacturing becomes more tech-heavy.

Fiscal policy versus monetary policy. During the pandemic, governments provided strong support to the economy with huge stimulus packages. And central banks supported those efforts by maintaining low interest rates. It seemed sensible at the time – necessary even – but, well, sometimes too much of a good thing can lead to a bad outcome. Now, with inflation significantly above the Federal Reserve’s (the Fed’s) 2% target, the central bank is less likely to adopt the kind of stimulative policies it’s embraced in the past, regardless of what kind of policies the US government goes for. It’s been hiking interest rates to try to combat inflation, and it’s likely to keep price stability in its crosshairs.

So, Robeco says, you’ll want to carefully watch the power play between central banks and governments – and stay alert for any signs of governments challenging the independence of their central banks for political gain.

Geopolitical stability versus instability. With a more assertive China and a more belligerent Russia, the world has become less stable. This could lead to more regulation, increased military spending, and less free-market trade – all of which could increase the cost of commerce. Robeco notes that trust around the world is weakening as divisions deepen, with China and India in particular becoming increasingly disadvantaged as that trust breaks down. It sees Iran, Taiwan, and the Senkaku Islands in the East China Sea as increasing hubs of tension.

What does it all mean for the economy?

The way Robeco sees it, there are three plausible outcomes.

Robeco’s macro views. Source: Robeco.

Base case: Stalemate. The investment house sees a better-than-even (55%) chance of a mild recession happening in 2024, with inflation dipping to below 2% which would allow central banks to cut interest rates. But that kind of monetary policy stimulus won’t stick around for long: Robeco sees inflation climbing back above 3% by 2025, forcing central banks to hike interest rates again. Finally, the firm says, inflation will fall back to around 2.5% toward 2029. In this scenario, tensions between China and the US don’t actually boil over, the power between labor and capital remains virtually unchanged, and the major central banks stay independent.

If things work out this way, as Robeco mostly expects, stocks in developed economies would see annual gains of about 6.75% between 2024 and 2028, according to the firm’s projections.

Bull case: AI gets wings. Robeco sees a 30% probability of above-trend growth and on-target inflation, helped by AI’s early adoption and rapid spread across sectors and industries. AI technologies will quickly become cheaper, so small and medium-sized companies will be able to adopt them seamlessly. High-income workers, meanwhile, will tone down their wage demands in exchange for job security and non-wage compensation, like tech education.

This is the Dutch fund manager’s almost Goldilocks-level scenario in which things run neither too hot nor too cold. Geopolitically, it envisions a resurgence in mutual trust with loosening trade restrictions that allow positive technology spillovers to emerging economies.

If the bull case comes to pass, stocks in advanced economies would see annual returns of about 12.75%, Robeco says.

Bear case: Derisking. It’s the most dire of the bunch, but fortunately, Robeco says there’s just a 15% probability of it playing out, with all three power plays coming out in force. In this scenario, mutual trust between superpowers hits rock bottom, governments are caught in the crosshairs of their central banks as they fuel goods inflation with massive military spending, and there’s an increase in labor costs as reshoring drives demand for domestic labor.

This turbulent environment would result in growth of just 0.5% per year for developed economies but would keep inflation stubbornly high at 3.5% on average. And that toxic mix of hot inflation and cold growth – or stagflation, as it’s known – would put central bankers in a seemingly unwinnable position.

Stocks in advanced economies should expect to see only a 2.25% annualized return in US dollars in the bear case. In each potential case, emerging market stocks might offer the highest potential returns, in part thanks to their lower valuations.

Five-year annualized return estimates based on the three macroeconomic scenarios. Source: Robeco.

Five-year annualized return estimates based on the three macroeconomic scenarios. Source: Robeco.

Where are the opportunities then?

Like you, Robeco’s always looking for cheap stocks. And one tool it uses to determine which country has cheap stocks is the Campbell and Shiller (1998) cyclically adjusted price-earnings (CAPE) ratio. It uses real earnings per share (EPS) over a ten-year period to smooth out fluctuations in corporate profits. And because structural differences between countries might lead to different CAPEs, it compares each country with its own valuation history.

Cyclically adjusted price-earnings ratios for developed countries. Sources: Barclays, MSCI, Datastream, Robeco.

Cyclically adjusted price-earnings ratios for developed countries. Sources: Barclays, MSCI, Datastream, Robeco.

For most countries, the data history for the CAPE starts in December 1981, which means we have over four decades of data. That’s a lot.

Japan, Singapore, Hong Kong, and Sweden all look cheap now. The Netherlands and the US look expensive. Most developed market stock indexes currently appear to be cheap or around fair value. Still, if AI really takes off – as it would in the bull case scenario – the US, with so many leading AI-related companies, would probably continue to perform well.

That’s why, despite its high valuations, you could consider buying some of the SPDR S&P 500 ETF TRUST (ticker: SPY; expense ratio: 0.095%) to gain some AI exposure. It’s got a heavy weighting in mega tech stocks. Then again, if AI really takes off, the benefits will likely become more widespread, so the S&P 500 Equal Weight Index (RSP; 0.2%) could be a better bet as it provides balanced exposure to the US economy.

Japanese stocks, meanwhile, look rather attractive on valuations – and even better when you consider their improving corporate governance. The iShares MSCI Japan ETF (EWJ; 0.5%) is one way to gain exposure.

On the other hand, if you want to gain some broad-based emerging market stock exposure, you could consider the iShares MSCI Emerging Markets ETF (EEM; 0.69%).

But you might want to step cautiously: Robeco notes that stock market risk looks less attractive compared to fixed-income risks at this stage of the economic cycle. And history shows that after a peak in interest rates, stock outperformance is notably weaker compared to riskier fixed income.

And, be aware: it’s not time yet to stop thinking about inflation. With the exception of that bear-case scenario, Robeco sees inflation averaging below 3% in the US – a level that historically has coincided with a negative bond-and-stock correlation (meaning that stocks and bonds would move in opposite directions). So bonds should provide some diversification to your stock portfolio. To take advantage of that seesaw relationship, you could consider investing in the iShares iBoxx High Yield Corporate Bond ETF (HYG; 0.49%) or the iShares 20+ Year Treasury Bond ETF (TLT; 0.25%).



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