Vanguard has been predicting a shift to a higher interest rate environment, signaling a return to sound money. This transition, challenging for investors, is seen as a structural shift that will outlast the current business cycle, the asset manager says in its annual report titled A Return to Sound Money.
The persistence of positive real interest rates is expected to provide a stable foundation for long-term risk-adjusted returns. Unlike the past decade, the future promises more balanced returns for diversified investors. In light of this, a defensive risk posture might be prudent for those with suitable risk tolerance, given the higher expected fixed income returns and an equity market still adjusting to this shift, the experts added.
Policy Shift Towards Restriction
Monetary policy is anticipated to become more restrictive in real terms, as inflation approaches the targets set by central banks. As economic resilience dwindles, central banks might reduce policy interest rates. However, after peaking, policy rates are expected to stabilize at a higher level than pre-COVID-19 levels, marking the end of zero interest rates and ushering in a long-term higher-rate environment.
The Re-emergence of Bonds
With higher interest rates, long-term bond investors, particularly in U.S. aggregate bonds and intermediate Treasuries, are likely to see improved returns. U.S. equities, especially growth stocks, however, seem more overvalued compared to a year ago.
Long-term Implications
The next decade is set to experience an enduring shift in interest rates to higher levels than those seen since the 2008 global financial crisis. This change indicates a return to sound money, characterized by positive real interest rates. The implications for global economy and financial markets are substantial. A reset in borrowing and savings behavior, more judicious capital allocation, and recalibrated asset class return expectations are on the horizon. Vanguard believes this environment will benefit long-term investors, despite potential short-term turbulence.
Global Economic Resilience and Policy Changes
The global economy, particularly in the U.S., has shown more resilience than expected in 2023. However, this resilience may wane in 2024, with monetary policy becoming increasingly restrictive. The U.S., while currently counteracting the impact of higher policy rates, might face economic downturns as inflation returns to target. In contrast, Europe risks anemic growth due to restrictive policies, and China faces challenges despite policy stimulus.
Future Outlook
A potential recession may be necessary to reduce inflation, through decreased labor demand and slower wage growth. Central banks are likely to cut policy rates in late 2024, but these rates are expected to remain higher than in previous years. This shift reflects demographic changes, long-term productivity growth, and higher structural fiscal deficits. This higher interest rate environment, a significant financial development since the global financial crisis, will likely persist for years.
Implications for Stakeholders
This era of higher interest rates will influence borrowing, capital costs, and saving behaviors across households, businesses, and governments. It will compel governments to reassess fiscal outlooks amid rising deficits and interest rates. For diversified investors, the permanence of higher real interest rates offers a stable base for long-term risk-adjusted returns. However, financial markets may continue to experience volatility in the near term as the transition to higher rates continues.
Wilmington Trust released its 2024 Capital Markets Forecast (CMF) “US Economic Exceptionalism: Can the reign continue?” which highlights the current state of the U.S. economy and the factors contributing to its ability to adapt, but warns that a number of potential risks exist, which could impact the country’s economic growth.
The CMF tells a story about the U.S. economic qualities, driven by:
Economic Exceptionalism – A prosperous U.S. economy due to factors such as diminishing economic scarring, labor flexibility, and the role of AI in driving productivity and innovation.
Equity Market Superiority – The nation’s dominant ability to create technological advancements, adaptability in its overall labor market, and history of achieving greater profitability could continue to serve investors in large U.S. companies.
Risks and Opportunities – Historic levels of stimulus and significant repricing of U.S. equity valuations will be critical to assess and monitor.
“The U.S. economy’s continued ability to deliver growth and withstand disinflation has demonstrated to be a compelling force for attracting capital toward U.S. large-cap equities,” said Tony Roth, Wilmington Trust’s Chief Investment Officer. “However, the overall narrative remains incomplete without acknowledging challenges to the long-term sustainability of this equity outperformance, including chronic deficit spending, total debt surpassing annual GDP, and the current interest-rate environment.”
“The power of technological investment, notably with artificial intelligence (AI), forward looking policy frameworks, and a flexible labor market, will propel significant productivity gains and pave the way for a renewed era of U.S. equity leadership,” noted Roth.
Drivers of Exceptionalism
For decades, the United States has been an economic leader — displaying more consistent growth than other developed countries. There are three broad components to consider as forces that have shaped this:
Growth Pillars: Infrastructure, capital markets, demographics, education, and labor flexibility are critical pillars to shaping economic excellence. Robust higher education, a flexible labor market and pioneering AI development have contributed to the US’s dominance here. In the coming year these structural advantages are projected to drive economic performance.
Policy Framework: Fiscal responsiveness of economies is also a key driver of relative performance, and the U.S. has showcased strengths targeted toward income and consumption. However, increased government debt poses challenges to long-term growth.
Innovative Capacity: Innovation is a crucial component of economic productivity as economies with robust digital infrastructure and significant investments in research and development are well-positioned. The growing significance of AI will shape the economic landscape, and the U.S. has demonstrated to be early adopters for these tools, which could continue to drive growth and productivity in 2024.
Equity Market Superiority
U.S. equities have continued to demonstrate remarkable performance by attracting investor capital and expanding global market capitalization. The drivers of this growth can be attributed to three economic characteristics, which all relate directly to U.S. resilience:
Valuation Expansion: The largest source of U.S. equity outperformance is justified by factors including its dominant position in innovation and swift policy response in the aftermath of the last two recessions. A potential “Goldilocks” scenario – characterized by slower but sustained growth and continued disinflation that allows the Fed to ease policy – could lead to a valuation rebound for sectors left behind in 2023, potentially benefiting large-cap investors.
Profitability: At the core of U.S. equity outperformance also lies a steady commitment to profitability, shaped by favorable fiscal and monetary policies, flexible labor markets, and strategic tax advantages for corporations. The U.S. maintains a commanding global position in innovation and is strategically positioned to maintain its advantage in technology development and adoption, which may continue to create positive economic tailwinds.
Currency and Liquidity: The interplay of currency strength and liquidity dynamics plays a pivotal role in U.S. equity outperformance. The dollar has continued to appreciate against a trade-weighted basket of currencies, which has provided a notable advantage to U.S. equities for dollar-based investors. Liquidity has not only supported U.S. equity returns but has also contributed to a climate of moderate inflation.
However, the extent of dominance might see some moderation or fluctuation over a longer timeframe than one year.
Risks and Opportunities
While key growth pillars largely remain sound and are likely to continue powering the U.S. economy in the coming years, there are also varying economic risks — particularly around growing debt and impaired ability to respond to future shocks. Concurrently, demographic shifts pose challenges to debt sustainability and labor force growth.
Market risks also provide some vulnerabilities for the U.S. market. Valuations and interest rates – while currently viewed as manageable — have the ability to dislodge the U.S. from the top ranks of global economies. Despite this, U.S. equities have a structural advantage and diversification may be looked upon as a tested strategy.
The potential for a U.S. economic recession has been reduced, but not eliminated. In the case of a recession, Wilmington Trust notes that the U.S. economy has the foundational elements to bounce back more quickly than other countries facing their own sets of economic challenges.
To read the full report, please click on the following link.
Florida home prices remain close to peak levels following rapid gains during the pandemic of approximately 60% that exceeded most other states, Fitch Ratings says in a new report.
If recent trends hold through year-end 2023, home prices will likely increase year-over-year by about 6% in Florida and the rest of the U.S. Fitch is forecasting an increase in U.S. home prices of 0%-3% in 2024.
Residential property Taxable Assessed Value (TAV) in Florida, which was 78% of aggregate TAV in 2022, has been more volatile compared with commercial property values, which are 15% of total TAV. Residential property value YoY growth of around 15% in 2022 powered TAV increases, while commercial values rose much more modestly at just under 5%.
Recent weakness in commercial real estate, particularly office properties, may weigh on assessed values, but Florida counties’ limited exposure to office property values will moderate the impact of declines on overall TAV.
Since 2001, home prices in Florida have been more cyclical relative to the U.S., characterized by higher price increases during upcycles and steeper declines during downturns. Florida has the strongest relationship of any state between property tax collections and home prices, largely due to the annual assessment of taxable values, which are not subject to multi-year smoothing.
This means localities are well positioned to capture market value increases in tax revenues but also quickly see the negative impact of home price declines on TAVs, which can lead to increases in property tax rates to offset declines. Florida’s levying practices and millage rate mechanism help stabilize tax revenues from year to year.
In the longer term, rising premiums and reduced availability of homeowners’ property insurance could affect market activity and home prices in certain areas. Insurance plays a key role in securing mortgages and enabling rebuilding following natural disasters.
Members of the Group of Boutique Asset Managers (GBAM) are operating on five continents, and all are squaring up to 2024 by focusing on their usual ‘bottom up’ approach. But regardless of where they are on the globe, it’s clear that consistent themes are emerging at the macro level as well as some distinctly local ones in their 2024 outlooks.
Continued retreat from peak inflation and interest rates are central to expectations. The uncertainty element around rates is whether they may be held at levels that spark a soft landing, if not a recession in certain developed markets. But at the same time there is a sniff of opportunity: Emerging Markets could be winners from US Fed rate cuts alongside local elections leading to policy changes and economic reform.
The political factor looms large, with more than half the World’s population going to the polls through 2024, while ongoing conflicts in Europe and the Middle East in particular pose threats to food and energy prices.
The continued march of technology, digitisation and Artificial Intelligence notwithstanding, the reduced likelihood of the Magnificent Seven accounting for such a large share of stock market returns will put the spotlight on active management amid recognition of valuations in traditional asset classes and opportunities in diversification into alternatives and convertible bonds.
In Edinburgh, Scotland, Andrew Ward, Chief Executive Officer at Aubrey Capital Management, the specialist global manager, says: “The three global factors that will most likely affect our business in 2024 include a normalising of global inflation and interest rates, putting cash back in the pockets of ordinary consumers, thereby boosting the revenues of the sorts of companies in which we invest; the ratcheting back of inter-state conflict and the threat of such, creating more stability for trade to flourish and ordinary humans to live their lives, travel and spend hard-earned cash as they wish; and the sensible development and growth of AI (and other appropriate tech) that benefits modest businesses like ours, allowing us the scope to do more routine data processing (of various types) inhouse, thereby depending less on expensive near-monopolistic ‘providers’, ultimately allowing us to dramatically reduce fees and improve net returns to our clients.”
In Stavanger, Norway, The Chairman of GBAM and Chief Executive of SKAGEN Funds, Tim Warrington, opines that: “This year, in contrast to last, the consensus seems to be a soft-landing over recession; albeit with most hedging, noting that much needs to continue to go right to both deliver and sustain it.”
Putting aside elections on both sides of the Pond, where Tim sees too much at stake to expect significant policy changes, he says: “The narrow basis to success in 2023 – the AI-charged Magnificent Seven delivering more than half the market gains – will not endure ad infinitum. And interest rate tops in the developed markets will be supportive to emerging markets. So active managers should have advantage, especially those investing in small- to mid-caps and further afield.”
Also in the Europe region, MAPFRE’s Chief Investment Officer José Luís Jimenez in Madrid, Spain, and Co-Founder of GBAM, echoes the points of both of politics and uncertainty when he says: “History, like economics, is cyclical and bearing in mind that next year more than half of the population of the World will go to the polls, despite many of the ballot results being already known, uncertainty is all over the place However, most investors are suffering somekind of Peter Pan Syndrome: ‘A soft landing lies ahead, and it will be excellent for stocks and bonds’; ‘Interest rates cuts are around the corner next year and thanks to a strong labour market, Covid´s savings and cheaper finance, the World economy will do well’. But all experienced economists know that predictions are one thing and reality another. Many things could go wrong next year.”
Shifting the spotlight away from developed to emerging markets, there are signs that investors may come to appreciate this sector more than has been the case in recent years.
Reflecting on the relative opportunities for emerging markets, Ladislao Larraín, Chief Executive Officer at LarrainVial AM, the largest non-banking asset manager in Chile, based in Santiago, says: “The shift in the Federal Reserve’s monetary policy cycle is key to improving asset returns in emerging economies. The accelerating decline in inflation in the United States and globally has made it likely that the Fed’s rate cutsare likely to materialize before mid-2024. In this context, we are highly optimistic about political and macroeconomic developments in Latin America, where recent elections have been won by pro-free-market forces. This, coupled with very negative poll standings for most of the leftwing coalitions in power, promises to reverse the pink tide in the region. Additionally, the region’s countries have favourable macroeconomic stories such as the agro- and oil export boom in Brazil and nearshoring in Mexico.”
Charles Ferraz, Chief Executive Officer at the New York-based investment boutique Itaú USA Asset Management says: “Looking ahead to 2024, the US markets remain influenced by interest rates fluctuations, government spending, and potential election-related volatility. Caution is advised for the US equity markets, but emerging market equities should benefit from the scenario. In Brazil, the markets anticipate potential gains as global interest rates fall, combined with the ongoing local adjustments. With a robust current account, favourable geopolitical positioning, and growing capital markets, Brazil becomes an attractive destination for investments. However, the fiscal deficit continues to be a challenge. Overall, this dynamic sets the stage for optimism in both the stock market and the local currency (BRL).”
From another emerging market region, Hlelo (Lo) Nc. Giyose, Chief Investment Officer & Principal at First Avenue Investment Management, the long only equities specialist manager based in Johannesburg, South Africa, spots similarities in that that local developments in policy could have a significant impact on return expectations, as the country’s GDP has been in decline since 2011 even as it faces a rampant public service wage bill funded by debt that has reached a limit.
“It is time for the 33% of unemployed South Africans to go back to work (productively) to drive both pension fund flows and economic growth per capita. The reason we are pointing this out is that 2024 is a watershed year where the governing party, the African National Congress, is projected to lose its majority in government. The country can now focus on reforms from parties that have been critical of the economic malaise of the past 13 years.”
Over in Hong Kong, Ronald Chan, Chief Investment Officer and Founder of Chartwell Capital, the independent asset manager focused on China’s Greater Bay Area and the Asia-Pacific region, identifies elections next year in Taiwan and the US presidential election as particularly important events affecting the local business environment, along with rates decisions by the US Fed affecting asset prices and stock markets in Asia. The possibility of a global economic slowdown “could pose challenges for companies in Hong Kong, however, it’s important to note that challenges are often accompanied by opportunities, and businesses that can adapt to changing market conditions may find new avenues for growth and innovation.”
The local market faces specific conditions: valuations of Hong Kong local stocks are at their lowest in 30 years; dividend yields are in many cases at their highest, ranging from 8%-11%; and while foreign capital has been cautious due to concerns around China, mainland Chinese capital may be overlooking local businesses.
Another way to approach uncertainty is to consider asset class allocations. Members of GBAM have identified a number of opportunities emerging into 2024 despite identified risks stemming from the ongoing macro environment, particularly uncertainty around the pace of change in interest rates.
Paulo Del Priore, Partner at Farview, the global multi-strategy investment manager with offices in London, UK andSão Paulo, Brazil, highlights that amid a global investment landscape still marked by increasing complexity, heightened geopolitical tensions, and volatility, there is a shift in the correlation between equity and bonds, which, he says: “Challenges traditional investment approaches, such as buy-and-hold, underscoring the importance of incorporating alternative risk premia strategies into traditional portfolios. In 2024, we anticipate wider spreads in absolute returns, contributing to a more positive outlook.”
In Zurich, Switzerland, Dr. Pius Fisch, Chairman of Fisch Asset Management, a global leader in convertible bonds, says that amid a “tug-of-war” between increasing risk of recession and simultaneously falling interest rates “we believe that 2024 will be a promising year for fixed income, and for EM corporates in particular.”
“Investment-grade corporate bonds should be able to benefit strongly from an easing of monetary policy, but high-yield companies should also stand to gain from potentially lower refinancing rates. In addition, solid fundamentals and continued low default rates represent a robust backdrop. In the emerging markets complex, we also see very attractive carry for higher-quality companies with strong balance sheets and short maturities.”
And from Francisco Rodríguez d’Achille, Partner & Director of Lonvia Capital, the small- and mid-cap company specialist based in Paris, France, comes thoughts that: “Like in 2022, so far this year 2023 has left a significant de-rating in our portfolio in terms of valuation. A pause in the interest rate policy by the central banks will bring a return to fundamentals and with it a strong revaluation of companies that are growing structurally without depending on exogenous factors, despite the fact that they have been heavily punished in terms of price and valuation.”
J.P. Morgan Private Bank released its 2024 Global Investments Outlook, After the Rate Reset: Investing Reconfigured, which defines five important considerations for investors as they navigate the dynamics of today’s new interest rate environment.
“Markets have entered an entirely new interest rate regime,” said Grace Peters, Global Head of Investment Strategy at J.P. Morgan Private Bank. “Three years ago, nearly 30% of all global government debt traded with a negative yield. It seemed the era of super-low interest rates might never end, but it did.”
“As we head into a new year, it’s time for investors to think about their investing goals and how they must adapt to – and even capitalize on – this market environment,” said Clay Erwin, Global Head of Investments Sales & Trading at J.P. Morgan Private Bank. “The rise in global bond yields is not just historic—it may mark a once in a generation entry point for investors that might not be available a year from now.”
To harness the new dynamics of a 5% rate world, J.P. Morgan Private Bank’s 2024 Investment Outlook explores five important themes.
Inflation will likely settle – you should still hedge against it.
“Compared to this time last year, the inflationary outlook is far less bleak. However, we think that 2% mandate will become the inflation floor, not the ceiling. Therefore, investors still need to prepare for a higher inflation world, just not as high as we’ve experienced recently,” said Erwin.
To grapple with the prospect of more meaningful inflation in 2024 and beyond, investors might first look to equities. Public companies may continue to maintain both pricing power and their margins.
Moreover, while investors used bonds to help insulate portfolios from slower growth in the previous cycle, the 2024 Outlook notes that investors should consider an allocation to real assets as an inflation hedge for the cycle ahead.
The cash conundrum: the benefits and risks of holding too much.
Low volatility and 5% yields on cash have been a magnet for J.P. Morgan Private Bank’s clients, who are holding significantly more cash than they did two years ago, having added at least $120 billion more in more in short term money market funds and treasury bills. This trend is global, but particularly powerful in the U.S. where clients have over twice the allocation to short-term treasuries and money markets as their peers outside the U.S.
“It feels good to hold cash when rates are high and other markets are this volatile,” said Jacob Manoukian, U.S. Head of Investment Strategy at J.P. Morgan Private Bank. “Cash works best relative to stocks and bonds in periods when interest rates are rising quickly, and investors question the durability of corporate earnings growth. But we think this is as good as it gets for cash.”
Bonds are competitive with stocks – adjust the mix according to your ambitions.
While there has been a painful stretch for bondholders this year, the new rate regime represents a reset in bond market pricing, and core bonds may now be poised to deliver strong forward-looking returns. Relative to stocks, bonds haven’t looked this attractive since before the Global Financial Crisis. Despite this, four out of every five J.P. Morgan Private Bank clients have not materially increased their allocation to fixed income over the last two years.
“We look to bonds to provide stability and income. Given the recent increase in yields, from our view bonds are now well positioned to deliver on both fronts,” added Manoukian.
With AI momentum, equities seem to be on the march to new highs.
Equities offer the potential for meaningful gains in 2024. Even as economic growth slows amid higher rates, large-cap equity earnings growth should accelerate and may propel stock markets higher over the next year.
“We believe the U.S. large-cap corporate sector has gone through an earnings recession already, with eight of the eleven major sectors in the S&P 500 having reported negative earnings growth for two or more consecutive quarters over the last two years. These companies have emerged leaner and resilient to potential challenges that 2024 could present,” noted Christopher Baggini, GlobalHead of Equity Strategy at J.P. Morgan Private Bank.
Investors don’t seem to have missed the valuation opportunity. While the S&P 500 trades at an above average valuation, there is a substantial discount to be found in U.S. mid and small-caps as well as European and emerging market stocks. Additionally, the promise of artificial intelligence and the potential upside in the stocks of drug makers with a growing share of the weight loss market also provide an attractive opportunity for investors looking into next year.
On regional opportunities, Alex Wolf, Asia Head of Investment Strategy at J.P. Morgan Private Bank, considers Indian equities a bright spot for 2024.
“In India, corporate earnings have kept pace with GDP growth – a rarity in emerging economies. Indian company profits, and thus stock returns, have tended to grow in line with nominal GDP,” notes Wolf. “Data over the past twenty years show that India has one of the closest relationships between economic growth and market returns.”
Pockets of credit stress loom, but they will likely be limited.
The next year could see stress in certain sectors of the credit complex. For example, commercial real estate loans, leveraged loans, and some areas of consumer credit – like autos and credit card – and high yield corporate credit could be vulnerable.
“An inescapable fact of the business cycle is that higher interest rates make credit harder to come by. We think these stresses will be manageable, and not enough to cause a recession in 2024,” added Peters.
Learn more about J.P. Morgan Private Bank’s 2024 Global Investments Outlook and download the full report here.
iBusiness Funding announced the launch of LenderAI Prodigy which introduces an innovative collection of AI chatbots inside their flagship end-to-end SBA software solution, LenderAI.
The first chatbot iBusiness Funding has implemented helps users navigate the SBA’s Standard Operating Procedures (SOP) quickly and accurately. A user can ask the chatbot any SBA-related question, and the bot will respond with the correct answer as per the SOP. It also cites the specific section it is referencing in the SOP for the user. Originally developed for and successfully utilized internally by iBusiness Funding, it is now available to all LenderAI clients within the new Prodigy feature.
This functionality showcases iBusiness Funding’s expertise with AI as well as their commitment to testing and refining technology internally before bringing it to the market, the firm said.
“The SOP chatbot was a game changer for our internal teams, enabling us to navigate the complexities of the SBA’s SOP with ease. Seeing its impact, we knew it was essential to adapt and offer this powerful tool to our clients,” said Justin Levy, CEO of iBusiness Funding. “You can ask the bot things like ‘How do I release collateral in loan servicing,’ ‘Please chart the maximum rates of SBA loans,’ or a myriad of other questions that commonly come up when processing SBA loans and get an accurate answer instantly.” With its ability to provide fast, reliable answers, this tool significantly reduces the time and effort it takes financial institutions to find information. It is also updated frequently to reflect any updates or changes to the SOP.
First in Market and Future Developments
As the first AI tool of its kind in the market, LenderAI Prodigy underscores iBusiness Funding’s role as an innovator in the financial technology and artificial intelligence spaces. The next chatbot to be released will provide lenders using LenderAI with a customized chatbot reflecting their own specific credit policies and guidelines that their staff can use internally. This will make it easier than ever for lenders to ensure their employees can quickly and easily understand their own guidelines and policies by relying on a single source of truth. Additional chatbots are in development, promising to further enhance LenderAI’s capabilities.
“Our goal with the first chatbot inside the Prodigy feature is to empower banks and credit unions with a tool that not only saves time but also ensures accuracy and compliance with the latest SOP updates. Our chatbot is future-proof and updated as changes are introduced to the SOP, ensuring our clients have peace of mind knowing that the answers they receive to their questions are always correct,” added Mr. Levy.
H.I.G. Capital announced that one of its affiliates has completed the acquisition of Mainline Information Systems, a leading IT solutions provider. Mainline’s management team, headed by CEO Jeff Dobbelaere, will continue to lead the Company.
Headquartered in Tallahassee, FL, and with revenues in excess of $1 billion, Mainline is a leading, diversified IT solutions provider serving the infrastructure needs of blue-chip enterprises. Founded in 1989, the Company designs and implements custom IT solutions for enterprises and provides associated professional and managed services. Mainline has leveraged its technical data center expertise, diverse partner network, and consultative customer-centric approach to become a leading provider of enterprise server, hybrid cloud, cyber storage, and network & security solutions.
“Over the past 30 years, Mainline has developed strong and enduring relationships by providing our customers with some of their most complex and mission critical infrastructure solutions. Mainline has become a clear industry leader and is incredibly well positioned to continue to drive business outcomes for our clients as the technology landscape evolves,” said Jeff Dobbelaere. “I am very excited to partner with H.I.G. and look forward to investing in the significant growth opportunities which can take the company to new heights.”
Aaron Tolson, Managing Director at H.I.G., commented, “Mainline’s technical expertise, its status as a trusted advisor for its customers, and the value it brings to its Original Equipment Manufacturer partners are unmatched in the IT industry. We have been very impressed by what Jeff, and the rest of the management team have built and look forward to helping the Company further accelerate its significant growth potential through organic initiatives and acquisitions.”
H.I.G. was advised by Guggenheim Securities LLC, UBS, and Latham & Watkins LLP. The Company was advised by Highlander Advisors and King & Spalding.
Photo courtesyRobert M. Almeida, Global Investment Strategist at MFS
The inflation ambush of 2022 ended a decades-long downward trajectory for interest rates. While rates may fall a bit as the effects of tight financial conditions weigh on aggregate demand and economic growth, we don’t believe the cost of capital going forward will resemble anything like the levels of recent years when central banks artificially set market prices via quantitative easing. Just as water ultimately finds its own level, in my opinion, interest rates will find their own, higher level.
As a result of higher capital costs, companies will find it challenging to meet investor expectations. In past notes, we have argued this is part of a large paradigm shift from high and easy-to-earn returns on capital to something lower and harder. While higher borrowing costs are the most notable change, they are not the only factor driving the paradigm shift. This note focuses on one of the other factors: a secular increase in capital expenditures and what this may mean to profits.
Falling capital intensity was the past
Globalization, in particular China’s emergence on the global scene in the mid-1990s as the low-cost manufacturer, was game changing. While it catapulted China from economic dormancy to the world’s second largest economy, its impact reached far beyond China as it allowed developed market companies to become de facto asset-light businesses by outsourcing their manufacturing to lower-cost locales.
Companies no longer needed to rebuild tangible capital because China, and Asia more broadly, did it for them. As a result, capital intensity (capital assets compared with revenues) steadily declined, as depicted below.
This matters because there is a long-term and inverse relationship between capital spending and return on capital. When capital intensity falls, all else equal, returns rise because less capital was deployed. Tangentially, the outsourcing of production also pressured operating expenses due to reduced need for human capital.
The combination of financial leverage by way of artificially-suppressed rates and falling fixed investment drove historic returns for shareholders. But that came at the expense of savers and labor, and exacerbated income inequality. Both trends have ended.
Rising capital intensity is the future
The pandemic, followed by the Russia-Ukraine war, exposed the risk of not having goods available for sale when customers want them. To make a car requires thousands of parts, but it only takes one missing part to halt production. For companies, having a product available on the shelf at a lower margin has become more important than an empty shelf at peak margin. While the building of semiconductor and electric vehicle factories has captured the bulk of the media attention, reshoring and added capacity has extended across electrical goods, chemicals, medical equipment and more. Companies outside of technology and the automotive industry are spending money too.
A brewing cold war between the US and China, and more recently a war in the Middle East, have made this risk even more acute. While the magnitude is uncertain, we can expect deglobalization to divert capital — which in recent years was returned to shareholders via dividends, stock buybacks and acquisitions — to fixed investment. That will likely become a drag on future returns.
Why this matters
While in the short run, trading impulses, such as monthly labor or inflation data, drive asset prices, in the long term, it’s return on capital that matters. Looking ahead, the shift from supply chain efficiency to resiliency will mean that companies that are short of tangible capital will need to make capital investments that will negatively impact returns.
Much like investors, companies are capital allocators. Their stock and bond prices are scorecards, voted on by the market. We’re exiting an environment where the consequences for bad decision-making were blunted by the tailwinds of artificially suppressed rates and globalization. And we’re entering one with a reduced margin for error.
Returns may prove resilient for companies led by great decision makers who understood that COVID-era cheap capital and stretched supply chains were unsustainable. However, companies with high capital needs and elevated debt burdens may disappoint. Since returns drive financial asset prices, this should also bring a paradigm shift in the importance of security selection and active management.
KKR, a global investment firm, has marked the beginning of 2024 with significant promotions within its ranks. The firm announced the elevation of 8 of its members to Partner status and 33 to Managing Director positions, effective from January 1, 2024. This move underlines KKR’s commitment to recognizing and nurturing talent as part of its growth and evolution strategy.
Joe BaeandScott Nuttall, Co-Chief Executive Officers at KKR, expressed their pride in this new chapter, highlighting the company’s nearly five-decade legacy of strengthening businesses and delivering consistent results to investors. They emphasized the importance of the firm’s culture and people, acknowledging the newly promoted individuals as embodiments of KKR’s values and dedication to client and portfolio company support.
The new Partners at KKR, recognized for their exemplary contributions, include Anne Arlinghaus from Capstone in New York, and James Gordon from the Infrastructure sector in London. Joining them are Franziska Kayser and Varun Khanna, both from London, with expertise in Private Equity and Credit & Markets, respectively. Keith Kim from Seoul, specializing in Infrastructure, and Prashant Kumar from Singapore, focusing on Private Equity, are also among the newly elevated. Completing the list of Partners are George Mueller from Credit & Markets in New York and Kugan Sathiyanandarajah from Health Care Strategic Growth in London.
In addition to the new Partners, KKR has also promoted a substantial number of professionals to the role of Managing Director. This diverse group brings expertise from various sectors and global locations, reflecting the firm’s wide-reaching influence. Among them are Mohamed Attar from Global Client Solutions in Dubai, Jonathan Bersch in Corporate Services and Real Estate from New York, and Rami Bibi from Global Impact in London. Also elevated are Ben Brudney, Zac Burke, and Daniele Candela, each with a strong background in Real Estate Equity, Global Macro, Balance Sheet & Risk, and Credit & Markets, respectively, all based in New York or London.
The promotions also span across various global locations such as Dublin, Houston, Tokyo, Sydney, San Francisco, and Mumbai, with professionals like Myles Carey, Todd Falk, Andrew Jennings, Gene Kolodin, Kensuke Kudo, and many others being recognized for their significant contributions to KKR’s diverse sectors including Infrastructure, Technology, Finance, and Real Estate.
This strategic move by KKR not only strengthens its global leadership but also signifies the firm’s dedication to fostering talent and expertise within its ranks. The promotions are a testament to the individual achievements of these professionals and KKR’s commitment to excellence in the investment sector. As KKR continues to navigate the complex global investment landscape, these leaders are poised to play pivotal roles in the firm’s ongoing success and growth.
Insigneo has successfully completed the acquisition of the Latin American consumer brokerage and advisory accounts of PNC Investments, PNC Managed Account Solutions, and PNC Bank.
This strategic move, initially announced on August 22, 2023, represents an important milestone for Insigneo, as it expands its Mexican client base as well as its geographic footprint by establishing new offices in Texas.
This transaction underscores Insigneo’s commitment to international wealth management.
Insigneo has been gaining significant ground by emphasizing client service, leveraging state-of-the-art technology, and focusing on continuous innovation. Clients who were part of PNC’s Latin America brokerage and advisory business will now enjoy all the benefits of Insigneo’s focused global wealth management approach and international capabilities.
Raul Henriquez, Chairman, and CEO of Insigneo Financial Group, expressed his enthusiasm about the successful completion of the transaction, stating, “The acquisition of PNC’s Latin American brokerage and advisory business underscores Insigneo’s commitment to global wealth management. We recognize the importance and relevance of the Mexican market and see this as a strategic move to immediately establish a relevant presence in that market, while positioning Insigneo to harness new opportunities in the region.”
The closing of this transaction solidifies Insigneo’s leadership in the global wealth management industry. The company remains focused on its alternative business model while driving growth through successful strategic M&A activities, a commitment further underscored by the recent appointment of Carlos Mejia as Head of Mergers and Acquisitions.
Javier Rivero, President, and COO of Insigneo Securities and Insigneo International Financial Services, added, “Both parties worked diligently and efficiently during this time focused on a smooth transition. Insigneo welcomes all incoming employees, investment professionals, and their clients to our growing firm.”
