MACQUARIEASSETMANAGEMENTOpportunityinavolatileworldOutlook2023December2022Outlook2023ImportantinformationanddisclaimerpAlettertoinvestorsTheglobaleconomyfacesdiverseandcomplexchallenges,butwecanplayakeyroleinpresentingopportunitiestoourclientsthatwillgeneratepositiveimpactforeveryone.”–BenWayBymanymeasures,2022wasdifficult:globalinflation,theendofeasymonetarypolicy,supplychaindisruptionsandanunprovokedwarthat,amongotherthings,droveEuropetoprioritiseenergysupplyoverenergytransition.Theseeventssetglobalmarketsonadownwardpath,andthechallengestheypresentedpersistasweenter2023.It’snotexactlythekindofenvironmentthatordinarilyinspiresinvestoroptimism–andyet,basedonourexperienceandtheviewsofourexperts,weremainstubbornlyoptimistic.Theglobaleconomyfacesdiverseandcomplexchallenges,butwecanplayakeyroleinpresentingopportunitiestoourclientsthatwillgeneratepositiveimpactforeveryone.Whenvolatilityanduncertaintyaboundandthecostofcapitalisnotzero,itisespeciallyimportanttobeanactiveinvestor.Tousetheanalogyofbuyingahome,ourclientswanttopartnerwithassetmanagerswhoknowmorethanwhichneighbourhoodtomoveinto.Weneedtofindtherightneighbourhood,butalsotherighthouse,ontherightstreet,tounlockthemostpotentialvalue–bothforinvestorsandforthecommunity.Theworkaheadwon’tbeeasy.Wewillremainpatientandfocusedasweputourideas,expertiseandresourcestowork.Webelieveleadershipisdefinedbythosewithdeepexpertiseandnetworks,whothinklongtermandcollaboratetomakeameaningfulimpactonmajorchallenges,suchasclimatechangeandtheenergytransition,whileensuringallimpactedcommunitiesaresupported.Theyear2022waspunctuatedbyshockstoglobalsystemsthatonceseemedresilientandsteadfast.Supplychainsgrewinsize,scaleandsupplenessoverdecades.Energyandfoodmarkets,alwayssubjecttomarketfactors,werereliable.Globalisationwasaninexorabletrend–andwebelievedmonetarypolicyhadprevailedoverinflation.Theseassumptionswerechallengedfundamentallyin2022.Whataretheimplicationsfor2023?InthisOutlook,wetaketheviewthatrecessionswillcastapalloverglobalgrowthinthefirsthalfof2023–especiallyinEuropeandtheUK,butalsointheUS.ButwithChina’seconomylikelytoacceleratesteadilythroughouttheyearaspolicyeasingstepsupgear,anddevelopedworldgrowthsettoimproveinthesecondhalfoftheyear,theglobaleconomiclandscapeshouldbemuchimprovedtowardstheendof2023.Wealsoexpectmanyofthe2022marketdisruptionstoease:supplychainswillstabilizeandimprove,commoditymarketswillrealign,andinflationwillmoderate(althoughnottocentralbanktargetlevelsof~2%).Theoutlookforenergyismixed.ThiswinterwilllikelytestbutnotbreakEurope’senergysecurity.Andwebelievethetransitiontorenewablesandmoresustainableenergywillcontinue.Itmust.Thecaseformoresustainablepoweronbothenvironmentalandsecuritygroundshasonlystrengthened,andmanymarketswillmakemeaningfulinvestmentstolessentheirdependencyonfossilfuels.Strategically,thisoutlookstrengthensourinvestmentthesisacrossfourmajordimensions:?Alternativesmustplayanactiveroleinportfolios.Manyinvestors,especiallyqualifiedindividualinvestors,underallocatetoprivatemarkets,meaningtheyaremissingopportunitiestodiversifyandprotectportfoliosagainstinflation–onceanon-eventandnowatopconcernamongourclients.?Infrastructurewillleadinvestmentpriorities.Thereisstrongglobalappetitetoinvestininfrastructure,particularlyrenewableenergy.Weanticipate$US2trillioninglobalinflowsoverthenextfiveyears.Further,governmentsaredrivingsignificantclimatepolicyinitiatives.Forexample,Australia’sgovernmentrecentlypassedmajorclimatechangelegislation,andtheUShassetaside$US369billionforclimateinvestment.Weapplaudthisleadership.?Energysecurityandcarbonreductionarenolongeroppositegoals.Foryears,theargumentwasthatyoucouldhaveeitherenergysecurityorsustainability,notboth.Nowweseethatthesetwoprioritiesmustbemetsimultaneously,ofteninconcertwitheachother.?Yieldhasreturned.Aftermorethanadecadeofnext-to-zeroyieldsforallbuttheriskiestfixedincomesecurities,there’snowanarrayofattractiverisk-adjustedreturnopportunities.However,seriousrisksmustbeconsidered,includingtherisksofrecession,risingunemployment,monetarypolicy,andothergeopoliticaldevelopmentsthatwillcontinuetoimpactallourclients’portfolios.Formostinvestors,publicequitiesrepresentalargeshareoftheirportfolios.Consideringhowstocksandbondshaveperformed,2022wasclearlyconsequential.Butaswemoveinto2023,weseemanyopportunitiesinvariousequitiesacrossseveralsectors,includingenergyandinfrastructure,andinlarge-caps.Withouroutlook–andourinvestmentmethodologyandexperience–weremainfocusedonprovidingwaysforinvestorstoparticipateintheenergytransition,perhapsthelargestinvestmentopportunityofourlifetimes.Wearedevelopingmorethan85gigawatts1ofnewgreenenergycapacity,recentlylaunchedanelectricvehicle(EV)infrastructurebusiness,andhaveinvestedinaglobalsustainability-focusedrealestatedeveloper.Andnow,withtheGreenInvestmentGroupfullyintegratedintoMacquarieAssetManagement,weareabletoapplymorethanadecadeofexperiencehandlinganarrayofsustainableinfrastructureprojectstounlockenergytransitionopportunitiesforinvestorsacrossourPrivateMarketsplatform.AndwhenitcomestoPublicInvestments,wearefocusedonengagement,workingwithcompaniesacrosssectorstounderstandthespecificactionstheyaretakingtoimproveenvironmentalandsocialoutcomesthroughstewardship.Theseinvestments,andourapproach,formthefoundationofportfoliosthatendurebecauseoftheirlong-termvalueandcontributiontoamoresustainableworld.Wefeelstronglythatthereisnodichotomybetweenagreatinvestmentandasustainableone.Thebestcompaniesandthebestinvestmentswillbesustainable.Weexpect–andhope–toworkwithothers.Wemanagenearly$A800billion2inaworldofmanytrillionsofdollarsininvestablecapital.Thismeanswemustcooperate,sharebestpractices,andbuildincrementallytowardsthescalethatweneedtosolvechallengessuchasclimatechange.Thisisn’taboutasingularassetmanagerbeingtheleader.Rather,giventhemagnitudeofourchallengesandopportunities,weneedmanyleadersbringinginnovativeideastoclientsandbroaderstakeholders.Thisishowwearegoingtoliveuptoourambitiontoinvesttodeliverpositiveimpactforeveryone.Staysafeandwell.BenWayGroupHead,MacquarieAssetManagementOutlook2023Contents6TheroadaheadAnewmacroeconomicregimeandtheimplicationsforinvestors7Supply-sidedynamics:Cyclicalversusstructuralchange14Globalgrowth,recessions,andtherecovery20Energysecurityandtheenergytransition27Globalequitymarkets:SteeringamiddlecoursebetweenoptimismandcautionMarketsfacemultipleheadwinds,buttherearesomebrightspots31Globaldebtmarkets:OpportunitiesaboundYieldreturnsastheglobaleconomyfacesaninflectionpoint35Realassets:AttractivetraitsindifficulttimesInterestratesdrivesomedivergence44WhoweareTheroadaheadAnewmacroeconomicregimeandtheimplicationsforinvestorsDanielMcCormack|HeadofThoughtLeadershipInlastyear’soutlook(Outlook2022:Pivotingtoanewera)wediscussedtheideathattheworldwasenteringanewmacroeconomicregimeafterthreedecadesinwhichglobalisationandthetechnologyrevolutiondroverapidgrowthinthesupplysideoftheglobaleconomy.Thisinturncreatedbenigneconomicconditions(lowinflation,fallinginterestrates,strongdemandgrowthandlongupswings)andpositivemarketdynamics(strongcorporateprofits,consistentlyrisingassetpricesandapolicyputoption).Eventsoverthelast12monthshaveonlyheightenedourconvictionthattheunderlyingdynamicsatplayintheglobaleconomyhavechangedinprofoundwaysandthattherelationships,behavioursandoutcomesthathaveguidedinvestorssincethe1990snolongerapply.Thekeypointhereisthattherateofgrowthinthesupplysideoftheglobaleconomyhasdownshifted.Ithasdownshiftedbecauseglobalisationisslowingorreversing,becausedemographicsarenowdeterioratingrapidly,andbecausechangesinpolitical-economypreferenceshavecausedproductivitygrowthtoslowacrossthedevelopedworld(DW).Noneofthesefactorsarelikelytoreversecoursewithanyalacrity.Theyhavebeenbuildingforyearsand,bytheirverynature,haveconsiderableinherentinertia.Itisthisthatgivesusconfidencewehaveenteredanewmacroeconomicregime,fundamentallydifferentfromthelast.Withinthatstructuralcontextthereisstillaneconomiccycletobenavigatedthat,asalways,hassignificantimplicationsforreturnsandassetallocation.WethinkitlikelythatboththeUK(asof3Q22)andtheEuroarea(starting4Q22)arealreadyinrecession.FortheUS,wethinkrecessionrisksarehighenoughforittobeconsideredourbasecase,althoughwedon’texpectonetostartuntil1H23.Theserecessionsarelikelytoberelativelymild,however,withpeak-to-troughfallsingrossdomesticproduct(GDP)rangingfrom-1.5%intheUSto-2.5%intheUK.Chinashouldseeasteadyaccelerationingrowthoverthecourseof2023ifpolicyeasingstepsupagear,asseemslikely.Intermsoftheimplicationsforinvestors,whileintheaggregatewestillseedownsidetogloballistedequitiesduetoearningsrisks,thereareopportunitiesinvarioussectors.USlarge-capshavebeenremarkablygoodperformersinrecenttimes,whileasglobalisationslowsandonshoringbecomesamajorthemewethinkconstructionandengineeringfirms,railroads,andconsumerdiscretionary-relatedcompanieswillbenefit.Yieldisbackinglobaldebtmarketsandwithcentralbanktighteningexpectationsstartingtopeak,thiscreatesanarrayofattractiverisk-adjustedreturnopportunities.DWsovereignsinparticularofferattractiveentrypointsandstrongprotectionlevels.Creditfundamentalsinbothinvestmentgradeandhighyieldmarketsarecurrentlystrong.Defensivepositioningiswarrantedthough,inourview,giventhepotentialforrecessionsandinflationtounderminethisstrongstartingpoint.Wearemorecautiousonemergingmarketsdebt,whereunderlyingfundamentalsaremoremixedandlikelytobestressedfurtherin2023.Inrealassets,infrastructureisastandout.In2023investorsarelikelytobechasingequityinvestmentsthataredefensive,havehighyields,andofferinflationprotection.Infrastructurehasallthesetraitsinspades.Italsooffersexposuretostructuralgrowthdriversintheformofdigitalisation,demographics,andtheenergytransition.Inaworldwherethereisadearthofcyclicalgrowth,assetswithstructuralgrowthdriverscouldstarttoattractapremium.Agriculture’sstablereturnprofileandinflationhedgecharacteristics,alongwithitsexposuretonewrevenueopportunitiesfromthegrowingdemandfornature-basedsolutions,alsomakeitarelativelyattractiveplacetobeatthecurrentmacroeconomicjuncture.Inrealestate,risinginterestratesarehavinganimpactontransactionvolumesinsomemarketsasbid-askspreadswidenandresidentialpricescomeunderpressure,particularlyinthemorehighlyleveredgeographies.Butinmanyinstancesfundamentalsremainsolid.High-qualitybuildingswithstrongcashflowsandpremiumtenants,andpropertyassetsinlocationswheretherearesupply-demandimbalances,shouldperformsolidlythroughthecycle,astheyhavedonehistorically.Higherreplacementcosts–drivenbyelevatedconstructionprices–mayalsohelpprotectpricing,oratleastprovideafloorforprimevaluations.WideningdiscountsforGradeBandGradeCassets,3andthosebuildingswithleasingriskand/orhighandrisingcapitalexpenditure(capex)requirements,shouldalsocreaterepositioningandrepurposingopportunities.Thefirstpartofthispaperexaminesthethreeaspectsofthemacroenvironmentthatwebelievearemostrelevantforinvestors.Thefirstthemefocusesonsupply-sidedynamics,bothshortandlonger-term.Itlaysoutsomeofthekeystructuraldynamicsatplayintheglobaleconomy,howtheyarechanging,andwhatthatmeansforthenextcycle.Thesecondexaminesthecyclicaloutlookandpresentsourviewonthecontoursofglobalgrowthfor2023.Thefinalthemeanalysesrecentdevelopmentsinenergymarkets,theirimpactonthecyclicaloutlook,andwhatthesedevelopmentsmeanfortheenergytransition.Thesecondpartofthepaperfocusesontheimplicationsofourmacroeconomicviewsforlistedequitymarkets,fixedincome,andrealassets.For2023,wearemostpositiveoninfrastructure,fixedincomeandagriculture.Listedequitiesandrealestatefacemoreheadwindsinthenearterm,buttherearestillthematicopportunitiesinbothassetclassesandcyclicalopportunitieswillpresentthemselvesasthedownturnsunfoldandmorphintorecoveries.Supply-sidedynamics:CyclicalversusstructuralchangeAggregatedemandrecoveredstronglyfromtheCOVID-19recessionin2020,fuelledbyanunprecedentedeasingofmonetaryandfiscalpolicy.Butsupplychaindisruption,combinedwiththefactthatmanyworkersdidn’treturntoworkquicklyfollowingthepandemic,meantthataggregatesupplydidnotrecoverwiththesamespeednortothesameextent.Theresultwasinflation,whichwasexacerbatedbytheenergycrisisstemmingfromtheinvasionofUkraine(Figure1).Figure1:HeadlineinflationisnowatitshighestlevelsincetheGreatInflationofthe1970sY501950195619621968197419801986199219982004201020162022Thesepressuresarestartingtoease,however.Globalsupplychaindisruption,neatlycapturedbytheFederalReserveBankofNewYork’sGlobalSupplyChainPressureIndex,hasbeenfallingfor10monthsnowandisdown77%fromitspeak(Figure2).Energyprices,particularlynaturalgasprices,havealsofallensharplyrecently,withUKandEuropeangaspricesdown53%and63%,respectively,fromtheirlateAugusthighs(seeFigure21onpage20).Outlook2023Figure2:Supplychainpressureshaveeased543210-12007201220172022Aswemoveinto2023,thereisanargumentthatinflationcouldfallsharplyassupplycorrectsatthesametimethatdemandretreatsastheDWeconomiesgointorecession.Weseethisasarealandnon-trivialrisk,butnotabasecase.Asidefromthestructuralsupplyissuesthatwebelievetheworldisgrapplingwith(moredetailonthisbelow),amoreproximatereasonforwhyweviewitasariskandnotabasecaseiswhatishappeningwithservicesinflation.Whilegoodsinflationmaybepeakinginmanycountries,servicesinflation–whichisdrivenmorebydomesticwagegrowth–isnowpickingup(Figure3).Inotherwords,thereducedcontributiontoinflationfromthegoodssectorduetonormalisingsupplychainsandtherebalancingofglobalcommoditymarketsmaybeatleastpartiallycounteredbyacceleratingservicesinflation,asthelaggedeffectsofwagegainsoverthepast12monthsworktheirwaythroughtoconsumerprices.Figure3:ServicesinflationisgatheringspeedacrosstheDW87654321020022004200620082010201220142016201820202022Outlook2023Ourbasecaseisthatinflationfallsduring2023asaggregatedemandweakens,supplychainpressuresease,andfoodandenergyinflationmoderates,butitdoesnotreturntocentralbanktargets.”Inshort,ourbasecaseisthatinflationfallsduring2023asaggregatedemandweakens,supplychainpressuresease,andfoodandenergyinflationmoderates,butitdoesnotreturntocentralbanktargets(~2%).Rather,itremainsstubbornlyabovetarget(mostlikelyinthe3-5%range),constrainingcentralbanks’abilitytousemonetarypolicycountercyclically,somethingthatinturnlimitsthevivacityoftherecoveryandmakesitlessrobustthananextrapolationfromrecenthistorywouldimply.Arguablymoreimportant,andmoreinterestingthandevelopments12-18monthsfromnow,iswhatishappeninginastructuralsensetothesupplysideoftheglobaleconomy.Inourview,supplygrowthhasslowedmarkedly,andtherearethreemaindriversofthisdeterioration:?Deglobalisation.Reshoringasaresultofrisingcostsintheemergingworld(EW)isoneaspectofit.Butdeglobalisationrunsfardeeperthanthat.Geopoliticaltensions,particularlybetweenChinaandtheWest,areonekeydriver.HeightenedconcernaboutthereliabilityandsecurityofsupplychainsintheaftermathofCOVID-19isanother.ButarguablymostfundamentalisthepoliticalbacklashintheWestfromthosegroupshurtorleftbehindbyglobalisationandbythosewhobelievethatpoliciesandpoliticaldecisionsshouldbemadeatthenationallevel,ratherthanatthesupranationallevelorbymultilateralinstitutions.?Demographics.Ageingisnowintenseenoughthatitisstartingtobiteoneconomicgrowth,particularlyinkeyeconomiessuchasChina’s.?WeakerDWproductivitygrowth.Arangeofreasonshavebeenputforwardtoexplaintheslowdowninproductivitygrowthoverthepastdecadeorso.Theimportantpracticalquestionisthedurabilityofthechange.Therootcauseofmuchofthechangeis,inourview,ashiftinpoliticaleconomypreferences.Developedoverlongperiodsbyslow-movingforces,theseusuallytakequitesometimetoshiftbacktoamorepro-growthagenda.DeglobalisationTheperiodfrom1989toveryrecentlywasoneofintenseglobalisation(“hyper-globalisation”).Globalisationwasaboontoglobalsupplybecauseit:?Addedhugeamountsofidleresources,particularlylabour,totheglobaleconomy(thelabourforcesoffirstEasternEuropeandlaterChinaandIndia)?Providedanexpandedmarketforinnovatorstosellintoandtherebyincentivisedmoreinnovation?Supportedtechnologicalandinformationaldiffusionaroundtheworld,helpingtobringcountriesbehindthetechnologicalfrontierclosertoit,andthosewithweakinstitutionsandsubstandardpolicyframeworksclosertoworld’sbestpractice?Intensifiedcompetitionglobally,whichaddedtoproductivitygrowth.Outlook2023Butinrecentyearstheprocesshasslowedandpossiblygoneintoreverse.Thispullbackcanbeseeninarangeofdata–fromgrowthinglobaltraderelativetoglobalGDP(Figure4)tomeasuresofglobalisationbythinktanks(Figure5)totheriseintariffratesbetweentheUSandChina,4theworld’stwolargesttradingnations.Figure4:Globaltrade-to-GDPhasflattenedoutoverthepastdecadeFigure5:Measuresofglobalisationshowaplateau2010rInafundamentalanddurablesense,globalisationhasbeenunderminedbytwomaindevelopments:first,thevirtuallyinevitableincreaseintensionbetweentherisingpower(China)andtheincumbent(theUS)5;second,apoliticalbacklashagainstglobalisation,whichcomesbothfromthegroupsthatlostout,orgainedless,fromglobalisation,andfromgroupsthatopposemultilateralinstitutionsonnationalsovereigntygrounds.LayeredontopoftheseforcesisanarrowingcostadvantageforChinaandtheEWingeneral,anaccelerationinautomationinmanufacturing6and,followingCOVID-19,anincreasedconcernaboutthesecurityandreliabilityofsupplychainsandapotentialdriveforautarkyincertaingoodsorsectors.Inthissensethepandemicacceleratedanalreadyexistingtrendtowardsslower,orless,globalisation.Thesefactorsareunlikelytodisappear,orfade,anytimesoonandindeedmanymayintensifyintheyearsahead.Theimplicationisthatdeglobalisationisatrendthatisheretostay,atleastintheneartomediumterm.nouncedOutlook2023DemographicsThedemographicoutlookfortheworld’smajoreconomieshasdeterioratedmarkedlyinthepast20years.ThechangehasbeenparticularlystarkforChina.RecentlyreleasedpopulationprojectionsfromtheUnitedNationshaveChina’sworking-agepopulation7contracting0.7%peryearforthenext20years,whereasin2002itwasexpectedtogrow0.5%peryearforthesubsequent20years(Figure6).Thedeteriorationinthedemographicoutlookhasoccurredforalltheworld’smajoreconomies,butChina’sisparticularlyconcerningfortworeasons:first,itistheworld’ssecondlargesteconomy,andsecond,ithaslimitedscopeto“fix”ademographicproblemwithincreasedmigration.Figure6:Demographics:2002versus2022%Tobesure,risinglifeexpectancyandtheassociatedincreaseinlabourforceparticipationratesforoldercohortsinmuchoftheDWcanbeanoffsethere,butquantitativelytheimpactisrelativelysmall.Outlook2023DWproductivitygrowthslowdownProductivitygrowthhasbeenslowingacrosstheDWforsometimenow(Figure7).Indeed,fortheG7asawhole,labourproductivitygrowthhasslowedfrom2.1%inthesecondhalfofthe1990sto0.7%since2015.8Theslowdownhassparkedanintensedebateamongeconomistsaboutitscause.Someofthemainexplanationsinclude:?Slowertechnologicaladvancement.ThemostfamousadvocateofthispositionisProfessorRobertGordonwhoarguesthatthetechnologiesoftodaydon’thaveasbroadapplicability,andarenotaspowerfulforliftingoutput,asthoseofthesecondindustrialrevolution.?Weakergrowthinglobaltrade.Byexposingfirmstonewtechnologies,newproducts,andnewmanagementpractices,tradetendstoboostproductivitygrowth.Theslowdownintradegrowthinrecentyearsasaresultofthepullbackfromglobalisationmayalsobeimpactingproductivity.?Secularstagnation.Theidea,recentlypromotedbyLarrySummers,9thatahigherpropensitytosaveandalowerpropensitytoinvestisdraggingdowndemandandloweringrealinterestratesandGDPgrowth.Companiesarereturningmoneytoshareholdersratherthaninvestingincapitalandinnovation.?Riseofzombiefirms.Inthepost-GFC10world,non-viableor“zombie”firmshavebeenkeptalivebybankforbearance,prolongedmonetarystimulus,andthecontinuationofcrisis-inducedsupportpolicies.11Thesezombiefirmsarenotonlydirectlyaffectingproductivitygrowththroughtheirpoorperformance.Theyalsoclogupmarkets,limitingtheexpansionofdynamicfirmsandincreasingbarrierstoentrytonew,morecompetitivecompanies.Inpartthisisastoryaboutpolicyorpoliticaleconomychoicesweakening“creativedestruction,”thatdynamicprocessthatliesatthecoreofcapitalisteconomiesandissocrucialto innovation,productivity,andgrowth.Figure7:LabourproductivitygrowthhasslowedacrosstheDW2015-20229.ItwasoriginallycoinedbyAlvinHanseninhis1938AmericanEconomicAssociationpresidentialaddress.Outlook2023deglobalisation,demographics,andweakerDWproductivitygrowth–aredurableandwilltaketimetoturnaround.”Wewouldmaketwoadditionalpointshere.First,whiletheargumentmadebyProfessorGordonabouttoday’stechnologiesbeinglessproductivity-enhancingthanthoseinthepastiswellmade,extremelyinteresting,12andmaywellhavesomeapplicabilitytorecentyears,itcanbearguedbothways.Indeed,onbalancewetendtosidewiththetechno-optimists(suchasProfessorJoelMokyr)andseethefutureaspregnantwithtechnologicalpotential.Indeed,thereareseveralpotentiallypowerfulall-purposetechnologies–artificialintelligenceandrobotics,justtonametwo–thatcoulddrivethetechnologyfrontierforwardrapidlyandhavea“stepchange”impactonproductivity.Thatsaid,thetimingoftheimpactofthesetechnologiesisuncertainandtherecanbeverylonglagsbetweentheinventionofatechnologyanditsbroadeconomicapplication.13Butifourcallaboutanewmacroeconomicparadigmofweakerproductivityandsupply-sidegrowthultimatelyprovestobewrong,wethinkitismostlikelytobewrongbecauseofarapidexpansioninthetechnologicalfrontier.Second,wethinktheargumentaboutzombiefirms,poormicro-levelsectordynamics,andaresultingweakeninginth