David Lebovitz: Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on The post-COVID world coming into focus, and has been recorded for institutional and professional investors.

I'm David Lebovitz, Global Market Strategist, and host of the Center for Investment Excellence. With me today are Jared Gross, Head of Institutional Portfolio Strategy, and Karen Ward, Global Market Strategist. Hi, Jared. Hi, Karen. Welcome to the Center for Investment Excellence.

Jared Gross: Hi, David.

Karen Ward: Great to be here. Thank you.

David Lebovitz: It's really great to have both of you on the podcast today, and we're going to be talking a little bit about our Strategic Investment Advisory Group's most recent paper on the things that have changed durably and the things that may have not changed so durably in a post-COVID world.

But before we dive into the meat and potatoes of the conversation, Jared, I want to start with you. Can you just give everybody a quick background on exactly what the Strategic Investment Advisory Group is, and maybe a little bit of a high-level view with respect to our most recent paper?

Jared Gross: Yes, happy to. So, the Strategic Investment Advisory Group, or SIAG as we like to call it, was established a few years ago by our CEO, George Gatch. The objective of the team is to produce in-depth content that's going to help guide our clients' strategic decision-making.

So, we're looking for identifying and exploring long-term trends that will influence both the economy and the market over an extended horizon. And to do that, we gather investment professionals from around the firm, all of our various market teams and global offices, and come together to consider a topic from a variety of angles.

And, you know, J.P. Morgan Asset Management, because of our breadth of resources, is sort of uniquely well-positioned to do this. So, the latest paper is entitled, The Post-COVID World Comes Into Focus. And as that title implies, it is a fairly broad survey of how the world is emerging from the pandemic.

So, we look at things like demographics, trade dynamics, inflation trends, fiscal policy, direct government intervention in the economy, changes to sort of commuter habits, and what that means for urban environments, the real estate market, and the equity market.

So, it's a really, I think, diverse set of views and topics that we've brought together under this broad idea of, as you said, how are we emerging from the COVID crisis? What's going to go back to normal? What's already gone back to normal? But more importantly, what's going to change for the long term?

David Lebovitz: And I think that that's really the big question that I've been getting in client conversations is, as we've gone back to the office more as economies have opened back up, we found ourselves in this world where there are a lot of questions about, again, how durable some of this will be and how durable or not durable other parts will be.

Karen, I want to pivot to you. Jared, you mentioned demographics. And as we all know, demographics are our destiny, particularly when it comes to economics. Can you talk a little bit about the long-run outlook for demographics in the wake of COVID and how you're thinking about the way that these trends may or may not evolve going forward?

Karen Ward: Yes, absolutely. I mean, it's one of those variables that of all the things we have to forecast is easier because we know how many people are alive, what age they are, how many people are being born. What we don't know is whether each of these cohorts are willing to work and that is what has changed.

It does seem to be in a more enduring manner because we knew our populations were aging, but that wouldn't be so problematic for growth so long as they stay in work. And in fact, there was a lot of optimism about that because economies like Japan suggested that particularly developed economies where there were more service sector jobs, people would stay in work. But actually what we've seen post-pandemic is the over 55 category, more of them have chosen to stay out of the workplace.

And they don't seem to be coming back. So, for whatever reason, they've made this alternative choice. And these individuals are often wealthier. It's kind of hard to entice them back with policy levers. So, the implication of that is that we just have fewer people and that can be a drag on growth.

Now, there are some potential offsets. Flexibility has seen actually female participation rise in many of the developed economies. But I think overall, the conclusion is that we're going to need some labor-saving technologies. Companies are going to have to be investing. So, there's all this fear about AI and automation and robotics.

But actually, we could really be looking as we look to the next 10 to 15 years that COVID has exacerbated a problem in shrinking workforces. And we're actually going to need all of those technologies to maintain growth.

David Lebovitz: And I think that that brings up another important topic that we cover in the paper. And so, Karen, I want to stick with you just for another couple of minutes here. We have obviously the advent of AI and huge fanfare and excitement around the potential for that technology to boost productivity.

The way that economies and businesses have dealt with labor shortfalls in the past, however, is simply by going and setting up shop in places that have better demographics. And so, you know, the world does seem increasingly fragmented in this post-COVID environment, arguably multipolar.

From a geopolitical perspective, do you get the sense that globalization is going into reverse or do you just see corporations and businesses being a little bit more discerning and thoughtful with respect to where their supply chains and manufacturing facilities exist across the global economy?

Karen Ward: I don't think globalization is going into reverse, but I do think the patterns of trade are shifting slowly and incrementally, but a way that we will continue to see. You know, prior to the pandemic, as you say, particularly when China entered the WTO, we had this flood of very cheap workers, and therefore China established itself as the manufacturing hub of the world.

And companies were really focused as a priority on what is the lowest cost and then just-in-time inventory system. And the pandemic really challenged that business model. So, what we're seeing already in the data, and this is slow moving, but we're seeing friendshoring, nearshoring, just little changes in the pattern of trade, perhaps a little less concentration in China that's moving to surrounding Asia, a little bit more activity in Mexico, for example. So, I think it's a shifting pattern, and it will be slow, but I do think ongoing, this is an enduring trend.

David Lebovitz: And I think the one point I would make in addition to all of that, which I think reinforces the point you're making is, if you look at trade openness as measured by the sum of imports and exports globally, that actually began to flatline post-2008. And so, this world where globalization is no longer increasing is actually a world that we've been in for quite some time.

And Jared, I want to thank you first for being so patient but bring you into the conversation, because one of the impacts of very rapid globalization in the early 2000s was that it allowed inflation to slow. We are now in a world where inflation is much higher than where central banks would like it to be. 

And so, obviously, there's an impact on inflation from these demographic trends, from these globalization trends. Do we get back to 2%? What is the outlook for inflation in this post-COVID environment?

Jared Gross: Yes, that's a great question. So, I think as you and Karen both noted, the demographic shifts that are affecting developed economies have been going on for a long time. COVID made them arguably worse, but they've been there. And deglobalization is something that, as you just noted, has been around for at least a decade in some form or other.

And I think, as Karen said, it's really more about a restructuring of trade flows than it is an outright reversal of globalization. It's also worth noting, since you brought up the impact on inflation, moving production from China, although it may in some instances lead to a higher cost structure, and there are some frictional costs associated with literally moving a new factory from point A to point B, but over the long horizon, there are many countries that produce at lower costs than China.

You know, one of the things we say in the paper is that China is catching up and getting caught at the same time. It has been very successful in developing as a middle-income economy, and wages across China have risen as a result. But the effect of that, of course, is they are no longer as competitive on a price basis when it comes to manufacturing production, particularly for some of the lower-skilled manufacturing that they were originally very successful at.

And so , by virtue of moving some of that to places like Vietnam or Mexico or Eastern Europe, there very easily could be a positive effect in inflation terms, and that prices may not actually come up as much as we fear. But whatever we make of the economic pressures kind of on the macro level, you do have to then, of course, balance that against what the central banks are going to do in response.

So, I'll just spend a minute kind of walking through this. You know, in the early wave of COVID, inflation was supply-driven. And one of the characteristics of supply-driven inflation is that it's fairly resistant to monetary policy. Raising short-term rates does not help cars show up on the dock. So, that was a problem that we faced.

But the supply-driven inflation is also generally self-correcting. Production will rise. Factories can move, and we've seen that. You know, the supply-driven pieces of the CPI basket have been coming down. But the second wave of COVID inflation was much more demand-driven.

You know, you had low unemployment, rising wages, lots of stimulus coming from the government in various channels, which led to a surge in demand and, at least to some extent, a sort of wage-price spiral, which is always what the central banks fear most. And, you know, it took them, particularly the Fed, a long time to get into the battle, but when they got in, they brought a lot of firepower.

I mean, the Fed has rapidly increased interest rates to north of 5%, to the point where we can say, I think with some confidence, that we have positive real rates sort of along the curve at this point. They've pivoted from quantitative easing to quantitative tightening, reducing the money supply, raising longer-term interest rates, at least above where they would naturally be.

Those are powerful tools. And we expect that they're going to work against inflation. What we're probably a little less certain of is how long it's going to take. With Paul Volcker back in the 80s, he hiked rates very rapidly, very high, put the economy into a tailspin, and then very quickly cut rates.

The Powell doctrine, if you want to think about it that way, appears to be a little bit different, which is hike until you get to a positive real rate, and then stay there as long as it takes for inflation to come down. Now, we're not 100% sure they're finished with that process, although it feels like they are at the minimum in the later stages of it.

They certainly have the ability to control inflation. They've probably done enough. The other thing that you have to look at, and this, I think, gives us more confidence that they will eventually bring inflation down is, there's a lot of leverage in the system. A lot of balance sheets added a lot of debt in the past few years, particularly when interest rates were so low.

And now, they're going to be feeling a lot of pain. I mean, if you borrowed money against fixed nominal cash flows at any point in the last couple of years, you're almost certainly underwater now. The value of those cash flows has gone down. The cost of funding them has gone up.

And so, that's going to ripple through the economy at some point. And we're seeing that with the banking system. That's just one very apt example of this. So, to come full circle, is 2% achievable? Sure. Is that going to be the end point of inflation in this cycle? It's too early to say.

I mean, the Fed is certainly not going to abandon the rhetorical high ground and admit that they want to achieve something other than 2% inflation because, we must be honest, jawboning the market is part of their arsenal, and they wield it accordingly.

And I think when you look at market behavior, you know, the front end of the yield curve, the two-year note, is highly volatile because the market keeps whipsawing back and forth between believing what the Fed says and doubting the Fed's conviction.

Whereas the long end of the curve has been relatively less volatile because they do appear to price in a fairly significant decline in inflation in the coming years. And so, I take that as sort of a proof statement that, at the end of the day, the Fed is going to be successful here, but it could take a while before we see it happen.

David Lebovitz: So, Karen, I know you have a slightly different read of the inflation tea leaves. Maybe I can just bring you in for a second to respond to Jared's view. How are you seeing things? Because I know that you do have a bit of a different outlook for inflation than perhaps the idea that eventually we do get back to where the Fed would like us to be.

Karen Ward: Well, I think it's an interpretation of the central banks. I mean, as Jared said, if they want to achieve 2%, there may be a growth cost to it. But if they want to, they can. I think my degree of skepticism perhaps is around the politics of that and whether they really can engineer a prolonged period of weakness in order to hit that sacred 2% number, or whether actually the conversation will evolve to say, you know what, maybe 2% was too low.

If we get down to 3%, is it really worth our efforts to try and get down to 2%? So, that's where I think that there's a healthy debate going on. But I think, who knows? We're trying to interpret central banks' political capabilities here. For us as investors, what's really important is just to recognize those uncertainties, and particularly to understand, because I think Jared and I 100% agree, the worst of the inflation is behind us.

Whether it settles at 2% or 3%, that's up for grabs. But we're not going back to 0.1% that we were pre-pandemic. And I think that's really critical for investors to think about when they think about all sorts of things, like where will interest rates settle? What's a discount rate I should apply? Because if we're not going back to zero inflation, I don't think we're going back to zero or negative interest rates either.

David Lebovitz: And I think that that's a really good point. And I think, you know, obviously there's a lot of healthy debate about the outlook for inflation. And the political angle, particularly in places like the United States where we have a presidential election next year, are certainly bound to be a bit muddy and a bit sticky.

And so, Karen, maybe sticking with you and sticking with policy and more specifically fiscal policy, what do you think fiscal policy is going to look like going forward? We clearly have abandoned the world of austerity that we were in for the better part of the post-2008 expansion.

And what I've observed over time is that when the fiscal taps get turned on, it's increasingly difficult to turn them off. And so, what are your thoughts on the role of fiscal in the aftermath of the pandemic?

Karen Ward: Yes, absolutely. For politicians, spending money is much easier than cutting back. And again, I think this is the enduring trend. Governments got a bit of a taste for spending in the pandemic. Okay, they're not going to be sending out checks in the post or doing any of the extreme actions they were required to do when economies were closed.

But they have big projects to focus on, which is where actually it's the combination of COVID and then the last paper that SIAG produced, understanding the impact of Russia's invasion of Ukraine and the energy transition, putting those two things together. Governments have projects they want to get done.

They need to transition the economies away from fossil fuels. They want to improve digital infrastructure. So, if you look at, and there's a chart in the paper which points to government investments, and just the contrast between what's projected to happen over the next couple of years, in the US, of course, it's the Infrastructure Investment and Jobs Act. And then on top of that, the IRA.

In Europe, it's the Recovery Fund. But government investment is on an upward trajectory to levels that we haven't seen in the last couple of decades. And it's not just that, but that's the contrast between where we were seven or eight years ago.

So, I would simply say, and this kind of comes back to Jared's conversation about monetary policy is that prior to the pandemic, monetary policy was really the only game in town, because governments had their foot so hard on the economic brakes of fiscal policy, that central banks were trying their hardest.

But in continental Europe, in the Eurozone, they had no choice. The central banks were trying to deploy negative interest rates, but the scale of the austerity was so vast, they really couldn't have any impact. But now governments have taken their foot off the brake, and they're touching the accelerator.

And that, again, creates a really different dynamic, not only for thinking about the macro picture, but also just for thinking about, well, if governments have got projects to be done, we as investors want to be ahead of some of those projects.

David Lebovitz: Absolutely. And I think, you know, the tension or the tug of war between monetary and fiscal policy going forward is going to be essential for all investors to monitor. And so, Jared, maybe I'll give you the final word, much like I let Karen respond to your views on inflation.

Karen shared her thoughts on both fiscal and monetary policy. How do you see the monetary front playing out over the course of the coming years, knowing or given the fact that fiscal looks set to play a larger role going forward?

Jared Gross: You know, I think Karen, and I, as we worked on this paper, one of the things we settled on was this idea that we've been through an era where you frequently heard reference to the Fed put, you know, the idea that when either financial volatility rises or the economy enters the downturn, that monetary policy will quickly respond and provide liquidity and essentially kind of save the day for the markets.

Part of the reason the monetary authorities were able to do that is because of exactly what Karen described. The fiscal authorities were sort of sitting on their hands for a long time. They weren't pumping cash into the economy, and the risk of inflation was much lower.

We've now kind of reversed that, where the presence of the fiscal authorities and the amount of money that's flowing into the economies from these various sources, many of which are outstanding policy choices, it's not a bad choice on the part of the fiscal authorities, but it forces the monetary authority to essentially step back and take a more defensive posture, because they have to protect against the risk of inflation.

I mean, that's essentially what we're seeing right now. The explosion of fiscal spending in COVID, which very clearly led to inflation, in part, because it was simultaneous with very easy monetary policy, but that has forced the hand of the monetary authority to walk it back.

So, we've seen tightening of monetary policy in the form of higher interest rates, in the form of quantitative tightening. I think they've also kind of looked the other way a little bit as the banking crisis evolves over the last few months, and they haven't jumped in with a kind of liquidity save the way they might have a few years ago.

So, I think when we consider how the interaction of fiscal and monetary behaves going forward, we're going to see a lot less of that central bank put. And maybe, and hopefully, maybe a little more of a fiscal put, in the sense that policymakers will decide affirmatively to address problems, because I think when you look back at the scope of history, many of the problems that the central banks were sort of attempting to resolve were not really actionable with monetary policy.

And so, there was sort of an inefficient mechanism to maintain growth. And so, we may ultimately move to a better place, although I will say it's early in the process and certainly unclear as to how that ultimately plays out.

Karen Ward: Do you mind if I jump in, David? I think when you hear Jared talk about this sort of changing, a lot of people get nervous about that. Well, hang on, I'd rather that it was the central banks rather than governments. I interpret this actually as really positively because, A, governments can enact activity quicker.

I mean, we just saw, you send checks in the post, people spend it. So, it's actually pretty powerful. But also, monetary policy has some pretty negative impact sometimes in inequality, and fiscal policy can do the opposite.

So, I think we should go against some of our natural inclinations to think, oh, well, if governments are going to be spending, that must necessarily be bad, particularly given that many of the projects underway are stuff that have to be undertaken by governments, things like grid infrastructure, et cetera.

David Lebovitz: I think that's a really good point and actually a perfect way to kind of put a bow on this whole conversation. And, you know, when we think about what all of these macro forces mean for investors, clearly there have been risks that have been created by everything that has transpired, but there are also opportunities as well.

You know, we spend a lot of time talking about fiscal. When we look at the opportunity for private investment and infrastructure to complement what comes from the public sector, it looks like it's going to be fairly substantial over time.

We didn't spend a whole lot of our discussion today focusing on the impact of COVID on urban environments and commuters and so on and so forth, but clearly, there is an impact on both commercial and residential real estate from everything that's gone on here over the course of the past couple of years.

And there's also an impact on businesses. And when we think about the types of businesses that we want to own going forward, it's really about making sure these businesses are aligned with what's happening on the policy front. They're positioned well to take advantage of the economy the way that we believe it's going to evolve going forward.

And finally, if we are in a world where inflation proves to be a bit more persistent, or even in a world where inflation goes back to 2%, pricing power is going to be key in driving those corporates' profitability. And so, you know, thank you both again for joining me today. I thought it was an excellent conversation, and I hope to have you both back sometime again soon.

Jared Gross: Thank you, David.

Karen Ward: Thanks a lot, David. Absolutely.

David Lebovitz: Thank you for joining us today on J.P. Morgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our website. Recorded on June 7th, 2023.

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