Chasing Income

Unlocking the Future of Capital Markets

Four trends to help investors grasp the ‘physics’ of finance

by Jim McCaughan

Mr. McCaughan is president, global asset management, and chief executive officer of Principal Global Investors. He oversees all global asset management activities, including developing global strategies and identifying and analyzing market opportunities. Visit Principal Global.

Like the future, capital markets are unpredictable and do not exist in a vacuum. Resembling a sort of financial physics, the world exerts a force on capital markets at least equal to the force that capital markets exert on the world.

While the future of capital markets may be impossible to predict, it is possible to identify the trends that can impact capital markets in the coming years. We recognize four current forces that could have a great influence on the future of capital markets: demographics; urbanization and re-urbanization; a structural oversupply of commodities and manufactured goods; and technology and infrastructure.

Demographics- Chasing Income

Seismic global demographic shifts are occurring and aging populations are seeking income.

The United States has a generation of baby boomers in their 50s and 60s that constitutes one-quarter of the population, though this trend is also present in Europe, Japan, and even China.

Accordingly, amassing a retirement “nest egg” becomes living off that nest egg and making that money “work for you.” This portends an excess amount of savings looking for fixed income and other yield assets. With increased amounts of capital chasing the same assets, prices of yield-producing assets are likely to be structurally lower.

This puts pressure on investors and retirees looking for income and yield via bond funds and diversified-income strategies. But, the effects could also spread throughout capital markets. Even investors in annuities or guaranteed products will be affected and insurance companies will need yield-based assets to fund those annuities.

Urbanization and re-urbanization

Like a replay of the Industrial Revolution, workers in emerging countries are transitioning from rural agricultural jobs to manufacturing jobs in cities.

In developed economies, however, the post-World War II trend of populations moving to suburbia is reversing. Consequently an area of potential disruption is the housing sector. Growth in U.S. suburbs was driven by baby boomers, who saw their retirement savings and the value of their homes take a hit after the financial crisis.

Millennials (those born in the late 1980s and 1990s) prefer city apartments and condominiums rather than the “McMansions” of suburbia. Younger demographics now exhibit a preference for renting versus buying. A “sharing economy” arose in the mid-2000s not just because of this preference, but because of technology.

With smartphones and mobile technology, the business models of Airbnb, Uber, Zipcar, and the like are now viable. And with crowdsourcing platforms funding business ventures, movies, and music, is the world really that far away from a Kickstarter-funded retirement?

Potential disruptions to already-established business models could be profound. We are already seeing disruption in the auto industry. Car-sharing services like Uber and Lyft are gaining popularity. Driverless cars could be a reality within five to ten years. Companies like Uber and Zipcar are preparing people for a time when the economics of owning an automobile will become unsustainable or downright foolish.

Manufactured goods and commodities- too much stuff

Manufactured goods have not maintained their pricing power, even in inflation-adjusted terms, over the last three quarters of a century.

In contrast to the second half of the twentieth century, I believe we are headed for a period where there is an excess supply of manufactured goods and commodities. When baby boomers were young, there were many bottlenecks in productive capacity for manufactured goods, food, and energy – as a result there was structural excess demand.

Growth came with a side of inflation. Those bottlenecks have dissipated, bringing about a manufacturing revolution to rival the Industrial Revolution. Prices on manufacturing goods have dropped, while functionality and value have increased dramatically.

The commodities supercycle has also increased supply and promoted a greater frugality in usage. The supercycle pushed up the prices of everything from metals to petroleum, which caused a build-up of capacity. Consumption is also becoming “smarter,” via more efforts toward energy efficiency and recycling. Consumption frugality has led to a situation where supply has outstripped demand and prices have declined.

Technology & Infrastructure – Innovation and obsolescence

In contemplating a future with potentially lower-than-normal interest rates and prominent deflationary pressures, fixed income investors will no longer make money out of effectively buying bond duration. The set of fluctuations that made that the trade are gone

Technology advances may drastically alter our infrastructure system, which could have massive implications for the utilization of capital.

The debut of autonomous vehicles within the next decade represents a sea change for our transportation infrastructure. As the technology proves itself, the public will demand its rapid adoption. Just like seatbelts and airbags, driverless cars will be the next major safety system.

In 20 years, driving a car could be seen as anti-social as smoking is today. Its rapid adoption will impact capital markets. Driverless vehicles can eliminate traffic congestion and more vehicles can travel more safely in less space. We might be swiftly approaching a time when our present amount of infrastructure could be excessive.

In the suburbs, road networks are based upon a hierarchy, where residential roads spill out into larger “collector” roads, which in turn connect to even larger arterial streets. It is possible that many of these roads, which are expensive to build, could be rendered obsolete.

Freeing up that capital and putting that space to more productive use would surely be a boon to global economies. I can also foresee changes for commercial real estate in the future. If people are freed from the physical and financial burdens of owning, storing, and insuring an automobile, does urban living become even more attractive? What do suburban malls look like if there is no need for all those parking spaces? How does the urban core transform if all those downtown parking garages are no longer needed?

There are a lot of natural responses to these issues, but it is technology that will enable them. Technological advancements have also created the possibility of a smarter electrical grid that decentralizes power generation. Rather than having massive power plants, a smart grid would distribute generation and monitor electricity flow.

Improving wind and solar technologies could turn residential and commercial buildings into mini-generators and create an efficient network that is less susceptible to outages or terrorist attacks. Is the world then best served by capital chasing infrastructure opportunities of the last century, or the current one?

Implications for investors

A global deflationary environment would mean that interest rates stay lower for longer than expected.

In contemplating a future with potentially lower-than-normal interest rates and prominent deflationary pressures, fixed income investors will no longer make money out of effectively buying bond duration. The set of fluctuations that made that the trade are gone.

However, investors will be positioned to make money by buying income streams when they are inefficiently priced. Income streams can come from a number of sources: real estate, emerging market debt, CMBS, yield equities, or municipal bonds. If 3% turns out to be a high Treasury yield in the future, then cap rates on real estate will also stay fairly low.

This also implies that we could see investors hunting spread over Treasurys. My cautionary message is this: you will have to look at when spreads are fundamentally cheap, rather than just looking at them relative to past experience. In real estate and infrastructure, technological obsolescence could be an issue. If my theses about lifestyles or the potential of driverless vehicles are correct, then you might see incremental values in downtown areas.

In turn, suburban real estate could languish, potentially affecting residential, retail, and office property. Real estate could be even further impacted by shifts in the current electrical transmission network. Predicting the future is essentially impossible because of the many variables, imponderables, and human behavior, which can mar specific predictions.

So the goal isn’t specific prediction, but determining general direction. Just like car’s headlights on a foggy night give us a decent idea of where that vehicle is headed in the next few seconds, trends like those that we have identified here can give us a glimpse of the likely path capital markets could take in the future.

Our responsibilities, as market participants, are to examine that evolution, follow those trends and challenges, and most importantly develop solutions!

A link to the full report here