Five economic risks to watch: Poloz

Five “tectonic forces” are shifting the global status quo, leading to an age of economic and financial uncertainty, according to Stephen Poloz, former governor of the Bank of Canada.

These forces — an aging population, growing indebtedness, technological progress, rising inequality and climate — are “forces of nature, and their interaction can give rise to sudden, earthquake-like eruptions of economic and financial volatility,” said Poloz, in a virtual keynote address at Franklin Templeton’s 2021 Investment Outlook on Tuesday.

This could lead to many different inflationary scenarios from a return to the 2% inflation target to an inflation outbreak, or to stagflation or deflation.

“Personally, I would not weight them equally, but I would attach a meaningful weight to each of them and suggest that [investors] think about ways to preserve [their] capital should any of them arise,” said Poloz who is a special advisor with Osler, Hoskin & Harcourt LLP.

“We should not fall in love with the high probability scenario where inflation just returns to 2% and remains there.”

One driver of high interest rates in recent decades was the population surge of the post-war baby boom. As this generation now moves into retirement, Poloz believes that the high real interest rates of the past “were an aberration” and should not be expected to return.

While there is an expectation for interest rates to normalize along with inflation targets, Poloz notes there is growing concern that inflation could get out of control as governments borrow a “staggering amount of money.”

The former central banker said that today’s central banks are well-equipped to keep inflation in check via monetary policy.

However, three of the tectonic shifts mentioned could disrupt central banks in their policy goals: growing indebtedness, technological progress and rising inequality.

Global indebtedness was on the rise long before Covid-19 hit, said Poloz.

As a result of monetary and fiscal policies that have prevented recessions, individuals and companies are not retrenching and rebalancing their finances as they might have done in the past. From an investor point of view, this leads to the danger of “zombie firms” that are not “washed out of the system” as they might have been.

In the case of technology, progress generally means more efficiency and lower costs for companies over the long-term, said Poloz. But, that same progress can have serious economic consequences in the short term in the form of economic depressions and disruption.

The world is currently experiencing a fourth industrial revolution as the economy becomes digitized through artificial intelligence — which is leading to fears within workforces that a few large firms will scoop up all the economic benefits, leading to growing income inequality.

“People believe and expect that economic growth is like yeast, it spreads everywhere, so everybody benefits,” said Poloz. “But the reality is more like mushrooms that pop up here and there and single firms can reap most of the benefits.”

Climate change is also having a seismic effect on the economy as more companies try to shift their businesses to environmentally-friendly processes. The problem, noted Poloz, is “markets are really bad at distinguishing between shades of green. They’re essentially only able to tell the difference between green and not-green.”

Firms will have to move towards “full carbon transparency,” which will require significant investments in analytics or consultancy work. And,  “firms who invest in this early deserve your attention,” said Poloz.

With these forces in play, “volatility beyond the norm is now a given,” said Poloz. A firm’s risk management for these factors will be key to creating shareholder value and will likely be “the next channel of intangible investment.”