Are markets on the cusp of long-term change?

The adjustment has been swift with a significant repricing of ‘risk’ as loose monetary conditions and cheap credit have been supplanted by the opposite. Conventional portfolio construction, namely the 60/40 equity and bond mix that has served investors exceptionally well for decades, has been harpooned. 

Markets are reeling from the highest inflation levels in 40 years, economies hurtling towards recession, huge levels of global debt, lockdowns in China, war in Ukraine, an energy crisis and a  deterioration in the relationship between the world’s two major superpowers. 

Regarding inflation, while the Russian invasion of Ukraine and supply chain issues dominate the political narrative, the Covid-19 global pandemic, and the extraordinary response of governments to it, represented a watershed moment, pulling the curtain down on a unique period of disinflation, ultra-low interest rates and a boom in global asset prices. 

The opening act for this period was ‘Asian Contagion’, a series of currency collapses over a tumultuous six months in 1997. 

It would be followed by the large-scale privatisation of the Chinese economy, which would eventually lead to China joining the World Trade Organisation in 2001. 

Together, this potent mix of extremely cheap currencies (comparative cost advantage)  and a surge in the size of the working age population (structural downside pressure on wages), propelled Asia to the role of global manufacturer, super-charging globalisation and the advent of just-in-time supply chains.

As economies opened, the Western consumer benefited as the price of ‘stuff’, from consumer goods to electrical goods and clothing, fell dramatically as demonstrated by plotting the secular fall in the prices of US durable goods.

The spoils of globalisation impacted fixed income markets as Asia’s export-led policies, led by China, generated huge current account surpluses that were recycled into US Treasuries and other high-quality fixed income assets as part of efforts to avoid a repeat of the crisis several years prior.

In the western world, an absence of inflationary pressures and a large marginal buyer of US Treasuries drove bond yields towards zero (and into negative territory in parts of Europe), negating the need for central banks to aggressively tighten monetary policy. Absent inflation, growth became the main factor in determining the relative price movements of bonds and stocks. 

Fast forward to March 2020 and coronavirus emerges with disastrous consequences for the world economy. The speed and magnitude of the contraction dwarfed anything experienced over the prior 73 years.

Rather than follow the road travelled in 2008, governments unleashed monetary and fiscal expansionary policies previously reserved for wartime emergencies, with vast amounts of debt taken onto government balance sheets. 

In America, the Federal Reserve moved hurriedly to lower rates towards zero, whilst asset purchases and a plethora of credit and liquidity lines were introduced to prevent capital flows from gumming up. ‘Helicopter’ handouts to households were delivered, with the combined effect plainly seen in an exploding M2 money supply figure:

In Europe, policymakers reached for a similar playbook, with deficit limits immediately suspended, a Pandemic Emergency Purchase Programme and a five-year, €750bn European Union Recovery Instrument launched by the European Central Bank to assist those hardest hit. Meanwhile, UK public spending efforts to tackle the pandemic cost approximately £6,000 per person, or £410bn in total. 

The largest burst of emergency spending in history broke the grip of the deadly pandemic and spared the global economy from ruin. However, with interest rates back at near zero , abundant liquidity in the system and many households much better off financially than prior to Covid, risk appetite and investment speculation returned reflating asset prices to extraordinary valuation levels.

Meanwhile, Covid-19 and its various mutations exposed chronic weaknesses in the concept of globalisation and just-in-time supply chains, triggering a behavioural change from governments and corporations who saw an urgent need to re-prioritise economic and energy security. In short, the winds have shifted:

If history is any guide, the following might prove useful. Deutsche Bank looked at what normally transpires when inflation in an economy hits 8 per cent. The study used 50 developed and developing market countries, comprising 126 unique observations and covering over 50 years of data (post the 1970 break with Bretton Woods): 

The conclusion is that, contrary to current consensus expectations which are amongst the most optimistic over this period, it would be unusual (caveat: not impossible) to see inflation fall back quickly to previous levels. 

Future portfolio effect

A combination of soaring inflation, rapidly tightening monetary policy and deteriorating growth is the antithesis of the investment conditions of the past 25 years so allocators should prepare for a change in cross-asset relationships, notably between bonds and equities.

With that in mind, our assessment is that they need to consider expanding their multi asset allocation menu, particularly in areas such as absolute return strategies, volatility dampeners, real assets and alternative income streams - securities that exhibit conventional bond characteristics, namely lower than equity volatility and a sustainable and attractive yield. 

Equally important will be flexibility to take advantage of short-term opportunities that episodes of volatility and dislocation will bring. 

Looking ahead

In the UK and Europe, helicopter hand-outs to consumers and profit caps on energy producers are stoking inflation, increasing aggregate demand at the time time as restricting supply. Political pressure has superseded common sense. The populist ESG and ‘green’ agenda has also ensured that little to no new infrastructure investment has taken place for a decade. Energy commodities remains attractive.  

The UK, post recent political and market drama, stands out in both on valuation and cash flow, whilst sterling’s dramatic plunge against the dollar will have corporate raiders sharpening their pencils. 

A similar scenario applies to Japan, where the Bank of Japan governor Haruhiko Kuroda’s yield curve control policy has crushed the yen. Listed companies are cheap, evidenced by a quadrupling of share buybacks over the past decade, and flush with cash. A potential kicker exists in the form of a reintroduction of tax-efficient savings schemes.

In the US, fast-moving data (airlines, home sales, new and used car prices, semiconductor chips, global shipping rates) is beginning to fall, in some cases sharply. Amazon vendors are ‘cutting prices, adding coupons’ ahead of an expected bleak holiday season.  Those large cap technology stocks and associated sectors such as warehousing, logistics and related commercial property, would likely be among the assets to suffer further downward pressure in the months ahead. 

The data the Fed is currently observing to influence decisions acts with a lag. This is likely to extend the global inflation cycle and ensure that the interest rate pedal is kept to the metal, pressuring risk assets. However, everything comes at a price, and the repricing in sovereign and investment grade debt has been short and sharp, and as always, such a repricing creates opportunities.

But either way, volatility is likely to remain very high, and require flexibility from investors in the months ahead.  

Craig Farley is head of multi-asset at TEAM.