RSMR’s O’Neill: regime change rules the world
The past decade has been a remarkable and benign period for holders of financial assets, with markets led by growth stocks, especially large-cap US technology names.
In the decade ending 31 December 2021, total returns on US equities averaged 13.7% per annum whilst the Nasdaq delivered a remarkable 21.4%. Global equity markets delivered over 9% in US dollar terms over the decade. Looking at bond markets, US Treasuries delivered positive returns of 3.0%, a major factor behind traditional 60/40 portfolios performing consistently well.
Investment regime change
Until this year, market setbacks in the post financial crisis period have been caused by concerns surrounding demand rather than supply shocks. A world driven by supply rather than demand shocks, as we are now facing, may herald a very different investment regime than has prevailed in the past 30 years, in which the risks of far less benign returns from financial assets have risen considerably.
Central banks, for example, must now grapple with higher inflation. 60/40 portfolios could previously cope with demand shocks because bonds rose in value. But with higher inflation, equities suffer because of the higher discount rate applied to future corporate earnings, while bonds suffer due to the impact of higher inflation and interest rates on the nominal returns offered. Therefore, bonds may not effectively dampen down portfolio volatility at a time of rising inflation.
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Looking at valuations, the past decade saw high growth rates in both corporate earnings and dividends, well ahead of nominal GDP or inflation. The extent of the valuation re-rating can be seen in the Shiller CAPE (cyclically adjusted PE ratio) which stood at 20x in 2011 compared to 40x today. This is the market re-rating that has driven the bulk of equity gains.
Geopolitics
The global economy has benefited for some time from relatively stable geopolitics, now a second and very real area of regime change. Globalisation is likely to be in decline for many years as countries and companies come to terms with the challenges of food and energy security and distant supply chains. Re-shoring supply chains is likely to be inflationary.
The impact of ‘greenflation’ is also being felt, with energy majors being encouraged to reduce fossil fuel output. BP in their recent results described reducing fossil fuel production 40% by 2030 compared with 2019 levels. This underinvestment in natural resources partly explains the higher prices prevailing today and why supply shortages are likely to persist.
Importantly for asset prices, the long-term downward trend in nominal and real interest rates accelerated post the financial crisis. Long term bond yields were depressed by central banks in the developed world adopting QE. This, combined with the decline in equilibrium short term real interest rates which in an era of secular stagnation became negative, drove the upward re-pricing of equity markets. The reduced discount rate favoured long duration assets such as equities in the US and Chinese technology sectors.
What can we expect?
However, we remain focused on the three long-term drivers of equity markets: fundamentals, valuation and sentiment.
The first of these – fundamentals – have now become much less supportive.
Equity valuations coming out of the pandemic, unlike post the financial crisis, were at high rather than low levels. Concerns over inequality have also resulted in policy change by most governments, aiming to raise the minimum wage and share of wages in national income, which could put pressure on corporate profitability.
Higher levels of fiscal policy, including higher defence and energy security spending, also suggest a higher level for neutral interest rates. The impact of a green or clean energy revolution will only add to these pressures.
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When investors feel able to look beyond the current conflict in Ukraine, economic fundamentals and valuations will argue for a more cautious and selective approach.
We expect lower returns than over the previous decade as asset prices adjust to the new investment regimes of higher inflation and heightened geopolitical tensions. This is not to say equity prices will necessarily be negative, but markets are more likely to de-rate than re-rate upwards. For returns to be positive, this effect will need to be offset by earnings growth.
Longer term, if secular disinflationary forces reassert themselves, as forward inflation rates currently imply, the outlook for asset prices will remain positive over the medium to longer term. However, if higher inflation expectations become embedded and there is a return to the economic environment of the 1970s or 1980s, investors could face a challenging decade.
Fund selection will be ever more important in an era when there isn’t a rising tide lifting all boats.
Graham O’Neill is senior investment consultant at RSMR
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