However, what constitutes the ‘new normal’ is uncertain and inevitably such uncertainty creates market volatility.
Investors have to figure out where this path is leading them.
As tepid as the post-Global Financial Crisis recovery was, the post-lockdown recovery has so far been very fast.
Post-2008 high inflation was not an issue but in this cycle it has been higher and stickier.
Moreover, demographics, deglobalisation and decarbonisation all suggest that the post-1980 disinflation is a thing of the past and that inflation will settle higher and retain upside risks.
This is important because inflation pressures and central bank reaction functions will most likely define the tenor of this business cycle.
If higher inflation is the new normal, then central banks are right to implement faster rate hikes.
For equity investors this dilemma has so far played out as a rotation from growth to value. Strong economic growth and high inflation suggest upward sloping yield curves.
Within equities, this is perfect territory for banks and commodity stocks.
The prospect of higher discount rates also suggests the sell-off in technology stocks may have another leg to run.
Equally, most physical commodities should fare well, especially industrial metals. But for multi-asset investors, this environment presents as many issues as opportunities.
Although spread product may break even, government bonds will offer little diversification.
Even inflation-linked bonds would fare badly as the change in real interest rates could offset the inflation uplift at most tenors.
In theory, this is also bad for precious metals, as the real and opportunity cost of owning them increases.
Finally investors should also be wary of property as new life/work patterns have not yet fully played out.
The change in outlook has been swift and brutal and no doubt many equity-growth focused investors are considering jumping on the cyclical-value train.
They should exercise some caution. Going with the rotation would appear to be a short-term trade opportunity now and timing markets – getting two transactions right over a short-time frame, both of which limit the probability of a profitable trade – remains difficult.
Firstly, the wind could change. Economies seldom move to a new paradigm overnight.
While there is little doubt interest rates do have to rise, there has been a certain feel of ‘playing to the gallery’ in central bank guidance lately – after-all, higher interest rates are unlikely to resolve supply side constraints.
In a world where the gig economy rules, it is pretty difficult to see a wage price spiral emerging and rising energy prices eventually become disinflationary as they damage economic growth.
If inflation eases – perfectly feasible by the end of the year and into 2023 – then pressure on central banks to act quickly will falter and the pace of adjustment in the bond market should then slow.
Secondly, the ‘great rotation’ has already closed a considerable portion of the valuation gaps which existed at the start of the year and many value stocks now trade close to their ‘normal’ price points.
Value sectors have not suddenly gained structural tail winds, so it is difficult to see how their long term earnings growth prospects have improved and ultimately it is earnings growth which drives stock prices.
Stable bond markets will allow earnings growth to become a more dominant return factor so consequently it is difficult to argue for much greater valuation narrowing.
The equity growth style factor is back in play at this point, industrial metals probably still perform well and the pressure would be lifted a little from bonds and gold.
This is still a difficult environment for multi-asset investors.
Those looking for protection could consider tail hedges contingent on changes in yield to offset the cost of option strategies, whereas diversification within equities could be achieved with a spread of sector bets.
However, in the long term volatility does not matter.
Bumps in the road are not mountains to be climbed and in uncertain times, maintaining conviction in a long-time horizon still remains the best approach, as it does not imply a cost and limits the potential for error.
For now that means looking through the short-term noise of supply chain issues and building positions in high quality assets when discounts emerge.
Good companies are not necessarily good investments but likewise a good companies do no’t become bad investments simply because they are cheaper.
Companies which have long-term growth prospects above the market average, with strong balance sheets, quality management and defensible competitive positions should be able to pass on price increases and grow their earnings in a sustainable way through the volatility.
In the end, the new normal might look a lot like the old normal.
Richard Garland is a portfolio manager at Berenberg
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