The world has changed dramatically in the last few years. Many of the old certainties are behind us. In this new world, what worked well for investors in the past might not be appropriate for the future. We believe that that the new era will be more difficult to navigate for investors. This is especially the case for people close to or in retirement. This group does not have the luxury of waiting potentially decades for improved returns.
Inflation and interest rates
In our opinion, the era we are just leaving began in the very late 1980s with the dissolution of the Soviet Union and the end of communism. This was obviously a remarkably positive event in world politics but economically, the most significant development was the transition within China from virtual isolation into a global export powerhouse. As highly competitively priced Chinese goods flowed out, a profound disinflationary impulse spread across the world. The cost of borrowing fell dramatically for most Western countries. During these decades, thanks to China, inflation was never an issue. This allowed Western central banks to keep rates very low, and to add, at times, massive amounts of new money. This stimulus appeared to have few adverse effects on economies and very positive effects on asset prices such as property, bonds, and equities. In such an environment, investing in any of these asset classes was the most important decision, along with buying any meaningful dips.
We believe that this world is now in the rear-view mirror. Inflation is now with us, driven by massive central bank stimulus, and is unlikely to go away. Meanwhile geopolitics has shifted from peace and internationalism into something a little more dangerous, adding another inflationary force, deglobalisation.
UK Long-term interest rates
Source: World Economic Forum.
We think that the most profound change might be a turn in the long-term interest rate cycle. After rates have largely fallen for the last forty years (see graph above), markets now face the prospect of resurgent inflation. One of the most notable characteristics of these long-term interest rate trends is that they tend to swing to greater extremes than many expect. In the 1940s the idea of double-digit interest rates would have seemed impossible, and in early 1980s, the idea of interest rates below 1% would have seemed laughable. In the UK, over the very long term, measured in centuries, a ‘normal’ level of interest rates is around 6%. However, one extreme leads to another. It is quite conceivable to imagine that the next forty years will see steadily rising interest rates, potentially to levels that are unimaginable today. The more the pendulum swings in one direction the further it eventually swings in the other. This is unlikely to be a positive backdrop in general for most property, bonds or equities.
Equity valuation is also important. It is useful over longer periods but not in the short term (where markets generally react to news flow). A valuation metric that works well over the long term (+10 years) is the Shiller cyclically adjusted price earnings ratio. This valuation tool (invented by Professor Shiller of Yale University) smooths out the effect of the economic cycle giving a clear ‘across the cycle’ picture of valuation.
Shiller cyclically adjusted price earnings ratio for the United States
As can be seen in the chart above, the Shiller price earnings ratio for US equity market is high. Even after the recent Ukrainian shock it has only ever been higher during the dot com bubble after which markets fell sharply. We have analysed this data set extensively, and from current levels the Shiller price earnings ratio is predicting negative returns for US equity investors over the next decade. Historically substantial market movements are mirrored across the world, including in the UK.
Economics and politics
Rather than openness and expansion the world seems to be retreating into a more nationalistic and defensive position. It is not just recent events in Ukraine that make us think this. China is now clearly regarded as a threat by the West. Even after the European Union’s positive response to the Ukraine, we think the trend for national politics will continue. After failures in Iraq and Afghanistan, the United States is a far less confident and expansionary force. It is also the case that some troubling trends in national indebtedness have been exacerbated by the pandemic. Sovereign debt to GDP in Greece is now 238%, in Italy it is 184% (both OECD statistics). If interest rates rise, these levels of debt imply great fragility. We think a financial crisis at some point seems inevitable in Southern Europe. Inflation also means food inflation and this itself has often been a trigger for political upheavals and revolutions, especially in poorer countries.
Surely diversification, the favoured technique for conventional long-term investors, can help to ride out this environment? We believe not. As the world globalised from the end of the Cold War onwards, it became easy for a regular private investor to buy their own stock market and pretty much any stock market in the world. As a result, nearly all stock markets increasingly move together.
Furthermore, we think diversifying a portfolio by adding fixed income might also disappoint. At current yields a UK 30-year gilt would almost half in price if the yield rose to the long-term UK average of 6% (bond prices fall as yields rise). However, there might be a case for a greater allocation to precious metals and commodities in general.
What is appropriate for a new world of investing?
During what has been a relentless bull market for nearly all asset classes, it is perhaps not surprising that low fee, passive index funds have grown enormously in popularity. However, if you agree with our new world view, this is the time for active investment. Choose your fund manager carefully. Look for genuine active fund managers, willing to de-risk portfolios and make meaningful decisions, not just pruning at the edges. We try to do this at WoodHill, with some success.
In our view of the world, investing is getting a lot harder. We are potentially moving into an environment of selling bounces rather than buying dips. We think preserving wealth is becoming the priority, especially for those investors looking to live-off investments made over the last 30 years or so. A reassessment of investment strategy is surely timeous and correct.
Author: Paul Wood CIO of WoodHill Asset Management.