Understanding the real correlations between investments and adding true diversification will be important.
Investment agility will be the key as we move from the quantitative easing experiment to the quantitative tightening phase.
The past decade has been dominated by structural forces reducing the long-term inflation risk. Digitisation, artificial intelligence, robotics, de-unionisation of work forces and super-efficient global supply chains have all conspired to put relentless downward pressure on prices.
Since the introduction of quantitative easing by the major central banks in 2009, bond-buying programs have artificially pushed bond yields lower and lower. Incredibly, bonds in negative yields peaked at just over $US18 trillion during 2021. The sole purpose of this exercise was to lower the discount rate, increase people’s capacity to leverage and create a little inflation.
The longer the quantitative easing experiment has persisted, the harder it has been for investors to resist. Equity risk premium – the extra component of return over the risk-free rate that investors demand to be in stocks – has risen. Returns for companies, particularly those with high growth rates and significant earnings potential in future years, have performed strongly.
Yield compression has also fed into other asset classes such as infrastructure and property. Money has flooded into new asset classes like cryptocurrencies and non-fungible tokens. Managers following long-term strategic asset allocation models have progressively remodelled their portfolio efficiency frontier and added increasing levels of correlated growth assets to hit their targets. The cost of holding protection strategies that cannot keep pace with the relentless equity rally eventually becomes too painful for investors, and they are abandoned. Active managers are replaced with passive index strategies and mandates to alternative strategies that are negatively correlated with equities are pulled.
But the cycle lives on and investors are often unprepared or badly positioned when things eventually turn. Central bankers have been reassuring us all for years that stimulatory policy should lead to higher levels of inflation. In the three weeks leading into the US Federal Reserve interest rate meeting in January, the real 10-year US Treasury yield jumped by 60 basis points from negative 1.1 per cent to negative 0.5 per cent. In response, the S&P 500 equity market fell nearly 10 per cent as the two-year forward price earnings multiple de-rated from 19 to 17.
Markets have since partially recovered, driven entirely by a re-rating in the price earnings multiple. You always buy pullbacks – right? While it is difficult to judge, it does feel like we have entered a different cycle that is characterised by greater inflationary risks and higher interest rates. So, we should be expecting that term premiums should gradually come back into bonds and equity risk premium should compress.
In the short term, everyone is grappling with the key question of whether inflation is structural or transitory. The likely answer is that it has elements of both. Strong consumer price index prints are forcing central banks to respond.
While the structural deflationary trends have not gone away, other things have certainly changed. Supply chains with single-point vulnerability are being reconfigured at often higher costs. The lack of labour mobility is adding to supply shortages and wages growth in certain sectors and countries. Even the noble push by companies to be more sustainable might be pushing up short-term costs, with the benefits likely to accrue further down the track.
The unknown for investors is at what yield level will private investors be prepared to step back into bond markets when central banks eventually step out. The most obvious answer is that it will happen when real long-run yields are at least positive again – a number above long-run central bank inflation targets. The pathway to get to that point will not be a straight line, and mini cycles are likely to be centred on a rising bond yield trend.
The reality is that the S&P 500 has fallen an average of 15 per cent peak-to-trough during the 21 non-recession corrections since 1950. Corrections rarely turn into bear markets unless the economy is heading into a recession. And with US corporate earnings expected to increase by 8-10 per cent in 2022 and the economy in reasonable shape, a global recession does feel a way off.
However, after returns of 29 per cent, 16 per cent and 27 per cent over the previous three years, investors are right to be cautious. This does not feel like a year to set and forget. The factors that have worked in the past are likely to give way to new ones.
Understanding the real correlations between investments and adding true diversification will be important. Investors will need to be cautious of crowded trades, where the slightest negative news can send more speculative owners stampeding for the door. While cash has never been the best returning asset in any given 12-month period, it can certainly rise to the top of the performance ladder from time to time. Managing portfolios in this new environment is going to require a fresh set of eyes and fair bit of dexterity.