Are we heading into a much more challenging investment environment?
Expected returns from most asset classes are at a record low. And it happens at the time when everything suggests volatility is very likely to pick up. Should we accept much less attractive risk-adjusted returns?
IMF has cut its global growth forecast for the 4th time already this year. The global economy has entered what some economists call a synchronized slowdown phase.
The Global economy has been expanding already for 11 years – the longest expansion phase on record. Some cyclical slowdown is therefore not surprising. There is, however, a strong divergence between what is happening in the manufacturing sector and the state of domestic demand. Global geopolitical tensions, especially between the US and China, are mostly to be blamed for and are affecting business sentiment much more than an average consumer. Yet, there are voices that even without the trade war the world would begin slowing down. De-globalization and slowdown in global trade are longer-term processes that began already before president Trump picked the sanctions and tariffs as a way of policymaking.
What makes this phase really dangerous is that the slowdown is happening when central banks around the world are close to their lower bounds of interest rates. There is a lot of discussion on the effectiveness and limits to further monetary stimulus. Even the central bankers admit that right now the fiscal policy is much more important and policy coordination is the key to protect economies and societies. In 2009, very few people expected crisis but policy response was well coordinated and effective. Now, everybody recognizes the deterioration but there is no agreement on the policy response. Countries that still have room for fiscal expansion are very resilient to do so despite calls from other countries and international institutions. There is even less agreement on structural reforms or global taxes (eg. carbon tax that IMF researched in their recent Fiscal Monitor: https://www.imf.org/en/Publications/FM/Issues/2019/09/12/fiscal-monitor-october-2019).
There is also another precarious aspect of the recent slowdown which is becoming more widely discussed. We are observing very low levels of growth, low interest rates and extremely high level of debts around the world. Income and wealth inequalities are large and rising what gives a perfect ground for populism to grow. It all looks increasingly similar to the conditions we had in the 1930s. How that period end up needs no reminding.
What are the market implications?
- Expected asset returns are historically low and will (unfortunately) remain so. There is no easy way out of the global debt trap and there are little chances for higher yields in the fixed income world.
- There is also no easy way to achieve higher productivity gains. Without that equity returns will also be meagre (that doesn’t obviously relates to all individual stocks but a broad asset class). Obviously, we might still see periods of the excellent performance of stocks but longer-term expectations are not encouraging.
- There will be more social upheavals and more geopolitical tensions. As a result, many assets will observe higher volatility and a higher risk premium (ie. lower prices)
- Another factor contributing to a higher risk premium is the liquidity premium. Structure of the financial markets over the last decade has changed and the depth of the market is now substantially worse than it used to be. We will see more dramatic price swings in less liquid assets (or even the liquid ones – just look what happened in the US repo market – the most liquid market in the world – in September this year).
- The countries that can demonstrate good governance and coherent social programs (aiming at reducing inequalities) should outperform those where governments will struggle with social unrests. The recent examples of Chile, Ecuador or even Hong Kong only show how social tensions could change the way we assess countries and what drives future returns.
- Precious metals should do ok in this environment as the demand for safe assets grows. Selected emerging markets should also still perform well.
There is another conclusion in terms of forward-looking expectations. Ray Dalio discussed that already at length. We are probably on the verge of some paradigm shift in the markets. It is hard to know how the change will look like and where are we heading but the current environment of low growth, low interest rates and high debt is not sustainable on the longer term. Hopefully, the shift will not end like in the the 1930s…