All-weather investing

August 19, 2022 10:29
Photo: Reuters

The world has changed. We are living through a pivotal time in history, marked by geopolitical realignment, high inflation, volatile financial markets and the end of a 40-year period of declining interest rates. The title of this new era could be “Brave New World” or “Back to the Future”. But I think “Revenge of the Boomers” is most appropriate, because a lot of these events rhyme with the past, particularly the early 1960s. That is when we saw interest rates bottom out after decades of decline, as well as the rise of the Cold War era, which is unfortunately rearing its head again in some respects.

Despite these challenges, I remain optimistic about the investing environment for several reasons. First, there are still signs of growth as the global economy recovers from the pandemic. Second, I believe corporate earnings will be the driving force of equity markets going forward, as opposed to multiple expansion, and that signifies a welcome return to fundamentals. Multiples needed to contract, and that is what we have seen over the past few months.

Third, I think we will experience a healthy recession in the next year or two. That’s right, a healthy recession. Despite all the worry about it, I see a moderate recession as necessary to clean out the excesses of the past decade. You can’t have such a sustained period of growth without an occasional downturn to balance things out. It’s normal, expected and healthy.

What this means for stock markets

We are heading into a period of real change, a fundamentally different marketplace where different leadership will emerge. That is in sharp contrast to the 2020 COVID-19 downturn, which was really a temporary blip in a decade-plus bull market. We know this because the same stocks that led the bull market — a relatively small group of tech-related companies — did so on the way back up.

In a true market shift, the leadership coming out of a bear market is usually a new sector or a new group of companies. And it’s not necessarily the same group that led on the way down.

That said, I wouldn’t count out the FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks, but I think it is going to be a very different market going forward. It won’t be driven by a small set of stocks anymore. It won’t be characterised by growth vs. value, or US vs. the rest of the world. Those binary concepts don’t make sense in this environment. The market will be less one-dimensional, and a broader mix of stocks will be expected to lead us out of this downturn.

What this means for bond markets

We are also seeing a profound shift in bond markets as we reach the end of a 40-year path of falling interest rates. Sharply higher inflation levels, not seen since the 1980s, are forcing the US Federal Reserve and other central banks to aggressively tighten monetary policy. The Fed is behind the curve, which means rates are probably going to move higher from here.

However, that doesn't mean we are going back to exceedingly high inflation and interest rates. It just means that, for decades, we lived in a declining rate environment that has been highly supportive of markets. That is all changed. Things are likely to be more difficult going forward. But even amid these headwinds, opportunities will emerge.

Is this the end of a 40-year declining rate period?

That is one reason I like to call this era “Revenge of the Boomers,” because it is reminiscent of the 1960s. Interest rates moved higher, but they didn’t spike to 16% overnight. It took decades for that to happen, and there were many policy mistakes along the way. Throughout the 1960s, rates stayed in the 3% to 6% range. It was a volatile period, but overall, it was a good environment for investing. The real trouble came later in the 1970s.

Fixed income providing diversification from equity risk

In the meantime, it is important to remember that higher nominal interest rates are good for savers. This is a novel concept for younger folks, but boomers grew up in a world where interest rates were sufficient to earn a decent return on savings accounts and money market funds. That is a positive change. It makes people feel better about saving, and I see it as a solid underpinning for the market.

Over time, higher rates will also bring income back to the fixed income markets— something that has been sorely missed in the era of easy money. The importance of that shift cannot be overstated. It should eventually restore bonds to their rightful role of providing diversification from equity risk.

Along those same lines, some inflation is a good thing. It allows well-positioned companies to raise prices, and it results in generally higher wages. That makes people feel better about their jobs and progress. It is hard to predict what will happen to real purchasing power, but we have seen in the past decade that without a little inflation, people feel like they’re not getting ahead.

What this means for investors

Maintaining a balanced, “all-weather” portfolio makes sense in any environment, but particularly this one. Market volatility has returned, but that is no reason to be discouraged. Indeed, the world has changed dramatically. But, for selective investors, change creates opportunity.

Copyright: Project Syndicate
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The writer is vice chair and president of The Capital Group Companies, Inc., chief executive officer of Capital Research and Management Company, and an equity portfolio manager.