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It is six months since we delivered Fidelity International’s new playbook for a world post-quantitative easing. Stock and bond markets have been through the worst year in a decade and now appear at least partially reset, but broader risks that we and others signalled would follow from a return to higher inflation and higher interest rates have also appeared.
As we discussed in our most recent quarterly outlook, the collapse of Silicon Valley Bank (SVB) in the United States, Credit Suisse’s denouement after years of concern, and the search for the next leg of a potential credit crunch, all significantly add to the tightening of conditions for corporate borrowers and households. In our opinion, the chances of that triggering some version of a hard landing for the US economy have risen significantly.
With that comes more volatility. But there are pockets of hope. Since Chinese authorities eased their Covid policy last year, the economy has reopened quickly. The central bank has strengthened monetary support, with room to do more if needed, and inflation in the world’s second largest economy is much more subdued than elsewhere. At the same time, the big structural challenges for the global economy, from shifting demographics and the need to decarbonise, will provide classes of assets that will outperform amid the volatility.
In this environment, we have zeroed in on three themes that are increasingly resonant as the year goes on.
Theme #1: Inflation protection
In contrast to China, Western central banks have tightened their policy stances. But inflation remains high, and to us it looks likely to persist due to both cyclical and structural factors. Resulting high interest rates are beginning to hurt the real economy, and recent stresses in the global banking system show policymakers forced into a trade-off between financial stability and price stability.
It is likely that central banks will have to keep rates high to deal with the continuing pressure from wages and prices, but policymakers are also striving to ease the impact on the financial sector with liquidity measures in the hope of avoiding further credit events that have potential to become systemic. The experiences of the ‘taper tantrum’ of 2013 and the US Federal Reserve’s short-lived balance sheet run-off policy of 2018 suggest that investors simply do not believe that economies can function under the weight of high real interest rates for an extended period. The cost of servicing the huge additional debts accumulated during the pandemic has only added to the difficulties for policymakers, and as the effects of pro- and counter-cyclical policies interact, it is possible that central banks will be forced to accept structurally higher inflation to avoid unacceptable system-wide economic turmoil.
How to respond? Investors need real returns that deal with the threat inflation brings. Real government bond yields are much higher than they have been over the past decade and offer value.
Likewise real assets can act as long-duration inflation hedges, with property income returns historically resilient to price rises. That said, geographical assessments are important here, given the issues being faced by the commercial real estate segment in the US.
Additionally, identifying high quality companies that are able to pass inflation on to customers is crucial. Those might be dividend paying companies that offer sustainable and growing income streams, or companies with competitive advantages that can generate profits higher than their cost of capital and, in turn, positive returns over time.
Theme #2: Emerging forces
Beyond conversations about the macroeconomic cycle and central bank policies, several structural trends continue to shape the global economy.
China is decoupling from the West economically, having emerged from the pandemic with a renewed focus on sustainable, domestically-driven growth. This decoupling is partly a result of the relatively benign inflation backdrop at home, in turn a function of other structural changes to the geopolitical and economic landscape. This decoupling generates challenges and opportunities for investors both in the short and medium term.
Decarbonisation, deglobalisation, and geopolitics will all make a profound mark over the next decade. Demographic changes, too, are inescapable, but China’s population may have peaked, and the push will come instead from other Asian and African countries over the next half century.
India is bouncing back from Covid, and its “Made in India” push could lead it to succeed China in keeping a lid on global prices. The desire of companies to diversify where and how they produce offers support to Prime Minister Narendra Modi’s efforts to replace or at least augment China as the world’s manufacturing hub, and its services sector continues to benefit from huge cost advantages and a strong skills base. All of this will enrichen a growing middle class whose borrowing remains low. That said, when it comes to investing, a focus on implementation remains key.
Finally, the urgent need for improved energy security means that investment in both renewables and energy efficiency will have to increase quickly. Bond markets will play an essential role in funding this part of the transition to a low-carbon economy.
Theme #3: Faster cycles
We also believe that the extraordinary steps taken to stave off financial crises and recession over the past decade coupled with the pandemic shock are already creating shorter, more volatile cycles, replacing the long period of benign low inflation that marked the build-up to the Global Financial Crisis. This environment requires investors to adjust their tactical and strategic decision-making.
Looking beyond long-only and benchmark-relative approaches, absolute return strategies can help optimise and diversify risk exposures, as they aim to deliver positive returns irrespective of market conditions, with low correlations to traditional asset classes and markets.
The market outlook is challenged both from a top-down and a bottom-up perspective, and this increases the need to look past traditional asset classes to achieve investment outcomes.
The strong start to 2023, with unexpected resilience across regions and sectors of the economy, looks to be fragile, and the likelihood of a hard-landing scenario has risen significantly. A cyclical recession remains our base case, but a more severe and longer-lasting downturn has become more likely. A lot will depend on how central banks navigate the trade-off between financial and price stability.
From an asset allocation perspective, that hammers home the need for caution. The risks associated with the current tightening of financial conditions are substantial and can be found in valuations in high yield bonds, the steep maturity wall due in 2024/25, and the ongoing tightening in lending standards. Yet the game has also changed: for the first time in a decade, bonds provide a baseline of meaningfully positive real returns and will do so for some time, and there are clear destinations for investment that will prove more durable and shock resistant.