Investment Strategy Observations May 2023

Ronan Smith

1.  The Nature of Long-Term Investment

Many investors do not remember the 1970s. Mainstream portfolio assets lost enormous proportions of their purchasing power. Consider the experience of holders of UK equities during that period (where most Irish equity investors were invested).

The table below shows the index value of a UK equity portfolio (Base 100 at the end of 1968). By the end of 1974, following the OPEC oil crisis, the portfolio with dividends reinvested had fallen by 48%.

Value of UK Equity Portfolio, income reinvested, gross of tax

Source: Barclays Equity Gilt Study 2015

The subsequent recovery was swift. The portfolio was making money by the end of 1975 and continued to appreciate. But high and prolonged inflation meant the investor’s purchasing power had, in fact, fallen to 29.8% of its start value by the end of 1974. It was still down in real terms at the end of 1982, after fourteen years.

1982 commenced an era of wealth generation that ended last year. During that era, global politics shifted to the right, there was coordination of monetary and foreign exchange policies, financial services deregulated and barriers to trade were eliminated. Global demographics meant there was a constant supply of surplus labour from less-developed economies. Productivity was enhanced by IT and communications technology.  So, company profits grew dramatically while interest rates fell from highly inflated levels to zero and below. Both effects boosted equity values. Meanwhile, falling interest rates benefited long-term bonds enormously.

This form of wealth generation did not apply to everyone. The losers were average and lower paid employees. Labour’s share of national income fell sharply from 1980 to 2009, in the US (from 65% to 58%) and UK (from 80% to 71%).[1] Wage rates grew only marginally since the 1980s to this year, while corporate profits mushroomed.

Deregulation, low transaction costs and taxes allowed portfolios to be managed efficiently. Investors, therefore, easily racked up returns well ahead of inflation, which remained modest under careful central bank stewardship. The consequences for inequality of income, but especially of wealth, were severe.

Of course, this is a very long-term perspective: there were many phases during the past forty years when investors were blindsided. Those who were extended during the tech bubble in the late 1990s and the Great Financial Crash, took some years to recover losses.

So, should we be trying to spot in advance those periods when a major asset class fails? One thing is certain: we should not try to call policy shifts, earnings surprises or other market drivers that tend to happen within a year. Even trying to foresee those occasional periods when markets go significantly awry must be tempered by an appreciation of the grinding efficiency that dominates most capital market activity. This efficiency means that, most of the time, markets have already priced in anything that you are likely to have any confidence about forecasting.

It makes sense, instead, to think of your portfolio as a collection of risks and to use your understanding of the current environment to evaluate those risks and to find ways to manage and limit them.

For me, the major risks facing portfolios now concern inflation: the impact of future inflation on the purchasing power of the portfolio and the effects of inflation on market values of assets and on economic policies that affect markets.

2.  Inflation

Inflation has peaked but has not subsided. Instead, it has become embedded in the global economy. Despite energy prices abating, price rises are passed through in a cost-push cycle, especially in services, food and consumer goods. Historically, it has usually taken some years to break this cycle and get back to policy inflation targets. In the developed markets, policy inflation is about 2% per annum – though that could change upwards. The IMF has recently published a forecast for consumer price inflation in these markets of 2.6% by 2024, reasonably close to the original policy. Many market analysts broadly share this expectation and market-implied forecasts for inflation are similar.

I believe, however, it will take longer to get back to policy target inflation because:

  • Inflationary behaviour has become embedded.
  • Monetary conditions will ease periodically when stresses arise (such as Silicon Valley Bank and Credit Suisse).
  • The ultimate intention of central banks is to get inflation back under control eventually, but that may take longer than many expect because a) economies are potentially on the brink of a recession and it may be worth trying to avoid one; and b) inflation reduces the government debt burden caused by deficit spending over many years and accelerated during COVID-19. This allows for some ‘compromise’ in the battle against inflation.
  • Labour markets remain tight.
  • Risks remain of renewed supply bottlenecks and energy shortages arising from the war in Ukraine and from trade wars.
  • Official sources and some market analysts have a natural bias towards forecasting a favourable inflation outcome and some may fear being in any way responsible for stoking inflationary expectations. So, expect them to be biased to the downside.
  • Significant cash balances remain in personal and corporate accounts to allow consumers and business to pay higher prices when necessary.

I also expect that the policy target will be lifted discreetly over the next two years, probably to around 3%, driven by the structural change in the global supply of labour, demographic dependency and the increased global propensity to run fiscal deficits.

3.  Bank Troubles

Since the collapse of Silicon Valley Bank in March, some other banks have faced difficulties, notably the banking giant, Credit Suisse, which collapsed days later, leading to regulatory intervention and forced takeover by UBS and First Republic Bank in Pennsylvania, whose banking business has been bought by JPMorgan.

There has naturally been some concern about bank security and rapidly rising interest rates. Savers have accelerated withdrawals from many banks, although mostly driven by chasing higher interest rates that have been offered by other banks.

While there are some minor parallels to the Global Financial Crisis in 2008, it is most unlikely that we are witnessing a repeat of that event. Banks have healthier capital ratios, there is lower leverage throughout the global economic system, and central banks are vigilant. A recession may happen, and some banks may suffer, but a repeat of the degree of contamination and banking crisis seen in the GFC is a remote risk.

4.  An Emerging World Order

Thirty years ago, the Cold War was replaced by a period of US hegemony, with China emerging as a new imposter, apparently more peacefully ambitious and chasing prosperity via the strength of its trade with the West and the rest of the world.

Putin has changed all that. While the US has been busy strengthening NATO and involving Europe to a greater extent in the defence and expansion of the West, China has been doing a good job developing alliances with other key powers, including Russia. Russia’s economy has remained buoyant through increased trade with India and China. Brazil is ambitious to develop stronger ties with China, to counterbalance what it sees as the US’s aggressive approach to world politics and conflict, and has continued to trade with Russia. Even the US’s relationship with and standing in Saudi Arabia is not what it was during the past half century.

The US may still be the world’s strongest economy and military power but its leadership is faltering. Its main ally, Europe, is fragmenting and economically sclerotic. The old adage attributed to the aftermath of the 1929 Great Crash that when America sneezes the world catches cold, may soon be archived.

What this means for investment is that portfolios should have access to the opportunities presented by economic activity in these newer powers. In simple terms that means including an element of emerging markets exposure. That has not been a profitable step throughout much of the past decade but is the right one to avoid over-dependence on the declining western ‘empires’.

5.  Artificial Intelligence

AI is at lift-off after decades of stuttering development since the term was coined in 1956 by John McCarthy. The most recent products in this field, generative AI (the ones that write essays on request), highlight many policy dilemmas. They challenge copyright law, undermine originality, threaten to replace labour on an unprecedented scale and pose immense challenges for competition authorities and for societies already excessively dominated by leading tech firms. They depend on ‘Big Data’ and on all the privacy issues that it gives rise to. But worse could come in the form of ethical dilemmas and legal difficulties associated with other emerging forms of AI, in which the manner of learning of the human mind is replicated and AI machines can become ‘sentient’ and ‘conscious’. We should expect AI to be one of the major themes of investment over the next few years.

6.  Trends in Investment Management

The integration of sustainability and ESG into the professional management of portfolios is one of the strongest trends in that industry in recent years. Managers and regulators alike are feeling their way in a very complex maze and much of what is happening, though well intentioned, may be inefficient for investors and unlikely to improve climate and other widely desired outcomes. But there are other trends and I find it useful to consider them as a background and source of insight into choices investors might make.

Since the 1980s, passive management has grown rapidly and accelerated in recent years. Because it is cheaper than active management and because it helps managers avoid some behavioural investment traps that lead to widespread underperformance, passive management can be the best way to access some markets, particularly liquid equities. But there are times, such as during the past few years, when the indices are distorted by very large and very overvalued companies. At such times, finding a competent active manager can be worthwhile.

Investment management has, like other business, gathered and used vast quantities of ‘Big Data’ and has used it in trading algorithms and investment analysis. However, the focus on data creates two key weaknesses: first the focus is on measurable factors rather than the most relevant: that leads to herd behaviour and creates value anomalies that astute observers can exploit; secondly, it shortens time horizons: data, after all, relates only to the past and usually provides models for short-term forecasting only. Investors willing to take the longer view, meaning they are reasonably indifferent to what happens to their investments over the next two or even three years, can often find unquantified but clear sources of value that busy professionals miss.

Alongside the greater facility for managing data and quantifying portfolios, there is an ever-increasing tendency to use derivatives to fine-tune portfolios, manage cash flows, and hedge certain risks. However, derivatives can also materially increase risks, generate costs and create misunderstandings. The experience of UK pension funds last autumn is a good example: a sudden rise in bond yields by more than had been stress tested caused portfolios designed to hedge interest rate risks to fall apart, with long term consequences for their ability to make returns and, in some cases, to survive.

There has also been a strong trend towards private assets, those that are not traded on markets. These are accessed by individual investors by means of closed-ended funds in which capital is usually committed for many years. Illiquid assets are also held in open-ended funds, particularly property. Both forms can be less liquid than many investors may desire, particularly when circumstances change, and both, especially private funds, carry very high costs.

A recent debate[2] arose between two of the world’s leading investment managers, Blackrock and Vanguard, about the wisdom of a traditional 60:40 portfolio (60% invested in mainstream global equities and 40% in government bonds in the investor’s base currency) for a typical long-term investor. Blackrock do not favour this at present because the traditionally low or negative correlation between bonds and equities reversed last year. They think that rapidly rising interest rates will hurt equities by slowing the economy while they will, by definition, also devalue bonds.  They look instead to many of the new, diverse, asset types mentioned in the preceding paragraphs, particularly private assets. At the same time, they argue that the current difficult environment requires investors to be more nimble – hardly likely if invested in illiquid assets! I strongly favour Vanguard’s approach on this matter: traditional mixes of primarily liquid assets, with a minimum of interference is wisest. Avoid the risks of the unknown, the unaccountable, the over expensive and the inaccessible. Old relationships will reassert themselves shortly so that bonds will act as a sensible counterfoil to the volatile but more profitable equities, while portfolios should always leave space for easy-to-access liquidity and some assets that will benefit if inflation stays high.

7.  Investment Outlook

Of the two major asset classes in aggregate, global equities and government bonds, equities offer substantially better return prospects over the next three to five years.

For the coming twelve months, however, there is a significant risk that equities could underperform. It depends on how inflationary pressures unfold, whether the already higher interest rates generate further banking or corporate credit difficulties and, above all, on the determination central banks demonstrate to return inflation to its target level.

Central banks seem resolute in bringing inflation back to target, so a recession is likely. Nevertheless, inflation could take a few years to drop substantially below 5%. Earnings may decline modestly rather than collapse. Only a few lenders should be affected and the rate of contamination should be modest. Some indebted governments may find the going trickier.

We should expect slightly higher interest rates than at present for a good deal longer than markets anticipate. Equities should hold up reasonably well despite worries and despite technical recessions. Dips, however, will occur and may be substantial because central banks are now less likely to loosen the purse to rescue them, but I don’t expect that weakness will be sustained.

Longer term, the prospects are for inflation to average 3% in developed economies, not 2%. Developed economies’ growth should be slow as should growth in China (despite a surge following the pandemic reopening), mainly due to trade wars. Ageing demographics will work against equity values. Political cycles globally tend to last for decades and recent patterns have been destructive of wealth. For all these reasons, equities, while they will still outperform other major asset classes, will earn a much smaller premium than before. It is not unreasonable, when long term investment planning, to think of before tax annual returns of: cash at inflation plus 0.5% (3.5% nominal return), long bonds at 1.5% in real terms (4.5% nominal return) and equities returning a real 3% (6% nominal return).

[1] Source data: Piketty, T. 2013. Le Capital au XXIe siècle (Paris: Seuil)

[2] As characterised in Financial Times, 19 April 2023, Page 13






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