Policy in a new era is gradually becoming clearer. Linchpin looks at what matters to those setting strategic asset allocations and concludes that long-term investors are well-placed.
We are moving into a new era for markets, something I have predicted for a number of years now. There has been a substantial rise in bond yields and some falls in equity markets. In the near term liquidity conditions, as measured by our friends at CrossBorder Capital, are close to the tightest they have been in 65 years.
The new cycle is emerging out of the old
CrossBorder also point out that US bond term premia have continued to fall over the past two years, even though bond yields have risen. Investors are willing to take the risk of having to reinvest at a lower rate in the future to secure safe assets in the short-term. This is further evidence of a liquidity squeeze and a shortage of safe assets to collateralise short term and repo lending. Falling term premia is also a strong signal of recession to come, which is consistent with many other signs in both the market and the real economy.
However, as always, the conditions for the next upward swing are slowly coming into place before the old cycle has bottomed. Central bank policy remains very tight almost everywhere in the world, but the strategy seems to be shifting to one of raising interest rates while being willing to provide liquidity at the same time. I quote directly from CrossBorder Capital’s most recent update: We may be heading for the Full Bagehot! Recall the Bagehot Rule: lend freely, at a high rate of interest against good collateral. Up to now, policy-makers have been doing the opposite – expect this to change... in short, we are likely entering a structurally higher interest rate and flexible liquidity regime.
This contrasts with the regime for much of the last fifteen years, where interest rates have been very low and monetary policy has seemed to be one of almost unceasing easing. It is also different from the last fifteen months where the emphasis has been on tightening. Behind this new shift central banks are recognising that while inflation must be mastered, the world’s financial system is still fragile.
Key features of the new era for investors
LGPS funds will over the next few months be reviewing their strategic long-term asset allocations as the results of the 2022 actuarial valuation come through. It will be particularly important that they look forward to the new world rather than backwards to the old one.
I suggest that the next ten years will bring some or all of the following:
Higher interest rates and bond yields as a result of central bank policy. This will increase the likelihood of corporate defaults, but long-term investors should be able to provide collateral and liquidity at advantageous rates.
Higher inflation levels, though policy-makers will succeed in keeping it under control.
Fiscal pressures on governments: if they can’t inflate away the debt they have incurred, taxes or spending will have to give at some point. This will lead to lower trend growth rates in the West.
Demographics will swing in favour of labour, as the working population declines and dependents rise. This may reduce profitability and add to inflation levels. It also probably means that savings levels remain high, as older people spend less.
The march of tech will continue both to create new industries and also to displace humans from old ones.
Geo-politics is the biggest risk
Geo-politics remains the imponderable swing factor. The gradual subsiding of the U.S. as the world’s policeman suggests a more volatile world, with numerous consequences. The growth in autocracy is likely to lead to more wars, and hence to the displacement of populations to ‘safer’ countries such as Europe and the U.S. China’s ambitions to be a superpower may well lead to two trading blocks in the world, with a negative impact on globalisation. Governments will probably have to spend more on defence, as Germany has recently recognised.
Why long-term investors should benefit
Long-term investors should be well positioned for this world, simply because they are a source of capital at a time when it is going to be scarcer and more expensive. However, gauging the right entry point and selecting the right manager will become more important. I draw the following conclusions about particular asset classes:
Public equity markets may fall in the short term but returns in the future will be in line with historical ones. The volatility of both individual stocks and markets more generally may be higher. At the margin, equity investing may become slightly less attractive.
Bond market correlations with equities will fall, making them once again an investable asset for long-term investors. Yields may rise further, but they provide ballast, income and diversification, all of which are valuable.
Long-dated inflation-linked gilts now yield -0.2% and are a reasonable short-term hedge against the risk that inflation may stay higher for longer
Private market returns may reduce as leverage becomes more expensive and taxation regimes less favourable. However, they have the advantage of not being marked to market, so any volatility is less evident.
Newer emerging markets in Africa and Asia ought to be well-placed, with better demographics, lower debt, and more scope to use new technology. But will the West and China eat their lunch?
If you would like to discuss any of this further, please contact me at research@linchpin-advisory.com