SustainAbility: Regime change

In recent weeks it has become increasingly apparent that the tectonic plates of investing are on the move.

Headlines about rising mortgage rates and pension funds having to sell assets are symptoms, not the cause, of the recent downward move in asset prices. The 2010s were a time of low interest rates and low inflation. It seems increasingly likely the 2020s will be a time of higher interest rates and higher inflation. This doesn’t mean that investing cannot be profitable – indeed the 2000s were a time of 5% interest rates and 3% inflation, and investors did well then – but the transition into this new regime is a bumpy one, with the turbulence currently getting stronger.

Since the global financial crisis (GFC) in 2008-09, the investment environment, until the start of 2022, was relatively benign and highly profitable for those invested in equity and debt markets. Deflationary forces, such as technology, shale oil and gas and globalisation, played a powerful role in keeping inflation at low and stable levels, which allowed central banks to set interest rates at low levels. Low inflation and low interest rates, and consequently steady economic growth, turned out to be a potent mix allowing asset prices of all kinds (equities, fixed income, property, etc.) to rise in value significantly with that ascent largely uninterrupted.

In hindsight, this stability began to end with the pandemic, which created an economic disruption so large that central banks and governments flooded the economy with stimulus of unprecedented scale. This was the right thing to do: however, when the economy recovered much faster than anyone expected, it was removed too slowly and began to create inflationary pressures. This was exacerbated by the war in Ukraine, the sanctions from which have also proved to be inflationary. As a final factor, globalisation is going into reverse and countries such as China and the United States increasingly see themselves as adversaries. All these factors have led to a historic rise in inflation, which central banks have not yet managed to control.

Interest rate rises push asset prices lower

As of today, central banks across the world are increasing interest rates at a pace not seen since the 1970s. This will have consequences for both asset prices and the general economy. As interest rates go up, the value of equities, fixed income, property, and other asset classes mechanically falls. Assets are worth more in a low interest rate environment than a high one. That is why we have seen equity and debt prices fall around 25% this year, depending on which market we look at. Property often follows next, as the higher cost of finance reduces the price buyers can pay. As this higher cost of debt works through the three key areas of any economy (consumers, government, and business), it will reduce the disposable income, borrowing ability and profitability of these sectors, which will impact economic growth, perhaps to the point of recession.

This is an overwhelming set of circumstances for any investor, even the grey heads who managed money through the financial crisis and after the technology bust of the late 1990s. I am one of those grey heads now and accept this is the natural rhythm of markets, but that doesn’t make it easier to work through. In these situations (2000-02 and 2008-09), the value of equities halved, and many investors decided not to continue. Both these bear markets ended, as they always do, and these endings heralded new bull markets. Although no one can predict the future, this pattern may well be repeated.

Are we there yet?

The most frequently asked question we get is ‘how far through this adjustment to a new regime are we?’ Of course, like the long journey with our parents when we were young, we wish we were already there, but the destination may be ‘just around the corner’.

The US inflation number for September, which came out last week, was again disappointing for those, like us, who can see many areas of deflation in the world of physical goods. No longer are there supply chain bottlenecks, and even commodity prices – the bane of inflation earlier this year – have come down. However, areas such as rent, healthcare and wages are remaining stubbornly high, the latter due to high levels of employment. These areas are currently outweighing the forces of deflation.

This means that the most important and powerful central bank in the world, the US Federal Reserve, will continue to raise interest rates rapidly, with all the previously mentioned negative consequences. Realistically, we need more evidence that inflation is falling before we can finally call this tightening cycle over. We still believe this is likely to occur in the coming months, as the economy inevitably slows, but it is a fine balance: over-tightening will lead to a recession, under-tightening to prolonged high inflation. This is a delicate and nuanced task.

The effect on portfolios

As equity and debt investors, these macro trends are currently the dominant influence on the investment performance of our sustainable strategies. We invest in high quality companies and entities, through equity and/or debt, and they will be more resilient than most through these turbulent times. Indeed, it is the expectation of times like this which makes us invest in this way. This has not mattered much this year, as the macro factors noted previously have been much more dominant in determining overall returns. This has meant we have given up some of the strong performance of previous years, and because equity and debt have gone down together (highly unusual – they usually move in opposite directions, but this is the impact of inflation) the falls have been greater than in the past. We think, however, that the sustainable trends we are locked into remain powerful drivers of future returns, and when the current environment passes there is no reason why our sustainable strategies cannot make further progress.

Grounds for optimism

As the saying goes, ‘if you want to be a successful journalist be a pessimist, if you want to be a successful investor be an optimist’. Of all the commodity shortages now, it is optimism that is perhaps the scarcest. Investors are as bearish now as they were in the depths of the GFC. What is underestimated at times like these is the ability of individuals, governments, and corporates to adapt to new circumstances. We saw this in the pandemic, where the scale of change in the way we work and treat disease was immense. How society will adapt to the current economic circumstances is the great unknown, but it surely will.

It should also be noted that lower prices imply higher future returns for investors (in the same way, higher prices imply lower returns). The income available from sterling investment grade credit, in excess of 7% for some RLAM funds, is highly attractive in a historical context. Also, the value of equities is now below their long-term average, albeit on profit forecasts that may not yet reflect an economic downturn. This is very different from a year ago, where credit income yields struggled to get above 2% and equities were expensive relative to historical averages.

No one knows what the future will hold, but every bear market in history has passed and economies and markets have reached new highs. This is something worth remembering in the coming weeks and months.

This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice.