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The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset Management
Markets are prone to recency bias. They tend to assume what will happen in the future will mirror what has happened in the recent past.
This year is a good example as investors are assuming that the global economy will revert to its pre-pandemic ways and keep trying to apply old rules of thumb.
The narrative for much of the pre-pandemic period was that low growth drove low inflation, low inflation drove low interest rates, and low benchmark interest rates compressed credit costs that in turn drove up stock valuations, particularly for growth stocks such as technology companies.
The markets have tried to run this trade numerous times over the past year. The US 10-year Treasury bond yield has pushed down towards 3 per cent on several occasions, before growth and inflation data pushed it back up. This has contributed to fluctuations in the valuation of growth stocks, which can be sensitive to changes in the benchmark bond yields that are used to discount the value of future earnings.
Investors need to stop and acknowledge that the combination of the pandemic and Russia’s invasion of Ukraine has structurally changed the global economy.
Inflation will be higher on average and more volatile. We have moved from a world of abundance to one of scarcity.
The abundance of the past few decades stemmed in large part to several positive supply shocks. China’s entry into the World Trade Organization in 2001 brought vast numbers of relatively low-cost workers to the global supply chain. Considerable additional oil and gas mining in North America pushed down energy prices and reduced the ability of Opec to generate economic and inflation volatility. Globalisation kept inflation low and stable.
The situation has changed. A shift in global supply chains and a race to electrify our economies, for both climate and energy security reasons, is likely to put continual pressure on goods prices for some time. Climate-related shocks are likely to generate bouts of cost pressures, not least through volatility in food prices.
Furthermore, growth will be more evenly dispersed by sector and geography. This is because of the other meaningful change to have occurred during the past two years: governments’ approach to debt. The political narrative has shifted from austerity to “build back better”. This is a particularly notable change in Europe where fiscal austerity acted as a meaningful brake on activity for much of the past decade.
Investors therefore need to adjust their mindset in at least three ways: first, the correlation between stocks and bonds will not be reliably negative in the way it was for much of the past two decades. Put simply, when inflation was absent, central banks only had to focus on growth. When the earnings outlook darkened, central banks reliably cut rates. This generated a consistently negative relationship between stocks falling and bond prices rising. Pairing stocks with bonds was enough for an all-weather portfolio. With inflation at least periodically back, this correlation will be unstable.
As a result, investors need other tools for reliable diversification, and 2022 provides a good guide as to the options available, most of which are in private markets. Alternatives such as core infrastructure and timber offer the most reliable support to the value of a portfolio during an inflation shock.
Second, with bond yields staying higher, the discount rate is back. One consequence is that investors should place more weight on the reality of near-term earnings, and less on the hopes of future profitability. Growth stocks are unlikely to benefit from the tailwinds of zero or negative discount rates. This leaves tech more vulnerable to potential earnings disappointment, particularly if artificial intelligence doesn’t prove to be the new economic miracle that seems to have been priced into some tech stocks today.
Third, portfolios should be more regionally diversified across all assets. The past decade was characterised by “US exceptionalism” — in nominal growth, interest rates, stock performance and the currency. With Europe on a notably different fiscal and monetary path, I expect it to be less of an underperformer economically and in terms of asset market performance going forward.
Investors have to stop relying on ideas that worked for the past decade. The world has changed and asset allocation decisions must follow.
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