Investing in a post-La La Land of normalised inflation and interest rates
The normalisation of the global economy will be a challenging and evolving journey. Characterised by global economic blocs running at different speeds, geopolitical risks loom large, and inflation and interest rates are unlikely to return to the La La Land ultra-low levels of the previous 15 years.
We cannot expect a return to the low inflation and ultra-low interest rates that prevailed for a decade and a half before Covid because it was the most abnormal of three abnormal economic periods since the sixties. These include the post-war period of high inflation, the runaway inflation triggered by the oil crisis in the late 1970s and the low inflation-low interest rate era that lasted from 2007 to 2022 and dwarfed the others.
Ten drivers contributed to this unusually favourable macro-economic and geopolitical period, and these have since predominantly turned amber or red. These are:
• Stable economic growth
• China’s contribution to global growth
• Globalisation
• Technology and productivity
• Debt and deficits under control
• A ‘peace’ dividend
• Well-behaved monetary and fiscal policy
• Organised labour
• Commodity prices
• AI may be transformative/China Xing deflation.
The only three drivers still contributing to the economy are transformative AI, China exporting deflation, and technology's contribution to productivity.
Thus, investing during this normalisation cycle will undoubtedly be challenging, with financial markets likely to remain highly volatile as they digest the new macro environment unfolding and respond to the increasing number of geopolitical risks that loom large.
In this uncharted territory, caution and careful selection will be the order of the day when making asset allocation and security selection decisions. Cash will remain king’ish as long as interest rates remain elevated and financial market conditions are unpredictable.
Fixed income assets are expected to offer attractive opportunities during normalisation, given their relatively high yields and risk diversification properties. Yields are finally compensating investors for risk after 15 years of low interest rates, and bond returns will be supported by declining rate expectations following the significant rise in interest rates to their highest levels in decades since 2022. This provides fixed-interest investors with downside protection in the event of a recession.
In the equity market, return prospects will largely be determined by listed companies' earnings, valuations, and fundamentals. Valuations are generally reasonable globally, barring the Magnificent 7 technology stocks and the slightly more expensive remaining US stocks. Stocks in China, Europe and the UK are trading at attractive levels, but economic conditions remain challenging.
What makes selection so important is that the performance across sectors has varied significantly. While IT, growth, and consumer discretion stocks have done well, other sectors haven’t done nearly as well.
These mega-cap stocks are currently expensive, trading at a forward PE of 29 times compared with the 21 times valuation of the entire index, according to Bloomberg data on February 26 this year. Some, like Tesla, fell short of investor expectations when the company missed Wall Street estimates for quarterly profit and revenue. Notwithstanding the Magnificent 7s historically high valuations, these stocks are the future, and if the world goes into recession, you definitely want to have some kind of exposure to stocks that will benefit from transformative AI.
Alternatives, like hedge funds and insurance-linked bonds, are making a comeback. Insurance-linked bonds experienced double-digit gains last year, giving investors exposure to the global reinsurance market, where a strong demand and pricing environment is creating the potential for further healthy gains in the years ahead.
Meanwhile, private capital remains an attractive asset class, with ultra-high-net-worth investors having increased the proportion of their exposure to private assets to 20% of their investment portfolios over the years and prospects still looking enticing.
Though careful selection and caution across these asset classes will equip investors to benefit from inflation and interest rate normalisation, the geopolitical risks looming large over the world pose the greatest risk to the world reaching a new normal safely.
These risks are set to play out as historical issues come to the fore and new sources of conflict emerge - and they span the political, economic, environmental, regulatory, cyber and security landscapes. They are also worryingly correlative and causative and include the following:
• The struggle for dominance between democracies versus autocracies in a year when half the world is holding elections.
• Moving towards a new end game: uni-polar versus a bi-polar versus a multi-polar world
• The West versus the Global South
• The risk of still widening income and wealth inequalities
• The fragmentation and division of Western values
• The spread of misinformation and alternative facts
• The decline of globalisation and the ascendancy of de-globalisation or regionalisation
• The catastrophic impact of climate change
Three things that worry us most are China reprioritising security over economic competency and legitimacy, slow growth in Europe spurring right-wing fragmentation and Russian concessions, and the US becoming isolationist, particularly if Donald Trump becomes president.
The only way to prepare for such unforeseeable developments is to ensure that investment portfolios are sufficiently well-diversified, flexible, and robust enough to navigate the headwinds while also benefiting from the opportunities arising from normalisation in abnormal times.
