Investments: Uncertainty becomes new normal

Most of the past three decades since the fall of the Iron Curtain have seen lower inflation and interest rates, rising stock markets and economic growth across much of the world. But with globalisation and world trade seizing up, central banks grappling with inflation and many countries experiencing lacklustre growth, is the ‘Great Moderation’ over?

If the economic environment feels particularly turbulent today, it may be because the last few decades have been an historic anomaly. The three-decade period starting in the early 1990s has been dubbed the ‘Great Moderation’ – a time (bar a couple of blips such as dot-com crash of 2000 and the 2007-09 global financial crisis) of economic expansion, extremely low inflation and interest rates, and, for the most part, rising stock markets. However, the past 30-odd years may have been the exception rather than the rule, and investors may need to get used to a different type of financial and economic environment.

There are various explanations as to why the world has enjoyed such a long period of relative stability and prosperity. One explanation is that monetary policy has been better managed, with governments increasingly giving central banks independence. This helped to smooth boom-and-bust cycles by preventing politicians from massaging interest rates to engineer economic growth at convenient moments in the electoral calendar.

Deregulation has also contributed to the increasing flexibility of the global economy, allowing it to adjust to shocks with greater ease; until recently, the advance of globalisation and free trade brought many countries improved standards of living through cheaper goods, and delivered unprecedented export earnings to others, especially low-cost manufacturing centres headed by China.

Technology has also been a factor. Says the US Federal Reserve: “Advances in information technology and communications may have allowed firms to produce more efficiently and monitor their production processes more effectively, thereby reducing volatility in production — and thus in real GDP.”

However, these factors have started to weaken in recent years. While most central banks remain independent, increasingly fractious geopolitics and trade wars have reduced globalisation from a sprint to walking pace. The KOF Index of Globalisation compiled by Swiss university ETH Zurich points to a significant deceleration in globalisation since 2010, although the researchers say it has not actually gone into reverse – yet. This means the unconstrained flow of cheap goods has slowed.

Increasingly fractious geopolitics and trade wars have reduced globalisation from a sprint to walking pace.

Technology still exerts some deflationary pressure, and it is possible that artificial intelligence will give productivity a fresh boost, but the most significant gains may have already been made. Meanwhile, deregulation has become less fashionable since the global financial crisis, which was blamed to a large extent on the lifting of longstanding constraints on financial market activity.

The Covid-19 pandemic has also had an impact since its onset around the beginning of 2020. The impact of lockdown restrictions on economic activity and trade led to greater reliance on government action and financial assistance on the part of individuals and companies, together with an expansion of government spending without precedent in peacetime. Furthermore, supply chains disruptions and product shortages from Covid have caused many people to proclaim the end of just-in-time practices in favor of more just-in-case stocking. Finally, inflation and sovereignty strategies post-Covid are becoming increasingly intertwined with nations seeking to safeguard their autonomy and stability.

Along with monetary policy that central banks, unaccustomed to price instability after so many years, probably kept too loose for too long, these developments contributed to a surge in inflation that policymakers have since struggled to bring under control.

A new economic paradigm

This creates a quite different climate for investors. While experts had warned that they needed to be alert to the potential for inflation – for example, by investing in stock markets rather than cash, or uncorrelated alternative asset classes, for example – for a long time this was theoretical rather than real. Investors hadn’t experienced any significant level of inflation for nearly 30 years.

Soaring inflation also meant that interest rates rose sharply. In the US, between March 2022 and July 2023, the Fed’s target range moved from near zero to 5.25%-5.5%, a level not seen since January 2001. This raised borrowing costs for governments, businesses and households alike.

The upheaval has changed the way assets are valued. A range of investment fields that had benefited from low interest rates – including private equity, commercial property, infrastructure and fast-growing companies – have appeared less attractive, especially real estate, which is also suffering from the post-pandemic persistence of working from home. Higher cash interest rates of between 4% and 5% lifted the hurdle rate for all investments, including in the stock market.

Investors have also had to navigate geopolitical turbulence that had been mostly absent since the implosion of the Soviet Union. The pressure of fracturing US-China relations, war in Ukraine and economic sanctions against Russia, including the freezing of more than $300bn of Moscow’s assets in Europe and North America, have been felt across financial markets.

It has been reflected in a slump in the Chinese stock market, now in a third successive year of decline, and in the strength of safe-haven investments such as the US dollar and, recently, gold, which set new records at the start of 2024. It has also been seen in commodity markets, with competition increasing across the world for rare metals and other materials, particularly those in demand for the energy transition.

The strategies investors have employed over the past two decades may not necessarily be as successful in the future.

The importance of borrowing costs

As a result, the strategies investors have employed over the past two decades may not necessarily be as successful in the future. For example, for much of the past decade, stock market investing has been straightforward – low interest rates and inflation created an environment that mostly had the effect of lifting all boats.

However, it should be remembered that a significant contribution to equities’ strong overall performance has come from a handful of large US technology groups – namely the ‘Magnificent Seven’ of Microsoft, Apple, Nvidia, Alphabet (Google), Amazon, Meta (Facebook) and Tesla – whose large weightings in benchmarks including the MSCI World and S&P 500 indices has put a gloss on investor returns.

Previously low borrowing costs made it possible for even weaker companies to thrive, or at least stay in business. Now companies are facing a tougher climate, and those that do not benefit from stronger pricing power, astute management and a solid market share may find themselves in trouble.

In a less benign economic environment, the strong are liable to get stronger while weaker companies with high debt, a fragile business model or uncompetitive products are set to struggle. Analysts point to the qualities of companies such as the European market’s so-called ‘Granolas’ stocks, termed by Goldam Sachs as “internationally exposed quality growth compounders” – a mix of pharmaceutical, luxury goods, semiconductor technology, software and agrifood companies that have continued to pay dividends and demonstrate their resilience through a variety of market conditions.

Those that look to bonds to generate income should reflect that this will not grow over time, whereas corporate dividends have historically increased in line with inflation.

For the first time in a generation, investors will need to consider whether their portfolios will deliver returns that exceed inflation. Although cash interest rates have shot up, often they are failing to keep pace with rising prices. And those that look to bonds to generate income should reflect that the price of those will not grow over time, whereas corporate dividends have historically increased in line with inflation.

Asset prices may also be affected by ongoing geopolitical tension and conflict, a scenario which affects trading relationships, disrupts supply chains and sharpens competition for key commodities. And while the volatility of oil markets may be exacerbated by conflict in the Middle East, this does not necessarily directly benefit sustainable products and energy sources, as Europe’s slump in electric car sales and the troubled economics of offshore wind energy have demonstrated.

No ideal portfolio can automatically address all these issues. However, good financial practice – careful stock selection, flexible asset allocation, diversification across a range of asset classes and geographical regions, plus strong risk management – will be more valuable than ever. The Great Moderation seems to be giving way to a more difficult and complex economic environment in which investors can no longer rely on past assumptions and habits.