investment insights
7 ways to drive portfolios in the medium-term: understanding asset prices and economic fundamentals
In late 2019, we invited our clients across Asia to re-think the way capitalism would have to evolve to address extraordinary challenges. Our conclusions were that in order to achieve a more sustainable equilibrium, a rebalancing from a growth model driven by markets, debt and asset prices to an economic engine fuelled by wages, social transfers and public investments would be a pre-requisite while this transformation could take maybe a decade or more. The Covid-19 pandemic then magnified dramatically this perspective. 15 months later, investors may share the perception that a renewed form of Beveridge capitalism is ultimately replacing the financial markets’ rule, at work for the last 30 years. If so, what may be the ultimate consequences in terms of financial and real assets’ repricing for investors?
The growing disconnect between asset prices and underlying economic fundamentals
Since the early 1990s, assets prices and economic fundamentals have evolved at very different paces. Globalisation and automation have placed increasing pressure on workers’ compensation. Rapid ageing populations have stepped up on their saving efforts. Private businesses have lowered their investments needs, making them less tangible. On the backdrop of higher saving rates and slower wages, growth had to rely on new drivers. Leverage and wealth effects emerged then as the perfect match. Cheap money, large access to credit and financial innovations provided the funding that the global economy needed, with excess money supply flooding property, private assets and public markets. The side effects of this dynamic are well-known: excessively inflated assets prices, extreme wealth inequalities, generalised moral hazard behaviours, artificial lifelines granted to “zombies” companies weighing on productivity growth, and ultra-low equilibrium levels of interest rates, amongst others.
From there, we can imagine what could be the consequences for investors, if and once the global economy were to reverse into a symmetric regime where income, consumption and investment growth would outpace persistently debt-dependency. Nominal yields from bonds’ coupons, equities’ dividends or properties’ rents should be higher on average while the overall pace of capital appreciation for all assets would be significantly lower. With monetary policies not forced anymore to suppress market volatility, the price for risk will be re-discovered, leading to wider credit spreads and equities’ premium distributions. Exciting investment opportunities will continue to exist, with returns, however, more directly influenced by idiosyncratic factors specific to business models’ long-term profitability, capacity to innovate and compliance with broad societal priorities. Re-invented fundamental stock-picking strategies may ultimately return as the winning ones, after the long age of market beta dominance.
The pandemic’s impact: the shift towards a new equilibrium
Has this transition started? How far are we from this potential new regime? Over the last 15 months, we are seeing many developments that look furiously consistent with the transition to the new equilibrium described above.
Governments have led extraordinary efforts to buffer the pandemic shock through massive fiscal transfers, and contemplate rebuild their economies with substantial investment plans. Surge in demand and shortages in a few markets have caused a stretch in supply and delivery chains as well as the services industries. Some investors consider the possibility of inflation spiralling out of control from central banks – for the first time in nearly four decades. Regulatory crackdown on Tech giants and the negative side implications from their abusive market power has been accelerating in China and is at the top of the agenda for US and Europe.
Despite the developments, we believe, however, that the reality is more nuanced. On the necessity for investments to comply with societal and policy priorities, the toothpaste is out of the tube and shall not re-enter into it. That said, we remain more sceptical regarding the capacity of the global economy to reflate itself, more or less independently from the assets’ inflation perpetuated through excess liquidity. With the brutal route of a hard deleveraging being denied for major economies after the 2008 Great Financial Crisis, governments had the only alternative to target productivity and/or income boosts while containing the rise in additional leverage through tighter macro-prudential regulations and selective defaults. This is the narrow path engaged by China and this is – probably – the way the Biden administration would like to engage the US economy.
The path ahead and what it means for investors
Such a strategy requires time and may prove hazardous. The debt-addiction of most economies is just too high. In China, refinancing conditions for highly indebted borrowers will probably have to ease again if a large default or a systemic chain of debt restructuring start threatening key sectors. In Western democracies, the political consensus to unleash massive spending, observed at the start of the pandemic, does not exist anymore, now the stake lies in pulling economies from their structural gravitational deflationary forces.
Beyond some stark political divisions, the debate at the US Congress also reflect conflicts between generations. Baby-boom born savers are reluctant to see the inflation pendulum moving back from financial to goods markets. How the coalition of millennials, X and Z generations would implement a true and lasting progressive agenda remains to be seen. In the interim, and beyond the very short-term cyclical developments, economies will continue to suffer more from disinflation than inflation, while central banks will continue to do “whatever it takes” to prevent the debt pyramid to collapse.
How investors, trapped into that twilight zone, should drive their portfolios?
1. As long as this interim period holds, investors must remain invested.
2. Their core holdings should remain liquid enough to be re-adjusted swiftly as we may move from one equilibrium to another
3. Core equities and credit positions should be transitioned, if not done already, to issuers whose profitable business models are aligned with societal and policy priorities
4. Stocks portfolios should focus on large, quality names whose earnings growth would make up for a possible compression in multiples
5. Core portfolios should maximize diversification between risk factors in order to face possible extreme alternative outcomes, while achieving a high level of efficiency in terms of risk-adjusted returns
6. Most aggressive investors could then redeploy the risk saved on core holdings into a few themes representative of the disruptions the global economy will have to digest over the next few years
7. This type of overall portfolio construction should be kept within a tight risk framework likely to survive sudden and rapid transitions.
Wichtige Hinweise.
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