Did Investors Miss the First Major Shift in the Investment Environment in 40 Years?
“All the secrets of the world worth knowing are hiding in plain sight.”
— Robin Sloan
I have been in the investment business for 28 years. Some people think that’s a long time. However, from my perspective, I’m still wet behind the ears when it comes to investing. I still have a lot to learn.
In fact, for my entire career the investment environment has largely been characterized by a singular regime of declining interest rates, benign inflation, a peacetime dividend between the world’s nuclear armed superpowers and the acceleration of globalization.
Behavioral biases make it easy for investors to lose sight of the forest for the trees — to get laser focused on the day-to-day headlines that move markets. This short-sightedness suggests investors risk missing the first major structural turning point in the investment landscape in 40 years. The US-China trade war, COVID-19 pandemic, end of the quantitative easing (QE) era and now, the Russia-Ukraine War have conspired to alter the course of investing history. As a result, what worked in investing over the past 40 years may not work over the next 40 years.
The Wonder Years
Since the US 10-year Treasury yield peaked in September 1981, interest rates have been steadily declining. The US 10-year Treasury yield notched its all-time low of 0.54% in early March 2020 as investors panicked and global markets were thrown into chaos by the outbreak of the pandemic.1 This constant decline in yields created a multi-decades long bull market for fixed income investments, as bond prices rise as yields fall. After peaking at an annual rate of 14.8% in 1980, not surprisingly, inflation followed a similar downward trajectory as interest rates, rising an average of less than 2% a year in the decade before the pandemic.2 A long period of low and relatively stable prices bolstered investor confidence, further fueling stock and bond market gains.
Commensurate with this protracted period of falling rates and stable prices was the end of the Cold War in December 1991 with the dissolution of the Soviet Union. The Cold War was a period of geopolitical tension between the United States and the Soviet Union and their respective allies, the Western Bloc and the Eastern Bloc, which began following World War II. The end of the Cold War ushered in a roughly 30-year peacetime dividend for investors.
Coincidentally, the term globalization gained popularity in the early 1990s following the conclusion of the Cold War. According to the Peterson Institute for International Economics, globalization describes the growing interdependence of the world’s economies, cultures, and populations, brought about by cross-border trade in goods and services, technology, and flows of investment, people, and information. Globalization has been a significant contributing factor to the declining rates and benign inflation environment of the last four decades. China’s controversial admission to the World Trade Organization (WTO) in December 2001 served to accelerate trends in globalization.
Over the past 40 years, falling interest rates, modest inflation, a peacetime dividend between the world’s superpowers and globalization have mostly allowed growth stocks, bonds and the standard 60/40 portfolio to handsomely reward investors.
But what if all that is changing now?
Figure 1: 60/40 YTD Versus Stocks
Changes Present Challenges
In a sign that the QE era may finally be ending, Federal Reserve (Fed) Chairman Jerome Powell in a March 21 speech to the National Association for Business Economics said the Fed would raise rates faster than expected, and high enough to curtail economic growth and hiring, if it decides this would be necessary to quell rampant inflation. Following Powell’s comments, the 10-year Treasury yield reached its highest level since May 2019.3 Interest rates have been firmly climbing from the lows set in March 2020.
Figure 2: Post-Meeting Implied Policy Rate
Extraordinary monetary policies implemented in the aftermath of both the global financial crisis and pandemic benefited holders of financial assets, but the transfer mechanism to the real economy was always a false promise. As a result, income inequality and the wealth gap are at all-time highs.4 Not surprisingly, populist sentiment is also on the rise. Anger and frustration have grown with a capitalist system that many now believe is rigged or broken. For example, the 2022 Edelman Trust Barometer revealed that 52% of global respondents say capitalism does more harm than good in its current form.5
At the same time, the US-China trade war, pandemic and the Russia-Ukraine War have exposed weaknesses in global supply chains. Prices are soaring across many inputs including for oil, nickel, palladium, wheat and semiconductors. Governments and corporations are seeking to bring supply chains closer to home and de-globalization trends are rapidly expanding. According to research from the McKinsey Global Institute, globalization likely reached its peak in the mid-2000s. And while output and trade have increased in absolute terms, the McKinsey researchers noted that the share of goods traded across borders has been in steady decline.6 Alongside globalization’s deterioration, inflation is surging.
Figure 3: US Inflation Expectations
Finally, all this anger and frustration boiled over into a military conflict in the Ukraine, drawing in the world’s nuclear armed superpowers. Forcing countries to choose regional and ideological alliances is reminiscent of the Cold War’s Western and Eastern blocs. The long peacetime dividend enjoyed by investors may be ending.
The end of the QE era, US-China trade war, pandemic and Russia-Ukraine War have combined to structurally change the investment environment that existed for roughly the past 40 years.
You Can’t Repeat the Past
In contrast to the past four decades, today’s investment environment is defined by rising rates, raging inflation, military conflict and deglobalization. But today’s investment portfolios are positioned for the old regime. Therefore, investors are at risk unless they begin to make modifications to their investment allocations. What worked over the past 40 years may not work over the next decade.
The standard 60/40 portfolio is down more than 6% year-to-date.7 Growth stocks aren’t the all-weather investments investors perceived them to be — it turns out they might be more like the Nifty-Fifty stocks of the 1960s. And, in this environment it remains tough for bonds to hedge stocks like they did during the past several decades.
Figure 4: Beta Sensitivity to Ten-Year Breakeven Inflation Rates
So, what should investors do? Consider investing in higher quality, shorter duration stocks whose dividends offset the harmful impact of inflation. Investments that are positively correlated with rising rates and elevated inflation are likely to benefit too. These include value, energy, materials, small caps, commodities and natural resource stocks.
I’m not arrogant enough to suggest this thesis is a 100% can’t miss forecast. Remember, I have been doing this for less than 30 years and still have a lot to learn. However, it’s plausible that investment portfolios currently aren’t positioned for the structural shift I have outlined. So, I guess the question you have to ask yourself is, what if I’m right?