A Brave New World Or Back To The Old Normal

Key Points

• The outlook for long-term returns for the major asset classes has shifted in favor of bonds and cash at the expense of equities. Expected returns for equities will be below long-term averages, while bonds look relatively attractive for the first time in 15 years. In the short term, cash is the most attractive.
• Inflation is likely to be higher over the next 10 years than the level over the past 20 years. We expect bond yields to reflect this dynamic over time.
• The mix of real growth and inflation in the nominal GDP composition has shifted towards more inflation and less real growth. Economic performance as a result will likely be more volatile. This will be net negative for corporate margins and equity valuations.
• Public debt levels around the world have risen substantially. Policymakers will have a tough task balancing between fiscal sustainability and taming inflationary pressures.
• Asset allocation in the near term should favor T-bills and short duration Treasuries. Long duration bonds and equities are vulnerable if rates continue to edge higher as we expect.

The past few years have brought challenges to investors that they hadn’t faced in a long time. Inflation around the world reached levels not seen since the 1970s. Some have tried to blame it on the War in Ukraine, and on the tight energy and food markets, but at the bottom of the inflation spike was the good old money printing and fiscal largess during the COVID-19 pandemic. Inflation is coming down slowly, but is still at a level inconsistent with price stability. Bonds have suffered losses not seen in decades. It is clear that bonds don’t like inflationary surprises, but the zero-rate policies of the past 15 years brought yields to levels that only made painful losses inevitable. Equity markets have fared better, having recovered most of the losses since the pre-pandemic highs. But with P/E multiples above average and with the equity risk premium in the US at a multi-year low, equities don’t exactly get an all-clear signal either.

If the reader should feel confused by all that, so is the market. The yield curve has been inverted for a record long time now, arguably signaling recession, while the US economy has remained resilient and the unemployment rate is very low. Bond bulls have been confounded by the gradual but inevitable rise in long term rates. Dollar bears have been left for a roadkill by the almighty greenback. Equity investors are taking refuge in the safety of index averages supported by a handful of mega-caps, while the broader market has been struggling. Let alone the added complexities stemming from the War in Ukraine, the collapse of the property sector in China, the yen’s weakness, and last but not least the economic malaise plaguing Europe right now.

Investors currently seem to have agreed on a scenario of soft landing for the US economy. Inflation is coming down, unemployment remains robust, consumers are holding up. This strikes us as a very middle-of-the-road outlook, not too hot, not too cold, just cool enough to bring us back to the goldilocks. In our experience, however, one extreme is usually followed by another extreme (think the principle of the pendulum), as the accumulated excesses have to be purged. We currently see imbalance that will not be easy to reconcile, hence we see higher risks going forward than a benign soft-landing scenario would imply. It is always difficult to say there the pain will manifest itself, but in cases like that defensive positioning is usually a good idea.

Since markets react to and reprice assets in response to change, it is worth asking ourselves what is changing currently in the investment environment. Will this inflation episode be gone and forgotten soon? And what is the outlook for growth, the economy, and financial markets? Here we focus on the US but many of the conclusions also apply to the other developed economies and to many of the emerging ones.

Growth

Growth is a function of two main variables – growth in labor force (population) and productivity improvements. The COVID-19 pandemic accelerated and revealed the trend towards lower growth in the working age population, and in some cases (e.g. Japan), towards outright decline in the labor force. Unemployment rate in the US is barely 3.5%, yet the number of job vacancies remains greater than the number of job seekers. As fewer people join the labor force and become producers, savers, and consumers each year, the potential growth in output also declines. The biggest change by far is taking pace in China, where the seemingly endless source of cheap labor over the past 20 years has slowed down to barely a trickle. This is due not only to the limited number of potential migrants to the cities but also to the aging of the population and the labor force. This is important for the inflation outlook, which we will address a bit later. Similar trends can be observed in some countries in Europe.  

Turning to productivity, its rate of growth is driven by capital deployment, the efficiency of its use, labor force education, technological advancements, etc. While these are difficult to forecast in their entirety, it is useful to note that productivity growth in the US from 1948 to 2022 averaged 2.1% and that real GDP growth for the same period was 3.1% per year^[1]. Since the financial crisis of 2007-2008, however, productivity growth has fallen to about 1.5%, and the real GDP growth to just 1.7% per year. It is clear that unless productivity growth picks up, maintaining high(er) growth rates will be impossible. Most economies put the long-term growth potential in the US at less than 2.0%. Charles Schwab, as an example, assumes 1.8% real GDP growth over the next 10 years. We expect that growth will remain meager in the absence of better productivity growth, and remain in the 1.5-2.0% range over the next 10 years. What can be a positive surprise here? A potential faster adoption of automation and robotics as well as artificial intelligence (AI) can boost productivity at the corporate and at the overall economy level. We have a bit of a precedent, when in the 1995-2005 period productivity grew at 2.8% per year, presumably following a wide adoption of the internet.

Inflation

Arguably the biggest debate currently among market participants is about inflation. How quickly will it go down and to what level? Is the Fed’s 2% target reasonable or does the target have to be raised to 3% or even 4% (notice that nobody is arguing that it has to be lowered!)? Are we going to experience the same benign inflation in the future that we did over the past 15-20 years?

To answer the last question directly – no, we are not! Inflation is likely to be higher over the next 10 years than during the 15-20-year period prior to the COVID-19 spike. The past 20 years were a temporary inflation bliss supported by China’s entry into the World Trade Organization (WTO) and other factors that are no longer present.

We expect annual inflation in the US to be in the 2.5-3.5% range, higher than the sub-2.0% rate of the past 20 years. Occasional spikes above that range are likely, making inflation less predictable. Why do we believe that? Several reasons: 1) China will no longer export disinflation; 2) energy will cost more than it did over the past few decades; 3) public debt levels are much higher now; 4) labor will not be as cheap; 5) highest industry concentration in the US gives corporations pricing power.

The world benefitted from the entry of China into the WTO at the turn of the 21^st century as the country built massive productive capacity and migrated millions of people from the villages to the cities. Cheap Chinese labor and enormous capital investments turned China into a preferred global manufacturing base. Jobs moved out of developed countries and that kept wages there at bay, while allowing corporations to increase profit margins. These trends are pretty much over now. Chinese wages have grown substantially in real terms and are no longer clear bargain once adjusted for productivity gaps. The supply chain issues during the COVID-19 pandemic have caused companies to orient their sourcing strategies closer to home. But probably more importantly, China is no longer a “friendly” partner to the West: it is an economic and geopolitical rival. That factor will be here to stay for a long time. There is no obvious country to replicate China as a cheap manufacturing base in the near term or on the same scale. Reshoring is likely to come with higher costs that will have to be passed on.

Moving on to the next factor – energy will be more expensive for the foreseeable future. Oil products in particular will likely cost a lot more at the pump. The oil majors have all but stopped allocating capital to large new exploration and development projects. This is a direct response to the highly uncertain regulatory and tax environment surrounding fossil fuels. Their production costs have also gone up along with everything else lately. Within OPEC, Saudi Arabia now needs average oil price of $90 per barrel in order to balance its budget, and other OPEC exporters need even higher prices. Russia is unlikely to become the cheap source of energy it used to be for the entire European continent any time soon. On top of that, environmental regulations and lack of new refining capacity will keep refining margins elevated. Refining margins in Europe have more than doubled from a range of $10-15/barrel to more than $30/barrel. All told, while we still need fossil fuels and particularly oil and natural gas, supply will not be as forthcoming as before.

Mandated green energy will also raise the marginal cost of electricity. Different studies put the investments needed to switch the world to green energy from $60 tn to $120 tn. Our guess is it will be even more. For context, the world GDP in 2022 totaled just over $100 tn^[2]. At the same time, we are likely to see rising demand for energy from developing countries, mostly China and India, as they strive to raise living standards for more than 2.5 bn people. Unless nuclear energy becomes popular and prevalent, the world will have to pay up for its energy use going forward.

High public debt levels are fundamentally inflationary. This is because governments are tempted to monetize the debt, or at the very least reduce the burden of carrying it by keeping interest rates low. That inherently tends to put upward pressure on inflation. The US had federal debt/GDP ratio of 30% in 1980, 60% in 2010 and 120% in 2022^[3]. Many studies have pointed out that once public debt reaches levels above 90-100% of GDP growth suffers^[4]. Regardless whether this particular level of debt/GDP is detrimental to growth, it reduces fiscal flexibility and more importantly, forces the government to keep interest rates below the rate of GDP growth in order to boost fiscal debt sustainability. This is because as long as the annual interest cost on the public debt in percent of GDP terms is below that of GDP growth, the government can run some fiscal deficit without increasing the debt/GDP ratio. Ultimately, this is prone to stoke some inflation.

Labor seems to have become in short supply since the COVID-19 crisis. While there are some short term factors at play currently, such as silent quitting, the working population in many developed countries is either stagnating, or outright declining. Unless robots and artificial intelligence fill the gap in a meaningful way, wages will likely grow faster than in the previous 20-30 years, when unit labor costs in the US lagged productivity growth. Shareholders benefitted handsomely from this gap at the expense of labor. It is yet to be seen if corporations will be able to keep labor costs below productivity growth in the future. With labor likely to stay in short supply going forward, one can expect a marginally higher pressure on wages and for labor to recover some of the lost ground vs. capital over the past few decades.

Lastly, industry concentration in the US is at a 100-year high^[5]. It’s not just Google and Amazon, pretty much every major sector is now dominated by large companies which naturally leads to less competition. Every consumer will have some empirical evidence of price hikes over and above the average rate of inflation of consumer goods over the past few years, starting with cereal and ending with luxury vehicles. For a corporation, a unit of price is always better than a unit of volume because it is 100% margin. One should expect corporations to exercise their pricing power to the fullest.

To summarize, investors should prepare for a world in which on average inflation will be higher and more volatile. This is likely to have implications for financial markets and asset prices.

Interest Rates

So what does all that mean for interest rates? Rates in the US will most likely be higher than what we saw during the foolhardy experiment with zero-interest rates and yield curve control a.k.a. quantitative easing. Petrified by the prospects of deflation after the financial crisis of 2008, central banks unleashed financial repression on the savers, while benefiting borrowers, i.e., governments and corporations. As a side note, the crisis of 2008 was a huge deflationary shock to the entire world. Policymakers were right to respond by pumping massive liquidity in order to prevent a deflationary vortex from developing and to ensure proper functioning of the financial markets. Markets and the global economy responded and righted themselves. The mistake was to carry on these crisis-related policies almost indefinitely during normal times. What we are dealing with currently is an inflationary shock that we have not seen since the 1970s. Central banks cannot provide the balm of lower interest rates to markets and consumers any longer. On the contrary, they now need to inflict some pain in order to cure the patient from the inflation disease. If inflationary pressures remain elevated as we expect, interest rates need to remain higher for longer. Further, high(er) inflation is also (more) volatile inflation, so if inflation becomes less predictable, markets are likely to require a higher inflation premium priced into long term rates.

Another reason interest rates are likely to stay elevated, compared to the past 10-15 years, is the need to fund large fiscal deficits in the public bond market. The US federal budget deficit remains 8% while the unemployment is 3.5%. One can only surmise what the deficit will do to in the next recession and how much more the federal government debt burden will rise. So if inflation is between 2.5% and 3.5%, then short term rates on average should be around that level, and if nominal GDP is to growth by some 4.5%-5.5%, then long-term rates and bond yields should be around that level also. That would bring the term premium to its historical average of about 100-150 bps, and possibly to 200 bps. As Treasury yields are now in the mid-4.0% range, we are getting close to the above target range. The main uncertainty for bonds in our view remains the question about the peak in short-term rates. The market recently expected that by mid-2024 Fed funds rates would be lower by some 175 bps, but the most recent data and pronouncements from the Fed have altered the outlook toward higher rates. If inflation remains elevated, yields have to remain higher too.

An interesting question here is the expected correlation between bonds and equities, which has important implications for asset allocation. A recent paper^[6] finds that the average correlation between bonds and stocks in the US between 1970 and 1990 was 0.35, while it was -0.31 between 2000 and 2022. The difference in correlations is driven by inflation and real returns on short-term bonds. If correlation becomes positive again, a 60/40 portfolio will need to have smaller allocation to equities in order to achieve the same level of volatility as the same portfolio when the correlation is negative.

Corporate Earnings

Corporations exist and operate in a nominal world. For the top line growth of corporations what matters is the nominal GDP growth -- real growth plus inflation (or GDP deflator). High nominal growth means higher revenue growth. Nominal GDP growth in 2022-2023 has been rather high due to the peak in inflation, hence corporate earnings held better than expected. But the mix is also important. Higher real growth and lower inflation is better for corporate earnings and margins, and vice versa.

Market consensus expects S&P500 earnings to grow about 6% in 2024 and 11% per year in the following two years. This view expects no earnings recession, just a growth slowdown in 2024. There is a risk that this may be too aggressive and earnings growth may turn out to be lower. The argument for such a scenario is easily constructed by combining an elevated outlook for inflation and a weaker consumption caused by exhaustion of excess savings, higher energy prices, rising unemployment and further erosion of real incomes. The scope for positive surprise to earnings in our view is limited, given the simultaneous increase in interest rates and energy prices going into the end of 2023.

Valuations and Asset Allocation

Cash – with yields north of 5.0%, T-bills offer an attractive option to invest some cash and wait out the current period of uncertainty. Cash has not yielded that much in a very long time and we find it attractive currently. We are overweight T-bills and short term bonds. The key risk is the timing of the Fed rate cuts, which will quickly diminish their potential returns.

Bonds – Treasury yields have repriced substantially from the lows of a couple of years ago and are now relatively attractive. At about 4.6% yield, intermediate Treasuries offer a positive real rate over expected inflation expectations^[7]. However, with CPI running at 3.7% for the headline number and 4.3% at the core level^[8], the key here is how quickly inflation will come down and where it will settle. We believe that the current yield (carry) is OK, but there will be little scope for capital gains to be had out of bonds. We are neutral on bonds overall, but prefer short duration over long duration and need to see a bit higher yields or for inflation to be decisively on a downward trend to become more positive.

Equities - At around 20x P/E, the S&P500 index is about 12% on the expensive side versus the long-term median of 17.8x. However, the key risk in our view is on the earnings side. If earnings surprise to the downside and experience a decline in 2024 in a potential recession scenario, the multiple will likely contract as well. Then the combination of the two may result in 10-15% downside to the index (5-10% multiple contraction and earnings cut by 5-10%). If earnings hold, we don’t expect multiples to expand further over the course of 2024, so investors at best can hope for 5-6% return.

The index is pricey also on some long-term valuation measures such as the Shiller’s CAPE or Tobin’s Q. Estimates of equity risk premium, although notoriously difficult to determine ex ante point at very low level of that measure too. Historically, these valuation levels have been followed by extended periods of flat market performance and mediocre returns, such as during the 2000-2012 period.

International equities are optically cheaper than US equities, but that simply reflects poorer fundamentals. While it’s tempting to think of international equities as one large asset class, they are anything but. There is a wide variety of markets with their own fundamentals and valuation metrics, particularly when it comes to emerging equities. We would rather pick countries and individual stocks than buy the index wholesale. The one and only common denominator for all international equity markets is the US dollar. The asset class as a whole will be attractive if and when the US dollar embarks on a long declining trend as it did in the early to mid-2000s. A likely scenario for dollar weakness would be one in which US fiscal policy tightens substantially in order to stabilize the debt/GDP ratio, which will cause the economy to slow and the Fed to cut rates to offset the fiscal drag. This policy mix would be similar to the one in Canada in the late-1990s when the Canadian dollar reached its weakest levels in recent history. Until this happens, we prefer to get our equity exposure through the US markets which currently have better fundamentals.

Putting It All Together

As we recover from the COVID-19 pandemic and its economic aftermath, we find that the investment environment over the next 10 years will be very different from that of the past 10-20 years.  We are likely to see elements of the 1960s and 1970s, rather than a repeat of 2000s and 2010s. Volatility should be higher. Equity markets will offer below-average returns. Indices will likely have only mediocre performance hence picking the right sectors, stocks, and factors will be important. Bonds and cash finally offer meaningful positive carry. Our current allocation is to be overweight cash and short duration Treasuries, while underweight equities and long Treasuries. Within equities, we prefer US markets over international ones until we see reversal of the strong dollar trend.

Mihail Dobrinov, CFA

Chief Investment Officer

Trimon Capital Management