Deglobalization and Investing
Since the beginning of the 21st century, globalisation has been on an unstoppable ascent.
The COVID-19 pandemic and the war in Ukraine have shown that global supply chains are weak, with companies rushing to fill gaps.
And because the gains from rising markets have gone more to capital than to labour, there has been a backlash against globalisation because of income inequality.
Some people are starting to wonder if globalisation has reached its peak and might be giving way to deglobalization, which would have big effects on economic growth, inflation, and the markets.
Since 1980, the capital markets have done very well. But globalisation isn't the only reason for this.
This is just one part of a fundamental super-cocktail that also included powerful forces like automation, technology, and the largest labour force in human history at the time.
At the same time, falling and low inflation became a huge driver for markets and valuation multiples.
The results were out of this world.
Since 1980, the S&P 500 has given an average annual return of 12.2%, which is much higher than the 7.9% it gave in the 30 years before 1980.
Since 1980, the traditional 60/40 mix of stocks and bonds has given an annualised return of 10.5%.
Around 2000, when the Baby Boomer generation started to leave its peak earning years, the super-cocktail started to lose its power.
Interest rates had mostly reached their natural lows, and productivity gains in developed economies had started to slow, which slowed the growth of GDP.
As the relative wealth of households continued to rise, frothy markets went through a series of crises, like the tech bubble, the global financial crisis, and the COVID-19 pandemic, followed by recoveries made possible by fiscal and monetary policy that was very easy going.
With the super-cocktail getting weaker, we think investors will have to deal with a very different market in the future.
The rate of economic growth is slowing down, and it will probably be lower in the years to come. This will be made worse by the fact that demographics are getting worse.
Even though inflation is not likely to stay at its current highs, it is likely to be higher in the long run.
With less growth and a stronger labour force, corporate profit margins will be under more pressure, so market returns aren't likely to be as high as they were in the past.
Lower nominal returns and higher inflation will make investors feel squeezed on both ends, which will lead to much lower real returns.
Even if inflation drops to 2.5% over the long term, it is likely that the real yield on US Treasury returns will be negative.
Even though yields have recently gone up, the current situation makes it hard for the 60/40 to work.
Looking for Real Returns—and a Good Return Order
The new cocktail that investors will have to deal with in the coming years sounds bad, but it's important to put things in perspective.
The future doesn't look like it will fall off a cliff as much as it will slow down from what had been a very good time for capital markets.
In the coming years, we think the most important thing will be to be able to get higher real returns and to be flexible enough to get returns from different places.
The key to building wealth for retirement over the long term is to make portfolios that produce a better return sequence.
For the classic 60/40 model that investors have used for decades, this will probably mean more exposure to stocks, since stocks can produce positive real returns when inflation is high but not out of control.
Keep in mind that the relationship between inflation and stock prices is not a straight line. Both very high inflation and deflation are usually bad, but inflation between 2.5% and 3% is still consistent with positive real equity returns.
Due to the possibility of negative real returns and a slightly higher correlation with stocks, allocations to traditional high-grade bonds might be cut back. However, they are still a good way to spread out risk.
Within that bond allocation, it makes sense to look for opportunities in a wider range of areas and put them together in ways that work well.
High-yield bonds can also be a good way to lower the risk of some of that higher allocation to stocks when building a portfolio.
Aside from that, investors must think about other ways to find and combine real return streams and premiums.
Given that inflation has been low for a long time, many investors have not put enough money into real assets.
Real assets become very important in a world with moderately higher inflation, but investors need to be careful because not all real assets are the same.
Some factor exposures may also be important to think about.
Value has run into problems, but historically, it has had a close relationship with inflation. This means that value still has a place in a world where inflation stays high for a long time.
And if long-term real yields stay low, some types of growth stocks could be valuable, especially those that can keep growing.
It is important to put these exposures together in an effective way and to find ways to add alpha through active management.
Even 20 or 30 basis points of alpha per year can be a big help in the long run when it comes to building wealth.
Because of these changes, return patterns across regions, asset classes, and industries are likely to become more different. This will give skilled investors new ways to add alpha and diversify.
Benchmarks are another important part of building a portfolio. How do we know when we've done well?
Instead of looking at a portfolio's ability to beat the traditional 60/40 benchmark, maybe it's time to change the way we look at things and focus on outcome-based measures, like improving the measured odds of a successful retirement.
In the end, investors must use everything in their toolboxes to get real returns that are positive over time, with some downside protection or less volatility.