Capital Market Assumptions - April 2023
Ninety One’s Capital Market Assumptions framework focuses on the key drivers of long-term performance. We do this to better understand possible future returns, enriching discussions with our clients.
The end of the current financial cycle is arguably almost upon us: inflation is elevated, output gaps are positive and developed market central banks have employed restrictive monetary policies to bring economies back into balance. This will likely cause a developed world recession in the coming year.
Tectonic shifts in macro forces are clearly setting the stage for a new financial cycle.
In parallel, we have witnessed several tectonic shifts in macro forces that are clearly setting the stage for a new financial cycle. Investors need to be prepared for the change.
New financial cycles typically look different to the last. The 1980s were led by Japan and consumer franchises in the US, the 1990s were all about growth and technology investing, while the 2000s were led by commodities and emerging markets.
As we entered the last financial cycle, from the early 2010s onwards, there were changes in several major macro forces and an extension of others: after the global financial crisis US households began a decade-long deleveraging cycle, European governments embarked on austerity, and China began to transition away from a fixed asset investment-led growth model toward a consumption-led one that resulted in a progressively declining growth rate. These forces were core headwinds to global growth and inflation. Declining growth rates in working aged populations also played a role. At the same time, the excess capacity in resource extraction that had been built in the prior decade, coupled with China’s economic shift and the US shale boom, placed material downward pressure on commodity prices, and, again, inflation. The final wave of globalisation and on-going technological disruption aided growth but added to disinflationary pressures.
These forces prompted developed market central banks to maintain exceptionally easy monetary policies, as they sought arguably unattainable inflation targets, given the power of deflationary forces. These dynamics underpinned the financial cycle of the past decade, with policy set far too loose relative to prevailing economic growth conditions, as evidenced by the material appreciation in asset prices over the period.
In an environment of weak growth, disinflation and easy monetary policy, investors were willing to pay up for growth in equities.
In an environment of weak growth, disinflation and easy monetary policy, investors were willing to pay up for growth in equities, while revising down discount rates (bond yields) due to declining inflation expectations and equilibrium interest rates. This pushed equity multiples higher and bond yields lower over the decade, creating a perfect environment for the rise of passive, ‘buy and hold’ investing. At the same time, free money was funnelled into venture capital, aiding a wave of disruption and excessive valuations, while a lack of capital expenditure, due primarily to a weaker growth environment, presented a notable headwind to ‘asset-heavy’ businesses. ‘Asset-light’ businesses, on the other hand, flourished.
In recent years, several forces have combined to set the stage for the next financial cycle: rising geopolitical concerns are promoting deglobalisation and the reworking of supply chains for national security reasons, thus we are not taking advantage of the lowest cost production around the world. At the same time global defence spending is rising. We are also embarking on an energy transition and broader efforts to achieve net zero carbon emissions. This will require a major investment cycle that will be underpinned by regulatory change and government subsidies.
In addition, US households appear to have finished deleveraging and the largest population cohort, the millennials, are entering the household formation part of their life cycles. This is the time when individuals typically take on the most debt, providing scope for some re-leveraging in the US economy. On average, we believe that the combination of these forces is inflationary and very resource and capital intensive, against a backdrop of notable underinvestment in resource extraction over the past decade. This is in stark contrast to the forces that emerged at the beginning of the last financial cycle.
The implications for investors are multiple: from an economic perspective, a higher and more volatile inflationary environment would cause increased volatility in central bank interest rate cycles. Increased capital intensity could improve productivity, leading to an upward reassessment in nominal growth rates and equilibrium interest rate expectations over the medium-term. Such environments historically have caused higher asset correlations and equity multiple compression. Government bonds would therefore be less reliable as diversifying assets and downward pressure in equity multiples coupled with some upwards pressure in bond yields would represent a notable headwind for passive returns in general, particularly given high starting valuations. A capex-driven and resource-intensive financial cycle could also result in very different market leadership versus the last cycle.
In the coming year, as we continue to transition from one financial cycle to the next, we think it’s important for investors to think deeply about these issues and how to structure portfolios for what’s to come rather than for what was.
This article was first published in Citywire Selector.
