News & Insight • Market Insights

09 January 2024 | Simon King

A View from The bridge - Changes

Our thought piece at the beginning of 2023 was titled “Reasons to be Cheerful” and identified some positive factors that might improve sentiment against a generally tough economic background.

We discuss the nitty gritty of what occurred in 2023 in a different article but overall our view has proven largely correct, although even we did not forecast the extraordinary rise in parts of the US equity market. One of our conclusions in January was that the market needed sight of the new normal. It is still far from clear what this will be but, in this piece, we follow the lines of David Bowie’s 1972 classic, which predicted a constant change of musical styles and outline our thoughts on what changes may lie ahead in the next decade. We ask ourselves a series of questions the answers to which provide an insight into how we see the world shaping up.

Where are we starting from?

We need to remind ourselves as to where we are starting from. From the aftermath of the 2008 financial crisis there was a period of unparalleled stability with very low levels of inflation and interest rates, but also subdued economic growth and unprecedented levels of intervention by government to offset the impact of both the great financial crisis and COVID-19. This led a whole generation to be convinced this was the normal and they should therefore expect similar conditions in the future.

The ravages of inflation in 2022 and 2023 and the consequent huge increases in interest rates were a rude awakening for the vast majority. Now everybody is trying to identify what should be regarded as the new normal. We do not have a crystal ball, but we are convinced it will not be the same, not because we are great believers in mean reversion but because we have never started an economic cycle from this overall position ie a weak global economy with high interest rates and unprecedented levels of government debt.

What are the consequences?

The major adverse consequences of the past decade are many. A rising tide has carried all ships, as an era of lazy, liquidity driven investment has driven all asset classes higher. Companies have been allowed to borrow too much and at artificially low interest rates. This has meant many poor-quality players have been able to exist for far too long. In addition markets have dried up as a source of equity funding, due to both demand and supply. This is no bad thing because the market in general has been a terrible allocator of capital in recent times, which ultimately is its only task of economic worth.

We do believe there will be some mean reversion in market dynamics. Quality companies delivering either high levels or consistent growth will become very valuable and enjoy the ability to raise further equity and debt. Debt defaults will increase, and bad companies will go bust in increasing numbers, as they run out of cash and cannot find any more, which is again positive for the long-term health of the economy.

What should we invest in?

Portfolio construction needs to be different. Many of you will have seen various articles commenting on the breakdown of the classic 60/40 model. This is a construct where a portfolio has broadly 60% of its assets in equities and 40% in bonds/fixed interest. This strategy worked for a long time with equities growing over time and bonds not doing much and therefore dampening underperformance when equities came under pressure. The evidence to support this theory has always, in our opinion, been flaky at best. It has also been compromised by the 40% becoming a bucket filled with “other” good and bad assets often dressed up as something they were not. Many were effectively equities and hence unsurprisingly the 60% and the 40% performed in very similar fashions.

We are of the view that moving forward, it will be more necessary to concentrate on investments that will produce positive returns over an extended period. Investors should look to a spread of exposures and risk, but each should command a position in portfolios based on their own merit. Bonds, for example, are a very different proposition when yielding 5% than when producing 1%. Investments should also be made to suit the actual underlying client and not to chase hot asset classes. Again using bonds as an example, the reason an individual may want to hold them is very different from the reasons a pension fund would buy them.

Where should we invest?

Although we are agnostic to where a company resides, we are very interested in where it does its business. At a country level we continue to focus on markets, which can stimulate growth on their own. The most obvious example of this is the US where overall economic performance continues to be better than expected and where stock market returns have been the most impressive. There is no reason, with the exception of government debt levels, that this should not continue. Whilst the US market is currently expensive on a short-term view, its size, capacity for innovation and general levels of optimism make it attractive in the longer term.

We find the demographics of India very compelling and whilst the current political and resulting currency stability continues, we believe it will deliver very attractive returns. Japan has been a very good performer in 2023 but much of those gains have been eroded by the weakness of the Yen. We are certain that even a slight shift in policy by the Bank of Japan will drive large capital inflows, which coupled with continuing balance sheet reform by companies, will mean even more upside. There are several other markets that will exit the current generic position of high inflation and interest rates in a very different fashion, and at a quicker pace than the norm and it will be crucial to identify these and invest in them.

Will politics be important?

Politics is always a subject which will have a major impact on both individuals and markets. In our view the next decade will be a crucially important one for all governments around the world rediscovering that one of their key responsibilities is to set the agenda for the long-term prosperity of their nations. Deglobalization coupled with governments working in silos, means that in the last 30 years too many governments and systems have become too short term and reactionary at the policy level. This has not been helped by a major swing from democracy to autocracy in many major democracies. There has also been a tendency for more rapid regime change with incumbents far more likely to lose than in the past.

This will not be a short-term fix, as vast swathes of capacity have been taken out of most systems and this will need to be rebuilt. We note that in 2024 there will be over 30 general elections with over 50% of the world's population being involved. By the end of 2024 we will have a much clearer picture as to the likely route map for at least the next five years. The major impact on markets will be an increase in uncertainty with more apparently illogical decisions and policies changing more frequently to sate the whims of populist factions.

Should we worry about migration?

Our use of demographics as an investment tool has meant we pay very close attention to the hotly debated subject of migration. It is a sign of the times and the political landscape that this is more commonly referred to as immigration in much of the media today. It is a simple fact that the world has always relied on the movement of large numbers of people, as demand and supply for labour has fluctuated in different parts of the world.

The isolationist and jingoistic strategies that have been employed by politicians of all hues in order to win elections, have resulted in a negative view on any migration. Despite this there has actually been a very large increase in global movement of people since 2019. The issue has been that the majority of this has been uncontrolled ie Illegal.

In the long-term, efficient movement must become the norm. However in the medium term, we believe it will continue to have a major impact both politically and economically, as individual countries struggle to provide the infrastructure such as homes, schools, and hospitals to cater for large net migration. One could argue that in the real world the uncontrolled element of migration is a sign of an efficient market overcoming political hurdles. In reality, we expect this to be a huge topic and one that will be a major factor in terms of determining future levels of global growth.

How will we divide the pie?

Regardless of one’s political allegiance, it is surely an unarguable fact that the pie will have to be divided more evenly in the future. This is not just in terms of the poor and the wealthy, where differentials are at historically very high levels, but more importantly, in terms of developed and developing nations. In our view, this will be a mechanical process, as countries with more youthful populations, excess capacity and entrepreneurial drive will simply become more successful and will be able to afford a greater proportion of the world's goods and services. This period of catch up has continued for some time and will not be dependent on the grace and favour of the developed world, since many of these countries are more than capable of generating economic growth, both independently and collectively. This will have a major impact on countries with limited growth prospects and ageing populations.

Is it all about inflation and interest rates?

We have spoken at length on the topic of inflation over the past two years. As such we do not intend to comment extensively on the subject in this piece. The crucial factor is at what rate it settles and how volatile it will be moving forward. Consumers tend to have very short memories and as such the fact that most are at least 10% poorer in real terms will dissipate and consumers will adjust consumption patterns without really noticing. What is crucial with inflation in market terms, is the impact it will have on future interest rates. Possibly the most important number for the next decade will be the level of interest rates and therefore the rate of economic growth that can be produced globally. We remain perplexed as to how little attention the crucial subject of economic growth currently receives. Ultimately it is the only number that matters.

Unfortunately, we are of the view that interest rates in the long term will be somewhat higher than most are anticipating. The fact remains that virtually all major governments have materially higher levels of borrowing then previously. They are also largely committed to significant levels of unfunded spending. As such, they will need to borrow further large amounts, which will mean substantial bond issuance over the next few years. Up until 2022, this would not have been a problem since most governments could borrow at broadly the same rate in the long-term as in the short-term. This is not normal and usually any borrower would pay more for long-term debt since the lender requires a premium for the fact that they are taking more risk. It is totally unclear as to whether this “term premium”, as it is known, will return. Again we suspect that it will, and this will produce a major constraint on the ability of both public and private players to invest for growth. Balance sheet strength for both governments and companies will yield outsized results, in that it will provide funding flexibility and optionality. Individuals will have to become used to more volatility and thus, higher interest rates and unless technology advance starts to realise true productivity gains, then periods of marginal declines in living standards are to be expected.

What will be the impact of technology?

The major driving factor in equity markets during 2023 was technology, and in particular anything related to the subject of artificial intelligence (“AI”). We are not smart enough to fully comprehend the ins and outs of AI as a technology. However, we do believe that it will result in some profound changes in life moving forward. In our view, its greatest strength will be to produce a step change in processing power and the ability to analyse vast amounts of data very quickly. This will essentially allow many tasks and processes to be run in real time. Whether this is the monitoring of industrial systems or the diagnosis of medical data, it will be hugely beneficial. We are cognisant of the dangers of AI but are actually more concerned around its misuse, rather than the likelihood of it becoming a rogue monster. We are hopeful that it will produce the long-awaited productivity gains that the global economy so desperately requires. Our focus will be not just on outright providers of AI but also on companies that can benefit from using AI in their existing models. Successful companies are usually good at adapting to and incorporating changes in technology. We must also recognise that there will be some companies and markets, which will suffer from the development of AI.

On technology generally, we have previously commented on our frustrations that it has failed to produce meaningful productivity improvements and indeed in the case of social media, may well have resulted in reductions. Whilst we appreciate social media may well produce personal utility, we struggle to see that it produces an overall net benefit to the economy and are concerned that its sheer scale and complexity leads to much wasted time and effort. It is vitally important in the next decade that society grasps the huge opportunities provided by technology and employs it to produce real advances in all areas of life. We can think of no better example than health care, where ageing developed populations must figure out how to reduce cost and labour intensity in caring for the elderly. Remote monitoring, predictive analysis of health data and process simplification could all yield massive benefits.

Will the new Blue Chips continue to prosper?

The performance of a small number of very large US companies has been the subject of much press during 2023. We have commented many times that the Magnificent Seven, Nifty Nine or FAANGS as they are variously known, are on the whole a very impressive group of companies. Indeed we have large investments in many, but not all of them. We have dubbed them the new Blue Chips, due to their ability to perform in all types of economic conditions.

Although we believe that most of them will continue to prosper for quite some time, history tells us that some of them will fall by the wayside. Capital discipline will be the key. All of them enjoy previously unheard-of levels of profitability and cash flow. How they deploy this cash will determine their future success. Very few companies are good at more than one thing, and we suspect that those that over diversify will be the casualties. As such we would anticipate the performance of this group of equities to meaningfully diverge over the coming years.

Should we invest in energy?

We have unashamedly taken a very pragmatic view to investment in traditional energy stocks and shares. Now that the ESG bubble has deflated the market can start to assess the real prospects and opportunities for all players in the wider energy market. It is undeniable that the world will have to electrify with green source energy in the next 20 years. In our view this will require not only consistent long-term planning and policies, but also a major increase in the price of traditional energy sources, mainly oil. This will result in the adoption of clean energy in a more rapid fashion. This will have to occur in order to effectively price out environmentally unfriendly energy systems. However, in the extended transition, there will be some substantial investment opportunities. Although this may be unpalatable to some, it is a means to an end and in our view, will result in society achieving its climate goals more efficiently.

Will things calm down and be more predictable?

Although it may feel that the past 10 years have been pretty tumultuous, we see little that will reduce this trend of variability in the next decade. Uncertainty and volatility are likely to persist, and this will add cost to the system and again restrain growth. Whether it be environmental, conflict or geopolitical drivers someone has to bear the consequences and the costs eg increased insurance premiums or simply repairing the physical and human cost of natural or man-made disasters. This will both divert capital away from more productive projects and make long term planning more difficult.

Variability in financial markets will also continue to be a dominant feature. Correlation ie where investment classes move up and down together, remains a conundrum with the very long term received wisdom breaking down from 2010 to 2020. We will see whether correlation returns. We will also have to get used to trends not being in straight lines. Inflation is a good example, where a long period of flat lining was replaced with a very sharp increase and then a very sharp decrease. It is likely that once it has stopped falling it will progress along a more volatile path with continual rises and falls due to all the factors we have mentioned previously.

In conclusion

In summary we hope we have provided a well-balanced view of what may occur in the next decade. By nature it is somewhat disjointed, but it will evolve and consolidate over time. Our aim was to find the new normal and although that is difficult to pin down, we do think it will be different to what has gone before. We are starting from a position for which there is no precedent or guidebook, and having to deal with the consequences of events and policies never witnessed before. This will require investors to be imaginative, think outside the box and appreciate that the pace and direction of travel will be very different in different places. The political landscape will change more frequently and have a bigger impact on markets not least around the subject of migration and the division of wealth. Growth will become ever more valuable. Technological advance and energy transition will be the crucial drivers. Overall people will have to adjust to fewer straight lines. All of this does not mean attractive investment returns will not be achievable. We remain convinced that patient and intelligent investors with reasonable expectations will be rewarded