Experts argue that interest rates and inflation will remain high, which will hold back index returns.
Since the stock market crash caused by the 2008 financial crisis, investment returns have been spectacular, driven by loose monetary policy and an ever more globalised world where companies could produce more for less, which rewarded shareholders.
Over the past 15 years, the MSCI World index, in sterling terms, has returned around 10% a year, even after a challenging 2022 when the index fell 8%, propped up by a weaker pound. The bull market can be traced back even further, to the end of the inflationary boom of the 1970s and the decline of interest rates from highs of 20% in the US and 17% in the UK.
But some investors are predicting a paradigm shift for stock markets and see a new era where inflation remains high and global economics slows. The consequence will be that indices will disappoint and struggle to deliver real – or inflation-adjusted – positive returns.
One person in this camp is Dan Brocklebank of Orbis Investment Management, the fund group behind the Orbis Global Equity and Global Balanced funds, which are both top performers over the past 12 months due to their contrarian “value” investment approach.
Brocklebank said: “The core issue is that it is a new paradigm. Valuation of shares and bonds will matter more now that interest rates are higher, so investors need to buy something for less than it is truly worth.
“A decade of central banks attempting to stimulate growth and prevent deflation has lowered the price of money, but this is now changing. However, market cycles do not correct in a year and excesses have been built up in so many places in investment markets. The stock market crash in 2000 after the tech bubble burst led to six years of value shares doing well. Given that earnings’ expectations for companies are still really high, and so are profit margin assumptions, there could be more market falls to come.”
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Brocklebank says the best way to invest in this new paradigm is to buy cheap, “value” shares, because major stock market indices, which are packed with the largest and most expensive shares, will do poorly.
“A passive 60/40 portfolio is not good option. Vanguard fans need to look past them and look at valuation as well. Valuation did not matter for the past 10 years – but now it does. The next 10 years could look very different to the last 10 years.”
He says that energy, banks and defensive companies are the best places to be invested.
Thomas Becket, chief investment officer at Canaccord Genuity, a wealth manager, also says that simply sticking with a passive fund will disappoint under the new paradigm of higher interest rates and inflation.
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He said: “Vanguard has been the best thing for the past decade. Vanguard won. But now high interest rates will have a big impact on stocks: good companies and bad companies will perform differently when money isn’t free.
“This differentiation should be good for active managers – and their improvement last year will not be a flash in the pan. The US stock market is expensive and may not move much in two years. The next decade could see a new paradigm, of value over growth investing.”
Becket argues that the outperformance of value shares, as well as the UK, European and emerging market indices, will keep going.
“It will not be a lost decade for investors if they look past what has done well over the past decade. I’m not anti-equities, but I think investors need to be more active.”
Do strong markets this year change things?
But does the strong start to the year for stock markets suggest Becket and Brocklebank are wrong? Not according to Steve Russell, investment director at Ruffer.
He says that behind this rally is a growing belief that we could have a “soft landing”, where inflation falls and there is no recession.
“This could happen. Higher interest rates will take time to impact economic growth and China’s reopening is playing a big part in this newfound optimism.
“But at the moment it seems as though investors are trying to have their cake and eat it. Markets want to have the cake of stronger growth, while also eating the cake of interest rate cuts later this year. In fact they are now forecasting interest rates to be lower in 12 months’ time than they are today,” he said.
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He argues that investors are not paying attention to what the US Federal Reserve is telling them, namely that they are unwilling to risk a 1970s-style inflationary period.
“Chair Jerome Powell and the other Federal Reserve members are desperate to restore some of the credibility lost when inflation turned out to be not so transitory in 2022. Hence their repeated statements emphasising the need to avoid the mistakes of the 1970s and not loosen policy too quickly.”
Despite their strong start, markets are not out of the woods yet, Russell argues.
He says investors should enjoy the early 2023 bounce, but the need for protection in portfolios has not disappeared.
“Remember that markets can be very wrong. Just a year ago they forecast only 0.8 percentage points of interest rate rises in 2022 – we ended up with 4 percentage points,” he said.
Have inflation and interest rates peaked?
The counter argument is that central banks are close to reaching their peak interest rates, which would bring an end to a period of dramatic valuation adjustments as interest rates rose.
Bond markets suggest a couple more interest rate hikes in the UK and the US before potential cuts later in the year as the impact of higher borrowing costs slow down economies – and hopefully inflation as well.
This is what has spurred markets higher this year – investors are betting that inflation can be brought down without many more interest rate hikes and that a recession can be avoided.
Chris Iggo, chief investment officer at AXA Investment Management, says markets are rallying because this period of monetary tightening is almost over.
He says: “Inflation is much too high for policymakers to be complacent and the medium-term outlook for inflation is uncertain. However, across economies headline inflation is falling quickly and could even get back to target levels before the end of this year. Even if there are final moves higher in policy rates in March, the market pricing of where terminal rates will be has been consistent in recent months and there is no need for that to change.
“The game going forward will be central bankers justifying why rates will stay high and markets second-guessing them by pricing in cuts. That game is already well under way in the US and UK with rate cuts priced before the end of 2023.”
While Iggo recognises that US shares are still expensive relative to other markets, he says that valuations are typical for US shares.
“The US market may still seem expensive, but the current price-earnings is bang in the middle of the valuation range that has been in place since 1993.”
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Even if there is a prolonged period of high interest rates, Dave Bujnowski, manager of the Baillie Gifford American fund, argues that this does not have to be bad for “growth” shares. His top stocks include Tesla Inc (NASDAQ:TSLA), Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX).
“Identifying great growth opportunities is not about asking what is expanding, but asking what is changing. And the good news is that there is a lot of change happening in the world.
“Are the forces behind an [economic] cycle what matters, or are the structural shifts that drive long-term growth what matters?”
Bujnowski says investors should look through the cycle and focus on companies instead. “During a downturn there can still be magical innovations taking place. Because macro conditions might be challenging, it does not mean there aren’t amazing visionaries out there looking for problems to solve,” he said.
Demand in the system may not necessarily grow, but Bujnowski says a growth business can generate new supply in a system and win market share.
“Demand for video entertainment has not increased in the past decade, nor the hours in a day, but how people got their content changed,” he said.
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