Regime Shift – Investing into the new era
The re-opening of economies after Covid has sparked a phenomenon investors have not seen in decades.
As this economic cycle ends, marked by a global pandemic, Azad Zangana, Senior European Economist & Strategist at Schroders, said we should not expect to see the same pattern repeated from the past decade. A new regime in policy and behaviour is unfolding which investors need to understand to safeguards their portfolios.
As part of his analysis, Azad identified five key themes that will shape the medium-term:
Central banks will prioritise controlling inflation over growth;
Fiscal policy is likely to be more active;
New world order will challenge globalisation;
Companies need to respond by investing in technology;
Response to climate change is accelerating.
Azad Zangana comments further:
“The type of inflation we are seeing has gone beyond the transitory shocks that central banks could ignore in the past. Central banks must now lower inflation, even if it means causing recessions, and interest rates may have to be higher for longer.
“Governments will attempt to alleviate the effects of higher inflation through taxing and spending policies. Public finances are in terrible shape after the pandemic, and so we may see greater pressure for re-distribution.
“The pandemic and Chinese lockdowns highlighted the fragilities of global supply chains, so we are likely to see increased diversification and onshoring or “near-shoring” of manufacturing. The war in Ukraine has also highlighted fault lines.
“Companies are facing higher commodity costs and higher staffing costs due to labour shortages. To achieve growth, companies will need to invest more in technology to boost productivity. This also means replacing labour with machines and AI where politically feasible.
“Though governments have been slow to coordinate and act in response to the climate emergency, companies are taking the lead.”
It’s all about valuations
As a degree of normality returns to markets for the first time in years, a focus on valuations must return too, according to Schroders Group Chief Investment Officer Johanna Kyrklund.
Having just lived through a once-in-generation crisis, in the form of the Covid-19 pandemic, we’re now seeing the status quo of the past 30 years turned on its head. After decades of relative peace and falling inflation, we are now confronted by increased geopolitical tension and rising inflation.
As investors, however, we are seeing a return to some semblance of normality. I don’t mean that this environment is easy by any means, but for the first time in a long time we have positive nominal interest rates on holding cash. This changes the investment dynamic considerably compared to a couple of years ago, when we were forced to buy ever-more expensive assets in a world of endless liquidity to generate return.
In recent months, the mindsets of investors have moved from “denial” to “acceptance” in terms of their expectations of central bank hikes. Market expectations are now reasonable. This is a big change compared to last summer.
Diverging central bank policies, driven by differing levels of inflation, exposure to the energy crisis and the pandemic, also create opportunities within asset classes.
In the last decade with quantitative easing and rates pretty much pinned down at zero across the world, there was very little differentiation in monetary policy. This made it hard to take investment positions that favoured one country over another.
Now, we still probably have to work our way through a recession in 2023, but looking back at how we came out of the 2001 recession, we saw economies recovering at different speeds. This made it interesting from an investment perspective and I certainly think this will be a great opportunity over the next couple of years.
Already, it’s worth noting that emerging markets were far quicker to deal with inflation last year, so they’re getting very near to the end of their tightening cycle. They’ve already taken a great deal of pain by pre-emptively raising rates, and we now see some value in emerging market assets.
So, inflation is the key to market performance in 2023. Provided inflation does come down, we could start to see a more benign environment for markets. But if inflation persists, then we’ve got a problem on our hands. Rates might then have to go even higher, and markets would have to reassess valuations once again.
However, compared to the volatility of 2022, we expect interest rates, and therefore fixed income, to be more stable in 2023, allowing investors to take advantage of the yields on offer. Indeed, the appeal of bonds has changed from being their diversification benefits, to their yields.
Turning to equities, we don’t think valuations are as attractive as bonds are and we need earnings expectations to come down further given recessionary risks.
What could be the triggers for a stronger recovery in equities? Any evidence of a weaker labour market in the US would allow the Fed to back off from raising rates, which would allow bond yields to adjust downwards and allow equities to re-rate.
There is also potentially more opportunity within equities. After years of unrelenting outperformance by the US, driven by the strength of the technology sector, markets outside the US now look very cheap.
But, as we’ve already touched on, investors will need to be more discerning and selective, both on countries and companies in this new environment. There will be an increased divergence between the winners and losers in both fixed income and equity markets.
We should also remember that historically some of the best opportunities for equities occur in the midst of recessions. Markets always move ahead of economic news.
So, in 2023 investors need to focus on valuations, not on the newspaper headlines.
Recession looms for 2023
Global growth is set for the weakest year since the 2008 financial crisis with the battle against inflation remaining centre stage, the audience were told at Schroders Crystal Ball 2023 Outlook webinar.
Keith Wade, Schroders Chief Economist, comments:
“The coming year is expected to be one of recession for the advanced economies with the eurozone now expected to join the US and UK in recording a fall in output for 2023 as a whole. The emerging markets have also been downgraded, but we still expect a modest pick-up here in 2023 as China revives.
“Inflation is expected to decline in 2023 in response to weaker growth and the creation of spare capacity in the advanced economies. Stable commodity prices and an easing of supply bottlenecks also help ease inflationary pressures.
“Although inflation is not expected to return to target until 2024 this should not prevent central banks from easing policy. The US Federal Reserve is likely to ease toward the end of next year and we anticipate the European Central Bank and Bank of England to be cutting in 2024.
“The US is expected to go into recession at the beginning of 2023 as the impact of tighter monetary policy weighs on activity. Fed policy reduces demand, squeezes prices and profit margins resulting in higher unemployment. Inflation and profits fall as a consequence allowing rate cuts toward the end of 2023.”
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