Shifting forces - Adapting to a new investment landscape
4 min read 29 Apr 24
In the early 1990s, the end of the Cold War and pre-eminence of Western liberal democracy was said to signal the “end of history”1. A period of ‘Great Moderation’ followed, characterised by above trend economic growth and declining inflation, as the global economy underwent a major increase in cross-border trade, connected by the advent and expansion of the internet.
Low and, in some cases, declining inflation allowed central banks to increasingly focus their policies on stimulating economic growth. This led to longer, better defined and more globally synchronised business cycles; there were 12 years from the Global Financial Crisis (GFC) in 2008 to the downturn triggered by the Covid-19 pandemic in 2020.
However, observes Parit Jakhria, the Director of the Long Term Investment Strategy team in M&G’s Investment Office, in the aftermath of Covid we’ve seen waves of structural change, particularly with the modus-operandi of central banks focusing on the twin dimensions of growth and inflation (as opposed to mainly growth previously). This has fed through to structural shifts in global markets.
He explains: “Last year, we experienced a rather violent deviation from the low interest rate environment we were accustomed to prior to the pandemic. Central banks’ efforts to clamp down upon soaring inflation led to interest rates and government bond yields reaching levels last seen 15 years ago, before the GFC.”
Given this context, Jakhria believes it is important to take a step back and reflect on some of the regime changes that have taken place in global capital markets pre- and post-Covid.
‘Central banks’ efforts to curb inflation led to interest rates and government bond yields reaching levels last seen before the GFC.’
Geopolitics as a risk factor
Another notable development is the end of the so-called ‘peace dividend’. Following the fall of the Berlin Wall in 1989, the world enjoyed an extended period of relative peace and prosperity. However, the current geopolitical climate is marked by rising tensions, instability and uncertainty, as the world faces multiple crises and challenges, with Russia-Ukraine and Israel-Gaza prominent examples.
“The geopolitical environment is extremely fragile, with the world order of the past thirty years increasingly challenged,” observes Jakhria.
With 40% of the world’s population (contributing to over half of global economic growth) entitled to vote in elections in 20242, together with the plausible prospect that Donald Trump will be re-elected president in the US in November, geopolitics is high on the agenda this year.
“Of the many factors influencing global capital markets, geopolitical risk is the most challenging to navigate, and arguably has the largest unknown element. Many developments are slow moving, often happening in the shadows, but tensions can escalate suddenly, leading to increased volatility,” Jakhria notes.
Over the longer term, a combination of greater strategic rivalry and reduced economic cooperation poses a headwind for potential growth in the global economy, while raising the risk of future shocks to inflation based on supply-side issues.
In the near-term, the “increased instability of the geopolitical order means investors will need to get accustomed to periods of considerable uncertainty”, he explains.
Soft-landing ahead?
To navigate this volatile environment, the Long Term Investment Strategy team (LTIS) believes it is necessary for investors to consider both cyclical and structural factors.
In terms of the cyclical outlook, this includes taking stock of how economies have digested rate hikes so far and whether a ‘soft landing’ – where inflation is normalised without the need for an economic contraction – can be achieved.
With 2024 well underway, there is a clear question that remains unanswered: are economies more resilient than previously thought, with the implication that the sustainable level of interest rates is higher than past estimates, or has the impact of the aggressive tightening merely been deferred by the strong starting position of private sector balance sheets?
“Monetary policy is said to act with long and variable lags,” says Jakhria. Several factors have helped, including greater fixed rate borrowing, which has delayed the feed-through of higher interest rates to aggregate borrowing costs, and excess savings built up during the pandemic, which have helped to support consumption and provide a buffer to rising interest costs.
“Markets for their part have oscillated for the past year between concerns for financial stability and confidence that the economy is resilient; at present, pricing appears to lean toward a benign outcome,” he adds.
“Given these conflicting prospects, the moves of the past two years have reset the valuation outlook, making core fixed income much more attractive in relative terms, and a useful addition to the portfolio. Meanwhile, the varying experiences across different regions highlights the diversification benefit more than ever of maintaining good breadth of coverage in global capital markets across asset classes and geographies.”
The promises and challenges of AI
In relation to longer-term structural drivers, LTIS will be watching the emerging technologies, notably generative Artificial Intelligence (AI), that gained traction in 2023 and the scope for them to drive a pickup in productivity growth.
The team believes AI has the potential to change the nature of our economies in the years to come. “Given some of the structural headwinds we face, such as low productivity growth and ageing populations, a leap in technological development may offer a new source of growth,” argues Jakhria.
In addition to the predictions that AI could drive innovation, efficiency and productivity growth, there are concerns that AI might take people’s jobs.
“History suggests that humans are incredibly adaptable in aggregate and not nearly as replaceable as one may fear. However, the potential for AI to disrupt the labour market in certain sectors is very material”, notes Jakhria.
“Whilst emergence of new technologies can be a source of optimism for investors, there is a risk of complacency, and in particular overestimation of the short-term benefits to the tech sector. We are yet to fully digest future risks (loss of jobs/regulation) and opportunities from AI and asymmetry continues to exist between the public/lawmakers and AI providers,” he adds.
Investing amid uncertainty
With a number of other risks to watch out for this year, including potential financial instability, politics, China’s economic outlook and climate change, the current environment is one where uncertainty remains elevated.
Against this backdrop, LTIS is taking a balanced view, cognisant of the remaining risks to the global economy, but acknowledging scenarios where the global economy can successfully navigate the challenges ahead.
The team’s thinking can be summarised across four areas: adjusting its starting position for higher bond yields, continuing to pursue geographical diversification, being nimble with strategic asset allocation (SAA) adjustments and going beyond equities and bonds for diversification.
In their view, one of the main investment ramifications of the changing investment landscape is the increased attractiveness of fixed income valuations.
“With bond yields having firmly left behind the lower for longer era, the prospective return environment for fixed income has improved considerably compared to the last decade,” Jakhria surmises.
The team’s thinking can be summarised across four areas:
Meanwhile, the yield for other asset classes, such as equities, has been more stable, reducing implied estimates of risk premia (the amount of additional return or compensation that investors expect to receive above the return on a perceived “risk-free” asset such as government bonds).
On balance, the changed relative value environment and ongoing geopolitical concerns warranted a re-weighting within multi-asset portfolios between fixed income and equities, according to the LTIS director.
A key tenet of Jakhria’s capital markets assumptions framework is the inherent future uncertainty, ie, there is only one realised past, but many potential futures. To navigate this unpredictable environment, diversification remains critical, both in terms of asset classes and geography, while shorter, more volatile economic cycles could require an even more agile, dynamic approach to asset allocation.
The Long Term Investment Strategy team, part of the Investment Office at M&G plc, sets the Strategic Asset Allocation (SAA) for internal client savings and investment products as well as providing various economic scenarios and modelling for M&G plc.
1The concept of the “end of history” was proclaimed by American political scientist Francis Fukuyama in an influential essay titled ‘The End of History?’, published in the international affairs journal ‘The National Interest’ in the summer of 1989.
2 Brace for Elections: 40 Countries Are Voting in 2024 – Bloomberg; Eight Key Elections to Watch in 2024 – Brunswick Group.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.
