The writer is Chief Market Strategist for Europe, Middle East and Africa at JPMorgan Asset Management
Another panelist at a recent conference proclaimed, “The decades of low inflation were golden times for investors.” The audience nodded furiously, then grew increasingly sullen as all of the panelists agreed that those days were behind us.
Along the same lines, I often hear the argument that low or negative interest rates, and the other monetary tactics that central banks have deployed to fight low inflation, have driven up all prices actives. Thus, higher interest rates should naturally depress the valuation of all risky assets.
Both arguments seem convincing. But neither is necessarily right. Or maybe I should say that the “low rate-reinforcement-yield” argument is not valid for all assets.
Certain asset classes have benefited from this. Companies that saw decent earnings growth while their peers languished were able to demand ever-higher bonuses. Global tech giants are the most obvious example. During the 2010 decade, when the 10-year US Treasury yield fell from nearly 4% to around 2%, the global tech sector produced an average annual return of 17%.
This is partly due to strong earnings growth and also due to investors’ willingness to pay higher valuation multiples. Low interest rates have also made potential gains in the distant future more attractive.
However, many segments of global asset markets have seen a much darker period in the era of low inflation. These were the assets struggling with chronically weak demand and dismal pricing power.
Take the global energy and materials sector, for example, which suffered for a decade from lackluster or non-existent earnings growth and stock market returns. This malaise has dampened all benchmarks for some regions. Europe is the best example, where weak nominal growth was at least partly the reason why companies in the MSCI Europe Index posted average earnings growth of just 3% and an average return of just 9% in the 2010s. That’s about half the growth in earnings and returns seen in the 1990s, when inflation wasn’t so desperately low.
When considering a multi-asset portfolio, it is even more apparent that the era of low inflation was far from golden.
Persistently low inflation has led to continued declines and, in some cases, negative short and long-term bond yields. Bonds have increasingly failed in the two functions they were meant to perform in a portfolio – to provide a nice source of stable income and to diversify risk exposure by rising in price when stocks fall. At such low interest rates, they served neither of these functions, and investors had to experience lower total returns and greater portfolio volatility. In other words, less comfortable days and potentially more sleepless nights.
To demonstrate this, let’s take a simple balanced portfolio of 40% UK gilts and 60% FTSE 100 stocks. In the 1990s, a time when inflation averaged 3.3%, this portfolio offered an average return of 14.5% per year in nominal terms and 11.2% in real terms. In the 2010s, this was only 7.2% in nominal terms and 4.9% in real terms.
Many readers will rightly point out that inflation is not doing investors much good this year, with stocks and bonds posting double-digit declines across most sectors, regions and asset classes. This is where I need to clarify what kind of inflation I am referring to, because inflation comes in good and bad forms. “Good inflation” is a reflection of healthy demand, enough for companies to have some pricing power and confidence to invest in their expansion. Then there is “bad inflation” – a cost shock that acts as a tax on growth.
While we are currently experiencing “bad inflation”, I believe this cost shock should pass within a year. Moreover, inflation will likely stabilize at a slightly higher rate of good inflation since the cost shock will serve as a catalyst for more robust demand and healthier nominal growth going forward as it encourages households, governments and businesses to invest in labor and energy savings. technologies.
Contrary to popular opinion, the new inflation regime should eventually prove to be a good thing for investors. Stronger nominal demand will translate into stronger earnings and sustainably higher interest rates. Multi-asset investors will benefit from higher returns, but only if they are brave enough to consider shifting their portfolio towards sectors of the economy that have languished for much of the past decade and away from those that needed from economic stagnation in order to prosper.