Following a summer break, it feels like a long time since I last wrote. As we head swiftly into Autumn and the world gets back to business, I cannot help but reflect on what has, undoubtedly, been an extraordinary year.
I have written before about some of the distortions and disconnects we see in financial markets and it has, indeed, been a strange year. Global equities are up significantly since the recent lows of March 23rd but the rally has largely been limited to internet and technology related stocks (chart 1):
On top of this, global equities have continued to rise on the face of sporadic but serious new outbreaks of Covid-19, particularly in Europe (chart 2).
If we take the US as a case study, the ongoing fears of the pandemic and greatly reduced activity in leisure have caused consumer confidence to fall sharply and diverge from stocks in a way not seen before (chart 3).
The most widely accepted explanation for this is the massive amount of monetary and fiscal stimulus provided by central banks, resulting in excess liquidity (money) flowing into risky assets.
Not only has central bank policy been extremely accommodative, it is likely to remain so for longer. Recently the US Federal Reserve announced a subtle but significant change in its policy framework consisting of two key elements. The first is that the Fed will no longer target 2% inflation but will now look to achieve 2% inflation on average over time. This means that the Fed has allowed itself room to overshoot for “some time” after period of low inflation. The second change is that a rise in employment above the Fed’s “maximum” level will no longer necessarily trigger a tightening of policy.
Since the 2% target was introduced in 2012, headline PCE inflation has only been above 2% for 14 out of 102 months and so the aim of the changes is to raise inflation expectations and implies a commitment to very loose policy for even longer.
The big question for investors is “will it be enough?”. Honestly, we don’t know but there are several growing risks on the horizon. The appetite for fiscal support is waning with the UK’s wage replacement scheme due to come to an end next month and the absence of a further support package in the US. The risks of a “no deal” Brexit are rising, and we also have the US elections in November to think about.
Nonetheless, the magnitude and power of monetary stimulus should remain supportive of equity markets. However, as I wrote in my last piece, we expect the long term returns from all asset classes to be materially lower than they were over the past decade. Our research partner, BCA’s valuation indicator points to an annual return of only around 3% for global equities over the next 10 years and the returns from bonds are unlikely to be much above zero, given their historically low yields (charts 4 and 5).
I would caveat this by saying that any forward-looking assumptions need to be taken with a pinch of salt and that some regions will outperform others. Nonetheless, investors would be wise to be pragmatic in their return assumptions from here.
So, where does this leave us? Well, as regular readers will know, we are firm believers in sticking to a sensible long-term strategy, not trying to “call” the markets and not trying to be too clever. Modern financial markets are extremely efficient and to believe that we have an information advantage over any other participants would be foolhardy, if not outright delusional.
We continue to believe that a well-constructed, diverse portfolio should deliver relatively attractive risk adjusted returns over the long term.
Until next time, stay well.