What does the new economic environment mean for investors?

Natalie Brain

Partner

The bottom line:

Investors should remain well diversified, re-consider risks and continue to focus on the long term. While recessions bring additional risks and economic pain, they do inevitably throw up some good investment opportunities – and investors should be ready to take advantage of them.

We’re entering a new macroeconomic era. Following the global pandemic, we’re now facing supply disruptions, a separation of global economic powers (the US and China) and prices rising at a pace not seen in 40 years. As central authorities scramble to control inflation, higher interest rates are curtailing economic growth. The cost of living is higher and recession is imminent – but the crucial questions are: how long will it last and how severe will it be?

As consumer spending is re-directed to the essentials, many businesses will face pressure from falling demand as well as rising interest rates. And with government debt levels already higher than ever before, additional government support comes at a higher future cost.

So, global economic risks have risen. Things haven't gone as markets were expecting, as David Wrigley explores in his article, and the future path is more uncertain. This year we have seen markets react accordingly, as they adjust to the new economic environment.

But successful investing isn’t about predicting the next recession and timing your investments accordingly. Long-term investors will see plenty of recessions come and go. Imagine you were in the 1990s and knew what lay ahead: a huge stock market bubble bursting, a devastating housing crash, near-implosion of the banking system, the Euro crisis, a global pandemic, two 50%+ stock market drawdowns, war on Europe’s borders and runaway inflation, you may well have stayed out of the market but missed out on significant returns in the meantime.

Over the last 20 years, global stock markets have returned around 500% - equal to about 9% per year (assuming 50% currency hedging) – despite many of the events above.

How have expected returns changed?

Yes, assets have fallen this year. But, as interest rates have risen, the flipside is higher expected returns in the future – and any investor adding money to their portfolio ought to welcome that change. Even investors drawing on their assets are helped by higher returns going forward.

The table below shows just how much our expectations for long-term returns changed over the first half of this year - and they will have further to go in the second half.

These are LCP’s best estimate returns, meaning for each assumption there is a 50/50 chance that the observed value will be either higher, or lower, than assumed with a very wide range of possible outcomes around the assumption.

What is our outlook for assets from here?

An understanding of the macroeconomic outlook can help long-term investors to 'lean in' or 'lean out' of asset classes around their central allocation over time, but this should always be appropriately sized and governed by their overall investment strategy.

Equities

Equities have had a turbulent ride this year. We’ve seen falls from post-Covid highs as cheap money is becoming more expensive faster than markets expected, and as we face a recession.

Given the current economic backdrop, it will come as no surprise that the earnings outlook has weakened. And, in my view, will likely weaken further as the effects of co-ordinated monetary policy tightening across developed markets are digested by the economic system.

While equities have become cheaper this year, I still wouldn’t describe them as cheap – although valuations vary across regions. As the US Federal Reserve leads the way with interest rate rises, a stronger US Dollar has meant US assets remain more attractive to investors and come at a higher price. Bo Yu explores regional equity allocations in more detail in his article.

How about different equity styles?

Different stock investing ‘styles’ are impacted in different ways by the current conditions. Growth stocks (such as technology) typically fare poorly in a rising interest rate environment, as the future earnings expected become discounted at a higher interest rate. However, value stocks (such as utilities) are less affected, as there is less impact on the attractiveness of near-term cashflows. Following years of strong performance from growth stocks – particularly in the technology sector – we’ve seen the trend reverse recently in favour of value stocks.

Credit

Given the intrinsic relationship between bonds and interest rates, credit assets have reacted quickly to the shifting economic backdrop.

As interest rates rise, the higher discount rate applied to their cashflows reduces bond values (i.e. the present value of future cashflows falls). In current conditions, fixed income bonds have suffered a double-whammy as higher inflation erodes the value of their future cashflows even more.

In response to greater economic uncertainty, corporate bond spreads have also risen. The below charts show the current level of investment grade credit spreads (the orange bar) compared with how that level has varied over the last 15 years, up to 18 October 2022.

Merrill Lynch £ non-gilts (all stocks) spreads

Source: Bank of America Merrill Lynch

Merrill Lynch £ non-gilts (over 15 year) spreads

Looking at the two charts we can see that both 'all stocks' and 'over 15 year' credit spreads have moved outside their ‘typical’ range. The difference between the two has also narrowed, reflecting more uncertainty over both the shorter-term and long-term outlook.

While default rates remain low, this offers attractive opportunities – though we may well see these increase as the recession unfolds.

Olivia Buah assesses different opportunities in the credit market in her article.

Property

Property assets appear to digest new economic conditions more slowly than equity investments, and I, therefore expect some adjustments on the horizon as the real estate market reacts to higher interest rates. Following the sharp rise in gilt yields, we’re seeing a narrower premium (i.e. additional return over gilts) on property assets which may well signal valuation falls to come as the premium readjusts to more normal levels.

While property assets can offer some inflation protection via rental increases, even long-lease property which benefits from explicit inflation-linked contracts is subject to caps which bite at levels much lower than the 10% rates of inflation we’re experiencing.

Recession will place additional strain on property assets – particularly within certain sectors, such as leisure and hospitality, where consumers will have less available cash to spend. But, over the long term, property continues to offer good diversification and an attractive illiquidity premium to investors.

What does this all mean for investors?

We’ve already seen markets react to the changing economic environment, but I expect more adjustments to come.

I’d like to remind investors to:

Remain well diversified. In almost all asset classes this means looking global, and giving emerging markets (especially China) some consideration.
Re-consider risks. As we adjust to the new macroeconomic era, investors should re-assess the risks they are taking and ensure that any 'bets' e.g. on countries, sectors or styles are appropriately sized.
Continue to focus on the long term. Long-term investors will see many recessions come and go. While recessions do bring additional risks and economic pain, they do inevitably throw up some good investment opportunities – such as credit markets just after the 2008 crisis. Investors should be ready to take advantage of them.

Yes, the world is uncertain – but it always is.