Repeat a few key lifestyle habits consistently for a decade, and they are likely to have had some visible consequences on your quality of life later on. Do sit-ups every day and follow a healthy diet, and you are more likely to have a six pack than your neighbour who lives off junk food and whose idea of exercise is reaching for the TV remote.
We understand the impact of our lifestyle choices on the health outcomes we achieve, even if this knowledge doesn’t motivate us to go to the gym. But while we are quite adept at understanding the costs and benefits of health trade-offs in our personal lives (nothing like a pandemic to turn everyone into an instant health expert), the long-term impact on our investments of the financial ‘lifestyle’ choices various economies make can often be obscured by prevailing narratives like ‘deficits don’t matter’ and ‘inflation is transient’.
In the financial world, central banks and governments are continuously making ‘lifestyle’ choices at the macro level in the form of monetary and fiscal policy. For more than a decade, we have been living in a world awash in excess liquidity fuelled by low interest rates and low inflation. Highly accommodative monetary policy was a ‘lifestyle choice’ for many advanced economies, to stimulate weak economies at a time when it was needed. However, in economics as with our health, bad habits have a cumulative effect over time.
In the case of developed economies, the layering of massive monetary and fiscal largesse on top of supply shocks in the wake of the Covid-19 pandemic tipped the scales against them. And, just like one salad or gym session cannot undo the impact of an accumulation of bad habits over time, unravelling the impact of poor policy choices will not happen quickly. We are likely to see continued volatility in the years ahead as markets digest the impact of the policy pivots we have seen over the last year, and are likely to continue to see going forward.
Last year’s UK bond market crisis, and the current banking crisis, have exposed fragilities in the global economy, but their roots can be traced back over a decade to the era of easy money post the global financial crisis. The persistence of a low interest rate environment created a sense of complacency and rewarded risk-seeking behaviour. While leverage and taking on excess risk may have sweetened returns in a low inflation/low interest rate environment, rising rates have quickly escalated the cost of capital and revealed that the viability of many investments was predicated purely on the continuation of a low inflation world. In a sense, we have been living in a ‘fast food’ investment world, driven by easy money.
While the crypto market was one of the first areas to suffer, more recently other interest rate sensitive and leveraged areas have come under pressure. There can be little doubt that the contagion concerns in the banking sector have been a result of the rising interest rate environment. This will not be the only area of the market where cracks are likely to appear.
While it may be impossible to identify exactly where the next crisis will erupt, it is possible to identify likely candidates of financial stress. In addition to leveraged private market investments and corporate real estate (particularly office space), we believe Japanese government bonds is another potential area of stress. Most developed market central banks allowed their bond yields to move higher as inflationary pressures rose, but the Japanese central bank is still exercising yield curve control. They have purchased more than $3 trillion of Japanese government bonds (accelerating purchases in early 2023), and now own most of the 5- and 10-year issuance.
This amounts to highly accommodative monetary policy despite inflationary pressures, at a time when they also have a sizeable fiscal deficit and a large debt to GDP ratio. Yen weakness (reaching a 32-year low in October 2022) was the natural consequence of a monetary approach at odds with other developed market central banks – this in turn created further distortions and pressures. While we don’t try to time markets, and we acknowledge that shorting Japanese government bonds has become known as a widow-maker trade due to large losses, it seems unlikely that the current approach can be sustained indefinitely. In addition, any change in Japanese central bank policy has potentially dramatic global consequences, because Japanese investors hold significant quantities of developed market bonds and other debt securities. A change in direction by the Japanese central bank could lead to Japanese investors liquidating these holdings.
However you choose to view the matter, it seems clear that a higher inflation environment will not benefit those who have built their investment strategy on the economic ‘lifestyle’ choices of the past decade. To bring it back to my earlier analogy, it is time to review your habits and switch from the ‘investment fast food’ to the ‘investment salads’. As monetary and fiscal policy is forced to normalise and it becomes clear that deficits do matter and inflation is likely to persist at higher levels for longer, the investment habits of the past will no longer be rewarded.
If your portfolio is positioned for a low interest rate environment and the assets that benefited from that, you are behind the curve. The ‘healthier’ investment choices are under-appreciated companies with low debt levels and robust earnings (underpinned by strong cash generation), ideally with pricing power, enabling them to pass on cost increases to customers. Selected emerging market bonds are another area that can potentially offer substantial value.
In a world without easy money support, investments will need to clear higher hurdles, and be assessed on their own merit and how well they are positioned for a different future environment. However, as we know, habits can be hard to break. Many investors are tempted to simply follow the strategies that used to work. A changing environment underscores the need for making space in your portfolio strategy for differentiated thinkers who are equipped to offer fresh insights and uncover the investments that will perform well in the future.
John Gilchrist, Co-Chief Investment Officer
