How we got where we are.
This week we’re going to take a look at the broader global equity environment. Because for the first time in 30-plus years it’s truly different. We’ll take a deep dive into how we got where we are, and why this matters; and look at the shape of the economy in the years to come and what it might mean for portfolios and investors.
When I entered the financial industry in late 1986, the tight money regime of Paul Volker at the US Federal Reserve had already set the tone for the first 22 years of my career. Obviously, there was volatility, but the secular trends in inflation, interest rates and bond yields were all down (Figure 1).
Figure 1: US 10-year Treasury Yield
Source: Bloomberg, as at November 2023
In fact, the cost of capital fell continuously with a few exceptions. Over these 22 years borrowing rose, funding stronger and longer economic cycles. Instead of trend GDP, trend GDP-plus emerged.
For equity investors, a superior growth/inflation trade-off drove equity valuations higher. Lower rates meant increased leverage was less problematic and we saw above-average profits growth – reinforced by cuts to corporate taxes. Value comfortably beat growth in terms of equity style. This was supported by a restructuring push which saw western manufacturing sites close in favour of emerging market-based factories, more sophisticated supply chains and reduced cap ex. Again, this further reduced imported inflation.
In 2001 as this period was perhaps ending, China, the largest labour force in the world, acceded to the World Trade Organisation. This added a huge new consumer market for companies to enjoy, meaning more growth and a source of low inflation for the world.
But 22 years of debt accumulation with declining interest bills became unsustainable. In 2007/08 a problem in the housing market became a global financial crisis.
The next 13 years saw low growth and low inflation. From 2007 until the recovery from the Covid-19 pandemic there was no earnings per share (EPS) growth globally. From 2012 to 2021 there was essentially zero earnings growth.
But markets recovered as interest rates went to zero. Although rates were starting to rise from 2016, in 2020 the pandemic struck and back to zero they went. In the 13 years post-GFC the US Fed Funds interest rate was at zero almost 70% of the time.
Growth was the order of the day, coinciding with the adoption of tech trends – the internet, social media, online advertising, e-commerce and smartphones. Areas like medical tech, communications, payments and certain consumer goods also benefited. Growth erased all of value’s gains over the previous 22 years.
Just as this trend was ending, the pandemic struck. The online world was the only thing open and tech earnings surged as real-world earnings collapsed. Rates went back to zero.
Reopening was difficult: supply bottlenecks, reduced factory capacity, shipping issues. Consumers, flush with pandemic savings, were eager to spend. Robust demand met inadequate supply and prices rose. Real incomes were squeezed and employees in a tight labour market demanded higher pay. A wage price spiral started.
Central banks responded with the biggest tightening in monetary policy since the 1980s. Now, inflation is falling and the economy has resisted recession – so far.
So what next? The conditions we’ve experienced over the past 20 years are no longer here. The world has changed and investors need to change with it. There will be impacts as inflation and interest rates stay at levels not seen for years; government indebtedness will affect economies; discussions around diversification, quality, and growth versus value need to be had. But we will cover all that in the next two blog posts …
