The Quiet Revolution

The magnitude of the humanitarian crisis in Ukraine continues to dominate the news, and our attentions are quite rightly focused there. By contrast, the quiet revolution that is occurring in financial markets is, understandably, much less well reported.

What we are seeing in financial markets is different from anything we have experienced for a generation and the response of asset prices is equally unfamiliar. We are living through a dramatic and possibly persistent inflationary shock, in sharp contrast to the series of deflationary crises that have been the norm for most of the last quarter of a century. Asset class returns have largely inverted– government bonds, which acted as the traditional safe haven in financial crises, are now the apex of portfolio losses. Cash holdings, meanwhile, have negative real yields, the extent of which haven’t been seen since the early eighties. Finally, commodities, which stagnated for much of the last two decades, have been among the best performing assets as much of their supply is constrained in markets around the world.

Against this backdrop, some areas of the equity markets are starting to look like the new safe haven assets. Despite the Ukrainian crisis, volatility has been relatively low, earnings have been robust and income stocks with reliable, progressive dividends, are a compelling alternative to corporate bonds. To the traditional balanced fund manager this may seem like an Alice in Wonderland world, but it may become the new normal as investors digest the first inflation shock of a generation.

Remembering crises past

Looking back over the past 25 years, all major financial and economic crises were broadly deflationary. The 1997 Asian debt crisis, the 2000 Dot-com bubble, the 2008 global financial crisis and the 2011 European debt crisis saw inflation rates decline in the two years following the crisis. Bond yields were also sharply lower – typically 2-2.5% lower 18 months after the shock. Equity markets, by contrast, initially saw declines but made new highs a few years later.

For portfolio investors, this playbook argued very effectively for the traditional 60:40 bond-equity model, the standard ‘medium risk’ allocation for almost a generation. In each of the crises above, bond holdings effectively offset equity volatility (there was, after all, no inflation risk), and both bonds and equities delivered strong real returns in the years that followed. Investors had of course little need to consider a commodity allocation – returns generally lagged other assets and there was no income support. In short, for almost 25 years, investors in the 60:40 model won, most ways around.

Then three unusual things happened…

For the first few months of the COVID-19 crisis in 2020 the familiar routine played out again – equities declined, bonds rallied and commodities weakened. Then three unusual things happened; first, the 2020 pandemic-led sell-off was extraordinarily short – in fact, it marked the shortest equity bear market in post-war history. Second, bond yields started rising sharply and haven’t stop climbing. Finally, a range of commodity prices started rising very, very quickly (and note, this was well before today’s Ukrainian crisis).

So, for the first time in a quarter century, the old 60:40 model didn’t pay out – bonds were in long-term decline and there was no commodity hedge. Fast forward to today, and the model failed again, just a year later. With the Russian invasion of Ukraine, energy and commodity prices rose further, while bonds have just seen one of their worst quarters in post-war history. For investors, the question is: are the old models broken for good or is this just an unruly interregnum?

Have asset class returns fundamentally realigned?

One might argue that the last two inflationary shocks are essentially one-offs, and that the tragedy of the pandemic and the horrors of the Ukrainian conflict are not recurring events.

With this in mind, most central bankers are still forecasting that today’s inflation rates will broadly return to target by early 2024. The Federal Reserve thinks this can be achieved with long-term interest rates targeted at 2.25-2.5%. This argues that 10-year bond yields are already close to fair value and implies that most of the base effects from rising prices will soon fade after we have seen inflation peak, probably in early summer. In effect, the forecasters are predicting a mid-term normalisation with little policy risk.

We are not so sure. Three things worry us: first, bringing inflation rates back to target may not be easy. The challenges are already clear – the US yield curve inverted this month (an inversion is where short-dated bonds yield more than longer-dated bonds), and this traditionally signals a forthcoming recession. Yes, the ability of such signals to predict timing is notoriously uncertain, but it shows how carefully central bankers will have to tread as they seek to tighten policy just enough to cap inflation, without triggering a recession. This is doubly difficult in a highly indebted global economy.

"We are not yet facing a wage price spiral, but the risks are present."

Second, the global energy market is a cause for concern given the dependence of Europe on Russian gas and oil. Wider energy sanctions are rightly being demanded in response to the horrific new atrocities uncovered in Bucha, and this presents some huge supply issues. To date there have been no significant new oil supplies promised by OPEC to offset this and, while renewables and liquefied natural gas imports offer long-term solutions, their deployment will take time. During this period, energy markets will remain exceptionally tight and highly vulnerable to new sanctions, supply cuts by Russia or other external shocks. Energy-led inflationary pressures are not over.

Finally, global supply chains remain stretched and increasingly precarious. ‘Just-in-time’ production models are becoming ‘just-in-case’ models, as industries find they need to re-shore production. The company management teams we are seeing are almost uniform in saying that many of the cost increases we have seen across the industry are simply not one-offs. We need to add wage pressures to this; we can rightly expect substantial demands, as workers seek to preserve real wages in very tight labour markets. We are not yet facing a wage price spiral, but the risks are present.

What does the quiet revolution mean for investors?

If we are right and this ‘quiet revolution’ in asset prices becomes more permanent, what are the implications for investors and what solutions does Sarasin offer?

We must consider the risk that the sell-off in bond markets continues. Higher policy rates will be needed to curb inflation, and indeed even policy rates well above neutral – estimated to be around 2.25%. The potential for the Federal Reserve to reduce its $9 trillion balance sheet sharply from May also presents huge uncertainty. We still see considerable risk and remain materially underweight fixed interest.

Equities remain an attractive asset class, but there is the likelihood of a long-term rotation in market leadership. Expensive, often unprofitable growth stocks are already seeing valuations undermined by higher bond yields. The new winners could be income stocks that can deliver strong, recurring dividend growth at a time of rising inflation. At Sarasin, we look to combine this with our thematic approach, focusing on the winners of the future, for example in areas such as the new low-carbon economy, automation and post-pandemic health care. We also continue to hold listed renewable and infrastructure funds across our mandates to provide inflation-linked incomes that are compelling alternatives to bonds.

"Commodity markets may be over extended today but they can still play a useful role in balanced portfolios going forward."

We have held substantial gold positions across portfolios for some years. We are now considering adding selected commodities, which will be particularly needed for the growth of a secure, low- carbon economy.

None of the above necessarily sounds the death knell for balanced, 60:40 style mandates, but it does suggest that investors should consider alternatives. At Sarasin, we have established dedicated growth mandates, comprising equities and alternative assets, with limited exposure to bonds. We also manage defensive equity income mandates which are real competitors to traditional corporate bond strategies. Finally, we have established a strong record in target return mandates which directly seek to outperform an inflation plus target – they utilise wide asset allocation parameters and deploy portfolio insurance. Our traditional multi-asset managers are also adapting strategies to reflect these challenges, but the quiet revolution in asset prices that we have discussed here may call for some dedicated solutions.

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