Investing in the Low-Return Era

We are currently living in an extraordinary period in human history. It seems like such a distant memory now, but just five short years ago the world economy faced its worst financial crisis since the Great Depression in 1929. In response to this, central banks took unprecedented action (figure 1).

Figure 1: Global Policy Rates, Central Bank Balance Sheets and Global Interest Rates (Source: BIS, 84th Annual Report) 

As a reaction to the 2008 financial crisis, global policy rates were slashed and central banks pumped astounding amounts of liquidity into the markets. In aggregate, these unprecedented interventions by central banks have created an artificial financial environment, never before seen in human history.

As a result of these interventions global stock markets have soared (Figure 2), with the US S&P500 and MSCI All Country World Index trading at record levels. At the same time global bond rates and credit spreads are at historic lows (Figure 2), while cross-market volatility is trading close to the lowest levels since 2005 (Figure 3).

Figure 2: Global stock markets, corporate credit spreads, euro area sovereign spreads (Source: BIS, 84th Annual Report)

Figure 3: Volatility in US equity markets, US Treasuries and G10 currencies (Source: BIS, 84th Annual Report)

Generating decent returns in this unprecedented environment of ultra-low yields and record high stock markets will most likely prove quite difficult for investors in the coming years. Yet, at the same time this daunting financial landscape will also create numerous opportunities, which intelligent investors can capitalize on.

Investing in a world where everything is expensive

Fuelled by the accommodative monetary policy of central banks, global financial assets have soared. As a result valuations have been stretched across the board. It doesn’t matter which asset class you look at, be it stocks, bonds, or commodities; valuations can no longer be considered cheap (Figure 4).

Figure 4: Valuations across major asset classes; MSCI World Index, Global Bonds & Commodities (Source: Barclays)

With valuations no longer cheap, returns for financial assets will now mostly have to come from fundamental drivers. This is especially true now that major central banks such as the Federal Reserve (FED) and the Bank of England (BoE) wind down there supportive policy and move closer towards increasing interest rates.

This new reality will make investing much more difficult in the future. All of the easy money has been made during the “Global Reflation Trade” where financial assets increased across the board, because of cheap valuations and accommodative Central Banks.

In the coming years fundamental drivers such as economic growth and corporate earnings will play a much larger role in determining returns for asset classes. As a result, we can expect clear divergences and a reduced correlation in the performance of major financial asset classes going forward (Figure 5).

Figure 5: Global equity market correlation and inter-market correlation of US stocks (Source: JP Morgan)

Reduced correlation between asset classes is a double-edged sword. First, it means that investors will have to apply more active strategies in order to generate decent returns. But at the same time this divergence will create ample opportunities for investors to outperform broad markets, as gains will probably be concentrated in certain sectors and countries in contrast to being spread across the general market.

With this in mind, investors should pay close attention to broad trends which will dictate market performance going forward.

Global divergences

The most obvious theme investors have to pay attention to is the large divergence in global economic growth and central bank policy. The recovery of global economic growth since the end of the 2007 crisis has been one of the most uneven and slowest in history (Figure 6).

Figure 6: Economic growth in the US, UK, Japan and various Eurozone countries (Source: Thomson Reuters) 

Currently there has been strong GDP growth and economic momentum in the United States and United Kingdom, with stagnating and sluggish growth in Japan and the Eurozone. This massive divergence in economic growth has caused a drift in the policies of the respective central banks. In the US and UK, the FED and BoE are seeking to normalize policy in light of positive economic developments. Meanwhile the European Central Bank (ECB) and the Bank of Japan (BoJ) are moving in the completely opposite direction.

European and Japanese equities can therefore expect a powerful supporting tailwind from the ECB and BoJ in the coming years. This implies that the Euro and Japanese Yen will remain under serious pressure versus the US Dollar and British Pound for as long as this policy divergence between the respective central banks holds true.

Pay attention to the fundamentals

The massive divergence between central banks means that investors have to pay close attention to various fundamental and macro-economic indicators. Since there is a wide array of indicators investors can study, I have decided to provide a small list of fundamental indicators I believe which will be most important henceforth.

Indicators for countries where central banks are moving towards policy normalization: In countries where the respective central banks are moving towards policy normalization such as is the case in the US and UK, fundamental drivers such as corporate earnings and global economic growth will become crucially important in dictating the performance for those respective equity markets. 

Investors can gauge global economic growth prospects by paying close attention to the monthly Markit PMI Index and national GDP reports which are released on a quarterly basis (Figure 7).

Figure 7: Markit PMI Output Index and Global GDP (Source: Markit Economics)

As global equity markets are trading close to fair value, relative sector prospects and performance will become increasingly relevant. On a sectorial level investors can gain an ample amount of insight by looking at the Markit Global Sector PMI. This monthly report released by Markit Economics gives an extensive overview of the business activity for a wide number of global economic sectors. In this respect speculators should put their emphasis on relative performance instead of just looking at the PMI scores individually. Relative growth and momentum by sector can be calculated using simple formulas and historic PMI data provided by Markit Economics. By applying these steps to the raw Global Sector PMI data, investors can create very insightful visual charts (Figure 8).

Figure 8: Global Sector PMI momentum and relative growth as of August 2014 (Source: Market Economics)