A case for new investment habits
• We may not know where the next crisis will be, but we can spot likely areas of financial stress
We can understand the effect our lifestyle choices has on our health , even if this knowledge does not motivate us to go to gym.
But while we are adept at understanding the costs and benefits of health trade-offs in our personal lives, the longterm effect on our investments of the financial “lifestyle” choices various economies make can be obscured by prevailing narratives such as “deficits don’t matter” and “inflation is transient”.
In the financial world, central banks and governments continuously make “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 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 enormous 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 effect of an accumulation of bad habits over time, unravelling the effect of poor policy choices will not happen quickly. We are likely to see continued volatility in the years ahead as markets digest the policy pivots we have seen over the past year, which are likely to be repeated.
The UK bond market crisis in 2022 and the banking crisis of 2023 have exposed fragilities in the global economy, but their root can be traced back more than a decade to the era of easy money after 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 and low-interestrate 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 is 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 where cracks are likely to appear.
While it may be impossible to identify exactly where the next crisis will erupt, we can identify the likely candidates of financial stress. In addition to leveraged private market investments and corporate real estate (particularly office space), Japanese government bonds are 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. It has
A NEW STRATEGY IS NEEDED AS THE TIME OF EASY MONEY IS OVER
bought more than $3-trillion of Japanese government bonds, accelerating purchases in early 2023, and now owns most of the five- and 10-year issuance.
This amounts to a highly accommodative monetary policy despite inflationary pressures, at a time when Japan also has a sizeable fiscal deficit and large debt-to-GDP ratio. Yen weakness reaching a 32-year low in October 2022 was the consequence of a monetary approach at odds with other developed market central banks. This in turn created more pressures.
While we do not try to time the markets and 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, a higherinflation 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 investment “fast food” to “investment salads”. As monetary and fiscal policy is forced to normalise and it becomes clear 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 underappreciated 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, 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 future.