The current environment
The past 18 months has been a lacklustre period for investment markets, as low economic growth globally has caused equities (shares) to deliver returns below their long term averages. Other asset classes have not provided much relief either. Interest rates on Bonds are close to record lows, while 2.7% is now considered a “good rate” on bank term deposits. Even residential property, which on average has strongly outpaced returns from the other asset classes over that period, is now lucky to deliver a 3% gross rental return on new purchases, with questionable further capital upside (and increasing potential downside, particularly if interest rates rise).
However this sideways market is unusual. Even up until early 2015 global markets were delivering strong returns, as post GFC stimulus measures pushed asset prices higher. So what is causing this and how long is it expected to last?
The graph below shows the 5 year price movement of the ASX200 Index:
Causes
The primary cause of recent returns is due to lower economic growth. This is something that is occurring worldwide, with much of it due to the ongoing hangover from the GFC. While Australia escaped relatively unscathed at the time due to the commodities boom, the global economy is still working through some of the longer lasting issues. Ultimately this affects everyone, including Australia, as global growth and trade and is hurt by lower demand and lower real incomes.
A second major cause is that the effect of stimulus enacted by central banks to restart the global economy post the GFC is diminishing. This is not necessarily a bad thing. Eventually the world needs to return to a normal sustainable setting that is not being driven by central bankers and debt. In the short term however things have been taking time to adjust.
A third major cause for Western economies, and one that is attracting increasing attention from voters, is the effect of globalisation. With many traditional working class (and increasingly non-working class) jobs being outsourced to developing economies, wage growth for the majority of workers has fallen significantly. While there are important benefits to globalisation in terms of increasing living standards for the world as a whole, the dampening effect on wages for Western economies means their economic growth levels have fallen.
How long will this last?
Ultimately everything goes in cycles. Excess capacity in the global economy will be worked through. New technologies and industries will emerge, and humans will continue to innovate creating new efficiencies which will create wealth. This in turn will be reflected in the growth of the global economy, as well as in the returns derived from investment markets. Despite talk of doom and gloom, ever since markets have been tracked, optimists have eventually carried the day. So long as patience and diversification is maintained.
More tangible and immediate however is the potential for Donald Trump’s presidency to radically alter the current state of markets. Interest rates (off which most assets are priced) have never been this low in modern history. This is not normal. And as with everything markets related, eventually they will mean revert. Plans by “the Donald” to introduce significant infrastructure spending and corporate tax cuts are expected to push up inflation, interest rates AND market returns. This trend is expected to extend more or less globally, especially for Western economies. Hence the reason why global equity markets have strengthened since Trump’s win.
Whether or not Trump’s measures prove to be a net positive for the global economy over the long term is subject to much debate. The negative affect of inflation can often offset the gains from higher economic growth. His social policies are even more controversial. However one thing is certain, in a world of rising inflation investors will need to be invested in asset classes that provide long term returns that exceed that inflation. Otherwise real wealth is eroded. It is this environment in which a well-diversified portfolio of global and domestic equities, bonds and alternatives provides the greatest benefit to investors.
The graph below shows the long term return of the US stock market (the S&P 500 Index, in orange) vs the return on cash in the US (represented by the LIBOR Cash Index, in yellow) vs US inflation (CPI Index, in white). As you can see returns on cash have not even kept up with inflation, while equities have significantly outpaced inflation over this long term period:
If you have any queries, or would like to discuss the markets or your portfolio in general, please don’t hesitate to call my direct line, 02 9119 3698.
Glen Holder, BCom, DipFP, CA, MAppFin
Director – Investment Management