The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset Management
A fellow panellist at a recent conference proclaimed: “The low inflation decades were a golden era for investors.” The audience nodded furiously and then became increasingly glum as all panellists agreed this era was behind us.
In a similar vein, I often hear the argument that low or negative interest rates, and the other monetary tactics which central banks deployed to combat low inflation, boosted all asset prices. And so higher interest rates should naturally depress the valuation of all risk assets.
Both arguments sound compelling. But neither are necessarily right. Or perhaps I should say the ‘low-rates-boosts-returns argument’ isn’t right for all assets.
Some asset classes did benefit. Companies that produced decent earnings growth when their peers were languishing were able to command ever higher premiums. The global tech giants are the most obvious example. In the 2010s decade, when the US 10-year Treasury yield fell from nearly 4 per cent to about 2 per cent, the global tech sector produced an average annual return of 17 per cent.
This was partly due to strong earnings growth and also to investors’ willingness to pay higher valuation multiples. Low interest rates also made potential pay-offs in the distant future more attractive.
However, there were many segments of global asset markets that had a much more dismal time in the era of low inflation. These were the assets struggling with chronically weak demand and dismal pricing power.
Take the global energy and materials sector, for example, which suffered a decade of lacklustre or non-existent earnings growth and stock returns. This malaise served as a drag on entire benchmark indices for some regions. Europe is the prime example, where low nominal growth was at least part of the reason why the MSCI Europe index companies had average earnings growth of just 3 per cent and the average return of just 9 per cent in the 2010s. This is roughly half the growth of earnings and returns experienced in the 1990s when inflation was not so desperately low.
When one considers a multi-asset portfolio, it’s even more obvious that the low-inflation era was far from golden.
Persistently low inflation led to ever declining and, in some cases, even negative short and long-term bond yields. Bonds increasingly failed in the two functions they were supposed to play in a portfolio — to provide a nice steady source of income and to diversify risk exposure by going up in price when stocks are falling. At such low interest rates, they were fulfilling neither function and investors had to suffer lower total returns and more portfolio volatility. In other words, less comfortable days, and potentially more sleepless nights.
To demonstrate, let’s take a simple balanced portfolio comprised of 40 per cent UK gilts and 60 per cent FTSE 100 stocks. In the 1990s, a period in which inflation averaged 3.3 per cent, this portfolio gave you an average return of 14.5 per cent per annum in nominal terms and 11.2 per cent in real terms. In the 2010s that was just 7.2 per cent in nominal terms, and 4.9 per cent in real terms.
Many reading this will rightly point out that inflation isn’t doing investors much good this year with both stocks and bonds experiencing double-digit declines in most sectors, regions and asset classes. This is where I need to clarify the type of inflation I’m alluding to, because inflation comes in good and bad forms. “Good inflation” is a reflection of healthy demand, enough for companies to have a degree of pricing power and confidence to invest for expansion. Then there is “bad inflation” — a cost shock which serves as a tax on growth.
While we are experiencing “bad inflation” now, I believe this cost shock should pass within a year. Moreover, inflation will probably settle at a modestly higher rate of good inflation since the cost shock will serve as a catalyst for more robust demand and healthier nominal growth in the future as it encourages households, governments and businesses to invest in labour and energy-saving technologies.
Contrary to popular opinion, the new inflation regime should eventually prove to be a good thing for investors. Stronger nominal demand will mean stronger earnings and sustainably higher interest rates. Multi-asset investors will benefit from stronger returns — but only if they are brave enough to consider reorientating their portfolio towards those sectors of the economy that have languished for much of the last decade and away from those that needed economic stagnation to thrive.