Two weeks ago in the editor’s note I explored what I characterised as the wishful thinking of investors who were anticipating a return to the low interest rate / inflation environment we experienced since the GFC. On August 26th, investors received a bit of a reality check when Jerome Powell outlined the Federal Reserve’s commitment to crushing inflation—even if it meant inflicting economic pain. The message was received that the optimism over the past few months was misplaced and markets around the world headed south.

Making a prediction about where markets will go is a humbling exercise. However, it is worthwhile exploring what may happen if we are indeed at an inflection point and the future investing environment is different than the recent past. We suffer from recency bias as investors so our inclination is to assume that things will continue the way they have been going. For the most part that is true. However, there are moments where one market era ends, and another begins. Sometimes this moment is dramatic like Black Thursday in 1929. But most of the time this inflection point is only obvious in hindsight and the narrative which appears so clear in retrospect papers over a chaotic period of differing opinions and unknown outcomes. While the long-term direction of the market is up, the types of investment strategies that have been successful have varied across these eras.  

As outlined in part 1, the post-GFC world has been characterised by low inflation and low interest rates. Throughout that period the secret to outperformance was simply to go further out on the risk spectrum. The ultra-low interest rate environment has profoundly impacted almost every corner of the financial system. Low interest rates have justified near record valuations and high levels of corporate, government and personal debt. Low interest rates have distorted the traditional relationship between risk and returns. Low interest rates have meant that almost any business idea got generously funded—even if somebody else already had that idea. That is why I’ve spent the last 5 years stumbling over a variety of shareable bikes littering the streets of Sydney and can barely see into a retail store because their windows are covered in BNPL stickers.

This is not a prediction, but I think it is worthwhile entertaining that the future will look different from the past. The deflationary forces that kept inflation in check in the face of rock bottom interest rates are breaking down. Geopolitical tensions and a post-COVID desire to secure supply chains is reversing decades of outsourcing and offshoring. Developed market labour forces are stressed due to demographic shifts, a meaningful amount of the workforce opting out during COVID and tighter immigration policies. The China boom is grinding to a halt under a mountain of debt, an ageing population and the natural slowing of an economy that has grown quickly for decades in a pursuit of parity with the West. Compounding the erosion of these deflationary forces is a decades long spending boom ahead of us to decarbonise the economy.

Will the same investment strategy work if this is our future? Probably not. In the new world that I described above, interest rates will almost certainly settle at a higher level due to the relationship between interest rates and inflation. We explored what it took to get the last inflationary surge under control in our latest podcast creatively titled The ghost of Paul Volcker.

An underappreciated aspect of successful long-term investing is to avoid the ‘Big Mistake’. We hear all the time about how finding a couple 10-baggers is the secret to investing. Unfortunately, what happens more often is to ‘discover’ these gems after they’ve had their run. To bet on a return to the post-GFC environment might just be that mistake.

What does the world look like if we are moving into a more normalised interest rate era? Well for one thing we are likely to see lower asset values. Losing the sugar hit of valuation will mean that dividends will once again contribute more to total returns. If we look at the last great inflationary era between 1974 and 1982, dividends made up 65% of total returns on the S&P 500. In the post-GFC period until the end of 2021 the dividend contribution to total returns was 13%. Narratives about a limitless future will matter less and companies generating cash flows today will matter more. Returns will be lower and minimising fees and other investment costs will be more important.

Once again this is not a prediction. It is simply an investor who is preparing for a variety of contingencies. I would love to hear your predictions. You can email me at [email protected]