The times they are a-changing — and so should your portfolio

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By Noah Solomon

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The oil embargo by the Organization of the Petroleum Exporting Countries in the early 1970s caused a spike in the cost of many goods and services, igniting runaway inflation. At that time, the workforce was more unionized, with many labour agreements containing cost-of-living wage adjustments. The resulting increases in wages spurred further inflation, which caused additional wage increases and ultimately led to a wage-price spiral that drove the consumer price index to hit 13.5 per cent in 1980.

Upon being appointed United States Federal Reserve chair in 1979, Paul Volcker embarked on a vicious campaign to break the back of inflation, raising rates as high as 20 per cent. His take-no-prisoners approach was largely responsible for the low inflation, declining rates and highly favourable investment environment that prevailed over the next four decades.

The long-term effects of low inflation and declining rates on asset prices cannot be understated.

“Interest rates power everything in the economic universe,” Warren Buffett once said. “They are like gravity in valuations. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that’s a huge gravitational pull on values.”

Low rates make it easier for consumers to borrow money for purchases, thereby increasing companies’ sales volumes and revenues. They also bolster companies’ profitability by lowering their cost of capital, making it easier for them to invest in facilities, equipment and inventory.

Importantly, rising profits and asset values cause a wealth effect where people feel richer and more willing to spend, further spurring company profits and even higher asset prices. Falling rates also increase the present value of a company’s future cash flows, resulting in higher valuations.

The impact of the one-two punch of higher earnings and higher valuations unleashed by decades of falling rates cannot be overestimated. Stocks had an incredible four-decade run, with the S&P 500 index rising to 4,796 by the beginning of 2022 from a low of 102 in August 1982, producing a compound annual return of 10.3 per cent.

Sadly, all good things must come to an end. The low inflation that allowed central banks to maintain historically low rates has reversed course. In early 2021, inflation exploded through the upper band of the Fed’s desired range, prompting it to embark on one of the quickest rate-hiking cycles in history.

Since then, stocks and other assets have suffered declines as investors struggle to digest a complete reversal of the very conditions that previously contributed to their extraordinary gains.

The good news is that inflation will probably abate as pandemic-induced savings are spent and disrupted supply chains are mended, providing central banks cover to taper and eventually cease their tightening campaigns. The bad news is that the deflationary influence of globalization, which kept inflation at bay in the face of historically accommodative monetary policies, is slowing or reversing.

Also of concern is that the Fed is now in a once-burned, twice-shy predicament. The Fed failed to act when inflation began to accelerate in 2021, claiming the problem was “transitory.” This miscalculation placed its credibility under increased scrutiny and serves as a stark reminder that highly stimulative policies can ignite inflation.

The upshot is that monetary authorities are unlikely to adopt highly stimulative policies anytime soon. Markets will need to adjust to a more neutral level of rates that are neither stimulative nor restrictive. Of course, a severe recession could prompt the Fed to become more accommodative, which constitutes a “be careful what you wish for” problem for financial markets.

Put another way, the economic backdrop for asset prices will be less favourable than the Goldilocks environment that prevailed from the early 1980s to the end of 2021. It’s one thing for 10-year U.S. Treasury yields to have declined approximately 1,500 basis points to less than one per cent during the pandemic from about 16 per cent in 1981. It would be an entirely different (and impossible) affair for them to fall to -11 per cent from their current level of almost four per cent.

If I am correct regarding the likely economic environment going forward, then the investment strategies that delivered the best performance over the past 40 years may not be the ones that outperform in the future.

Notwithstanding this year’s outperformance of value stocks compared to growth stocks, there remains ample room for this trend to continue. As mentioned, we are unlikely to return to the hugely stimulative policies that supported growth stock outperformance.

Although growth stocks have suffered severe declines in absolute terms, they remain expensive in relative terms. At 20.2, the current P/E multiple of the MSCI World Growth index remains higher than its long-term average of 18.6. Conversely, the MSCI World Value index’s multiple of 10.6 stands below its long-term average of 12.6. All else being equal, a reversion to average multiples implies further value outperformance of 26.8 per cent compared to growth stocks.

Continued value outperformance also augurs well for international stocks when compared to U.S. stocks. From the end of 2008 through the end of 2021, the S&P 500 rose at an annualized rate of 16 per cent, producing a cumulative return of 587.3 per cent. In comparison, the MSCI All Country World index ex U.S. rose at an annual rate of 8.6 per cent, delivering a cumulative return of 190.7 per cent.

This U.S. exceptionalism was largely driven by the performance of eight mega-cap growth companies, including Apple Inc., Amazon.com Inc., Microsoft Corp., etc. From the beginning of 2015 through the end of 2021, excluding these companies from the S&P 500 index would have cut its annualized rate of return by nearly half to eight per cent from 14.9 per cent. Moreover, the valuation of U.S. equities remains elevated relative to those of other countries from a historical perspective.

According to Charles Darwin, “It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change.” Investors would be well advised to reposition their portfolios in response to a future economic environment that is likely to be different than that of the past.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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