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Generating real returns for investors in a post-ZIRP

Investors have just experienced the worst traditional investor market environment in more than four decades. Looking forward, they face the prospect of continued inflation, elevated interest rates, worsening credit conditions, and a recession.

December 8, 2022

Andrew Jackson

Head of Fixed Income

Perhaps more than ever, it is important to take a step back and observe the tectonic shifts that have been unfolding over the past few years. The post-zero interest-rate policy (ZIRP) era and the progress of deglobalization may have adverse consequences on portfolio performance if investors are caught unprepared. Andrew Jackson, Head of Fixed Income at Credit Suisse Asset Management, explains how he believes investors should strategically allocate assets to prepare for a potential paradigm shift.

The hunt for yield is over, but the hunt for real returns begins

Over the last decade, we have seen the most unprecedented and coordinated action ever undertaken by the world’s central banks. Quantitative easing and the zero (or near-zero) interest rate policies of major economies have been the safety net as well as the inflation device for all risky assets. No matter what the macroeconomic shock, the answer has been to reduce interest rates or pump markets again. In 2022, though, the unthinkable has happened: increasing interest rates are now the problem as central banks fight the forces of inflation. And so we find ourselves in a year in which the traditional 60:40 portfolio has delivered its worst-case scenario, and that is before most economies have even entered a recession. Looking forward, it is important to be mindful of the potential for further pain. And, if all of that was not enough, interest rates now mean that for most investors, delivering positive real returns just got at least 3.5% harder.

Figure 1: Advanced economies’ exports as a share of GDP

Source: IMF, Bloomberg, Credit Suisse

Further headwinds as reshoring gains importance in a deglobalized world

Russia’s invasion of Ukraine came on the back of a significant cooling in US/China relations over the past few years. The COVID-19 pandemic has highlighted the vulnerability of the global supply chain. Governments and companies are now looking for ways to better mitigate external dependencies. As such, the debate is now running hot on whether globalization is in retreat, and there are a number of indicators that could at least act as warning signs for attentive investors. Trade as a share of GDP, which had been increasing steadily since the mid-1980s, has been stabilizing since the Global Financial Crisis (see Figure 1). Trade barriers were on the rise while tariffs were implemented under the presidency of Donald Trump, and the America First policy has not been fully reversed. While not retreating from China, a large number of Western multinationals have diversified their production lines to Vietnam and India, for instance. The desire to produce closer to where goods are being consumed – so-called reshoring – is growing in importance, while friend-shoring may be the “maître mot” of a bipolar world.

Deglobalization would have further inflationary effects

If globalization were deflationary, it could be reasonable to expect that the reverse would be inflationary. In our view, deglobalization may lead to less efficiency and a fall in productivity, an increase in overall prices through higher labor and input costs, and margin compression. In turn, inflation may increase in a first stage before stabilizing at a higher level in the new equilibrium. This pattern has partially occurred this year as the major developed economies experience their highest inflation in more than 40 years. At this stage, it is too early to predict whether inflation will return to its pre-pandemic norm or if a new, higher equilibrium level will be reached. However, there is one observation that can be drawn with higher certainty in our view: a bipolar world is emerging.

The emergence of a bipolar world is exacerbated by the increased risk of a military conflict

February 2022 may go down in history as a defining moment, an inflection point, when the world started to separate between the West – democratic countries led by the US and its allies – and the East – an autocratic world led by China and Russia . However, in our view, these tensions have been years in the making. We are currently facing a situation where China is emerging as a challenger to the established power, the US. China’s goal is to reorganize the global world order into a system that better reflects the country’s importance in the world and is more attuned to its values. History suggests that a geopolitical situation where the hegemon is being challenged is an unstable one. At the same time, populism is on the rise in democracies, while autocratic countries are experiencing a concentration of power. Both developments undermine global stability.

Strategic asset allocation should prepare a shift in course and continue to observe caution

It may be too early for investors to radically change course. The market’s obsession with pivots, buying dips, and projecting V-shaped recoveries is an issue for central bankers. Pain will need to be felt in economies, and by extension markets, in order to tackle the inflation that those same dip-buyers assumed would be transitory just one year ago. Positive outcomes may unfold, but there remains a meaningful possibility that significantly worse outcomes are still ahead of us. One wonders whether members of central bank governing councils have expressed such hawkishness in recent weeks purely in order to remind us of this fact. Meanwhile, strategic asset allocation should at a minimum start planning for a radical shift in the world order. There are a number of warning signs that are reminiscent of difficult periods and that cannot be ignored. So, what should be done? Investors should continue monitoring the situation closely to assess how it evolves. Economic, political, and societal indicators are key to observe. For instance, in the past, a rise in military expenditures combined with a reduction in economic exchange across countries has pre-empted military conflict. Likewise, a concentration of power with no or few incentives to raise issues (e.g. freedom of speech) has the tendency to lead to economic mismanagement and social unrest. Proceed with caution.

 

Real returns will be hard to find, risk has not disappeared, and real assets should be favored

We are of the opinion that from a long-term investor point of view, the main focus should be to identify which types of assets would perform well and which ones would be adversely affected in the event of a long and severe recession. This is predicated on the assumption that our base case is a short, sharp recession in the US and a longer, milder recession in Europe with a commensurate global slowdown. In this base case, a myriad of risk assets will perform well and relatively consistently. There is, however, a material chance that this base case is vastly too positive. In a bearish or acutely bearish scenario (let us remind ourselves that almost no one predicted inflation would even rise to these levels), markets will need to reprice extremely significantly in some asset classes. In our view, real assets such as commodities, gold, inflation-linked bonds, selective real estate, and equities should be favored. Relatively sleepy parts of Fixed Income offer much better return for risk, and within portfolios, we would use caution in the face of the deglobalization trend. Active management will be of value as multinational companies would be adversely affected while domestically focused businesses would benefit from deglobalization. 

Finally, investors should decide when it is time to change course. This decision should be based on probability, taking history into context, and related to cross-asset risk premiums. Depending on valuations, such as risk premiums, some risks may be worth taking despite the challenging situation. Contrarily, other asset classes may need to be shunned entirely because the risk premiums do not reflect the future risk paths. As individuals and responsible institutions, we need to act and prepare for a positive outcome. At the same time, we should start planning for the right asset mix with the goal of protecting our portfolios from the negative consequences of a protracted severe recession or those related to the emergence of deglobalization and a bipolar world.

1 The October 12, 2022, United Nations General Assembly vote on condemning Russia’s annexation of parts of Ukraine paints the picture: 143 countries voting in favor, 5 against, while 35 abstained, including China.

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