Stuck in Low Gear

Market Views / Stuck in Low Gear

Navigating the investment landscape in a “lower for longer” world

Background

Even before the disruption created by COVID-19, the world economy was stuck in a low gear and was likely to remain there for the foreseeable future. Both advanced and emerging economies were already under considerable strain due to high debt, worsening demographic trends, and lower productivity growth.

More than a decade ago, the 2008 financial crisis acted as a powerful brake on world growth and the impact is still felt today. Between 1995 and 2007, the global economy grew by 3.5% per year. After the crisis, the growth rate dropped to 2.6%. As a result, the world economy today is about 10% smaller than it would have been had the pre-crisis trend continued. Against this backdrop, low inflation expectations are becoming entrenched in economies around the world, particularly in parts of Europe.

Now we are contending with a global pandemic, which has and will continue to disrupt global supply chains, how and where we work, and will impact every part of our daily lives. More of our initial thoughts on the pandemic later.

Low growth, low inflation and mounting debt imply that interest rates and government bond yields will remain low. In this environment, investors must know and understand the role of every asset in their portfolio and look for the most efficient ways to achieve their objectives. The massive policy intervention during and after the global financial crisis was successful in preventing a total collapse, but it simply kicked the can down the road and failed to spark much inflation or above trend growth. It also left substantial piles of government debt in its wake.

Low-growth malaise is driven by significant and complex issues that aren’t easy to solve. Indeed, major policy shifts in many economies would be required to alter this picture. Read our full research paper on the drivers of the “lower for longer” world here.

Getting the Big Things Right

In an environment of low growth, low expected returns, and where all assets look “expensive”, getting the “big things right” is more important than ever:

Diversification

Avoid excessive concentration of risk, as recovering from large losses will be more difficult than in the past. True diversification requires a wide variety of tools, including a broad range of public and private asset classes, optimization of beta exposures, and full use of active management and liquidity risk budgets.

Understanding and managing risks

Know what risks are being taken, and why. Among other things, this helps investors react appropriately when those risk materialize. For example, a bias towards risk assets will result in volatility and understanding this upfront can help avoid the inclination to sell and crystalize losses in a downturn.

Managing liquidity

Ensure there is adequate liquidity in your portfolio to meet all cashflow needs (e.g. payments to beneficiaries, capital calls, collateral requirements and rebalancing). This prevents forced selling during a market downturn. Having liquidity available also allows access to investment opportunities when they arise.

Keeping costs low

Manage your costs. They are one of the few things that investors can control and, in today’s low return environment, they represent a material share of expected future returns. Keeping costs low requires scale and a pragmatic focus on how assets are managed, such as focusing active management in areas more likely to generate outperformance.

Look for threats and opportunities

Stay on a constant look out for both threats and opportunities. Global warming presents an opportunity to invest in the transition to a less carbon intensive economy. Conversely, online shopping has had a significant negative impact on retail real estate, an asset owned by many institutional investors. Disruptive forces can upend traditional notions of risk when it comes to investing.

Reaching Return Targets

The lower for longer investment landscape has had – and will continue to have – broad implications for investors. It will slow down the rate of wealth accumulation, hurting banks, savers, and asset owners.

In this environment, investors who need to maintain their return targets have a limited set of strategies available:

Increase allocation to riskier assets: An “easy” way to increase expected returns is to double-down and increase the portion of the portfolio invested in assets with higher expected returns, such as equities. Doing this, however, significantly increases risk (the way doubling-down does when gambling) and, as a result, investors should use it with restraint.
Leverage: Leverage can be used to increase expected returns while controlling risks. It can be added to individual investments (such as mortgages on properties or corporate loans on private equity investments) or to the overall portfolio (through repurchase agreements, for example). Because it magnifies the investment and liquidity risks, it should be used judiciously and requires careful monitoring of liquidity risks that can arise.
Search for alpha, net of fees: Every additional basis point of return, and every basis point of costs, is more meaningful today than it was in the past, when overall expected returns were higher. Costs must be contained wherever possible and “more expensive” strategies like active management must be focused on areas which offer the greatest potential for active returns net of fees.
Pursuit of other risk premiums: Private-markets assets like real estate, infrastructure, private equity and private credit offer an illiquidity premium which might be attractive to investor portfolios depending on desired asset mix and risk tolerance. However, as with other risk premia, the rewards for taking on these risks have reduced over the years, so they cannot be viewed as any sort of silver bullet in a low-growth environment. Moreover, many private assets aren’t immune to the economy and introduce their own risks into any portfolio, all of which requires careful management.

Conclusion

We are facing a prolonged period where expected future returns are likely to remain low by historical standards. In some cases, they may even be negative. In this environment, investors must remain disciplined in their approach. This includes prudent cost management, strong diversification, a keen understanding and management of risk and effective liquidity management.

Initial thoughts on the implications of the COVID-19 pandemic

Since the beginning of the year we have seen an unprecedented decline in global economic activity, as governments prioritize the health and safety of its citizens, even if it means locking down social and business activities. We developed this report prior to COVID-19’s threat to the global economy and financial markets. The pandemic has only further strengthened our view that the “lower for longer” environment is here to stay for the foreseeable future.