As we approach the end of 2023, we find ourselves looking back on markets that seem considerably more content than they were a year ago: equities are in the green, inflation rates have come down from their multi-decade highs, and higher starting yields protected most bonds from further losses this year. However, a deeper look at the structural shifts that have taken place in recent years would have us describe markets as more complacent than content, and we believe prudent investors must pivot away from the strategies that worked from 2009-2021 and recognize the new paradigm that is unfolding across markets globally.
After a decades-long regime of near-zero interest rates, lax lending standards, and central bank rescues, we see the world as being driven by two broad forces:
- Sustained higher inflation due to extremely high global debt levels, and
- Erosion of the post-Second World War global order.
Management of these forces poses the greatest test facing our leaders in decades. Investors must understand the world as it is, not as the financial media would portray it. As such, they need to acknowledge the following realities:
1. Structurally higher inflation: although inflation rates have fallen significantly from the multi-decade highs seen in mid-2022, that decline plateaued in the second half of the year and inflation remains well above the 2% target set by central banks. Deglobalization, record-high debt levels, and structural fiscal deficits are likely to spell the end of the longest period of low inflation in history. It’s also important to remember that prices increases due to inflation are cumulative and exponential, not linear, and that even when CPI rates are falling, prices are still rising. The market is pricing in an assumption that inflation will return to target even without a painful recession – we disagree and believe that investors must be prepared for a return to an inflationary paradigm closer to what was the historical norm prior to 2008.
Chart 1: Despite year-over-year headline inflation (red, right axis) falling from multi-decade highs, monthly core inflation (black, left axis) remains persistently above pre-COVID levels
Tightening financial conditions: while abundant liquidity remains throughout the economy, this is a remnant of pandemic stimulus and is rapidly diminishing. That unprecedented infusion of money into the system was the result of a joint undertaking between governments and central banks. However, while developed governments continue to run outsized fiscal deficits, monetary policymakers have an inflation mandate to uphold and are no longer facilitating the accommodative policy that led to high inflation in the first place. In addition to pushing through rate hikes at a near-record pace, central banks like the Federal Reserve and Bank of Canada have gone from liquidity providers to liquidity absorbers as trillions in balance sheet stimulus is unwound.
Chart 2: The Fed (blue, right axis) has unwound ~$1.3 trillion in quantitative easing stimulus while the BoC (red, left axis) has unwound $250 billion, with more tightening expected from both
2. Surging debt and interest expense: an estimated $2 trillion has been directed globally towards interest on government debts in 2023, marking an increase of over 10% from the previous year. The U.S. government alone saw its interest expense surge to nearly $1 trillion annually this year, with further increases expected as existing treasury bonds mature and are refinanced at much higher rates. The rising burden of interest costs presents governments with increasingly complex fiscal decisions as they balance these obligations against other critical spending needs. It also provides a persistent and growing source of annual budget deficits, which is another force driving inflation structurally higher. In fact, global debt levels have reached such astronomical heights that their repayment in inflation-adjusted dollars now seems implausible. So even while developed governments are unlikely to default in nominal terms, they are likely to default in inflation-adjusted terms via higher inflation and currency debasement. We explored the challenges posed by higher rates in more depth during the most recent Chieduch Group quarterly podcast, titled “Shifting Winds: Assessing the Impact of Interest Rates.”
Chart 3: U.S. federal interest expense has nearly doubled since 2020, while total U.S. federal debt is approaching $34 trillion
3. Challenging conditions for borrowers: like governments, corporate and real estate borrowers are also facing significant challenges due to higher interest rates. Higher rates adversely affect the value of their assets, seen most famously in this year’s bank failures alongside some high-profile defaults for real estate firms in the U.S. and China. Even though the BoC and Fed have not hiked rates since the summer, the headwind from higher interest rates is far from over: absent a dramatic shift back toward 0% rates, corporate borrowers have years of painful refinancing ahead of them. The longer rates persist at these levels, the more likely we are to see defaults and credit losses continue to rise.
Chart 4: Corporate borrowers are facing years of rising interest costs as maturing bonds are refinanced with coupons that pay current substantially higher yields
4. Shifting geopolitical and demographic trends: Increasing trade and international cooperation has been a boon for markets and economies in recent decades, with cheaper goods manufactured internationally keeping inflation low even as domestic services became consistently more expensive. This trend drove asset prices higher and led to an era of historically accommodative monetary policy, known colloquially as the “Fed Put” (the concept that if things get bad, the Fed will do whatever it takes to keep asset prices afloat). The failure of global supply chains in 2020/2021 exposed just how fragile this assumption was, and rising geopolitical tensions (Ukraine, Israel, Taiwan) suggest the world is shifting away from a more unified global economic order to a bifurcated reality between the West and China-Russia aligned nations. Furthermore, deteriorating demographic trends present a headwind to global growth, while increasing political polarization domestically has rendered governments less effective in responding to these challenging trends. For more context on shifting geopolitical priorities, listen to the Chieduch Group podcasttitled “Windward Investing in a New Global Paradigm.”
Chart 5: After rising consistently for decades, U.S. trade as a % of GDP has declined meaningfully as globalization in the western world has slowed and, in some cases, reversed
5. Valuations are priced for perfection: despite these more challenging conditions, financial assets are being priced very optimistically, with valuations generally hovering at historically elevated levels. This discrepancy in valuation is a residual effect of an era characterized by negative or zero interest rates—a financial climate that appears increasingly unlikely to return. Additionally, there is a notable delay in the mark-to-market adjustment of private asset prices by numerous funds. This hesitation is seemingly rooted in the optimistic, albeit speculative, hope that these assets will rebound to their previous bubble-like valuations. Given the structural changes we outlined in previous points, we think this assumption is a dangerous one to make.
Chart 6: Investors today must pay more per dollar of revenue for the average S&P 500 company than at the height of the Dotcom bubble – an indication of stretched equity valuations
Formulating a successful investment strategy in the coming years will require an understanding of these global trends. Ultimately, we believe financial outcomes are likely to be driven more by politics and policy than by pure market fundamentals, which is an environment that requires investors to maintain a dedicated focus on both macroeconomic and company-specific factors.
Of course, we’d be remiss if we didn’t speak to the Fed’s unexpected olive branch at their final meeting of the year. The statement was more accommodative than expected, and Chair Jay Powell struck a conciliatory tone during the press conference, even if he was less than two weeks removed from stating that it would be “premature” to discuss rate cut timing. Certainly, this meeting was welcomed by markets, where the response was to push already lofty equity valuations higher while increasing rate cut expectations for 2024 above and beyond what the Fed’s new projections are forecasting. With core inflation having plateaued at roughly double the Fed’s 2% target, we are treating market expectations of multiple cuts next year with a healthy dose of skepticism, and believe that the risk in that scenario is a rebound in inflation starting the tightening process over again.
The good news is that much higher bond yields mean that this is the best time to invest conservatively in nearly 15 years, with high-quality government bonds providing attractive returns despite being very low risk. For taxable Canadian investors, the opportunities are even more compelling given the availability of discount bonds that provide most of their yield in the form of locked-in capital gain when held to maturity.
Entering the New year, we expect investment opportunities to grow once the market starts to shed the excessive optimism currently built into valuations. A more cautious stance will afford greater flexibility to take advantage of these opportunities, and higher bond yields provide significantly improved returns for investors who adopt this more conservative approach.
Ultimately, markets and economies have undergone significant and structural changes over the past five years. We strongly believe that the investors who outperform in the coming years will be those who avoid becoming entrenched in stale strategies and instead put their money to work in ways that embrace a new macroeconomic and investment landscape.
Happy Holidays and Happy New Year