Financial markets are hot and they have been for some time. Why? One of the main contributing factors is quantitative easing. The liquidity that central banks created over the years has been vital in underpinning the global economic system.
This is beginning to change. Bonds have enjoyed a bull market for nearly 40 years, driving yields to historic lows. At the same time, global economic growth is picking up almost everywhere you look. These two states are arguably incompatible, with one or the other likely to give over the next year or so.
Looking at the global economy, it’s hard to identify anything from a data point of view that causes any concern. Unemployment is low. Most countries that recovered quickly from the financial crisis such as the US, UK and Germany have some of the lowest levels they have ever seen. Even some of the more structurally-challenged economies such as Italy and France are experiencing a cyclical uplift alongside a drop in unemployment rates.
Industrial production, consumer demand and business confidence are all high. GDP expectations for the global economy are constantly being raised. Yet despite this, inflation remains elusive and this is really the crux of the matter. Why doesn’t stronger growth and low unemployment kick off inflation, interest rate rises and a collapse in fixed income valuations? Will inflation be structurally lower for good?
The internet, ageing populations and central bank interference are all responsible for the lack of inflationary pressure evident around the world.
Price discovery is easier now than ever before, with only the highest profile brands able to charge prices well above their competitors. The unprecedented access to information online has enabled people to find the cheapest prices for their products, virtually anytime and anywhere.
Retail equities have been decimated due to this ‘Amazon’ effect, and in many cases for good reason. Margins have been depressed, shopping malls are half empty and fulfilment centres are taking up more commercial real estate.
However, this is not the first deflationary force that the world has seen. Chinese manufacturing acted as a huge deflationary factor for the global sector in the early years of this century. Back then, the fear was that anyone who did not source their products in China would soon disappear, including all western industrials. A decade on, and after some pronounced pain and restructuring, these industrials are booming with an improving economy and margins regaining historic highs.
The lesson here is that inflationary effects are often time limited and will not put a lid on prices forever.
Demographics are another reason behind low inflation and even mispriced assets. As the population ages, people spend less and save more for their retirement. This reduces demand and pricing pressures, while pushing up (supposedly) safe fixed income products.
Anyone buying fixed income or mixed asset products today must assume that inflation will be low forever if they believe that their capital is safe from any drops in value. Otherwise, they must come to terms with the significant risk that their holdings will experience sizeable losses when interest rates rise and bonds fall, all for some pretty meagre returns.
If, or more likely when, this turns out to be the case, there may be some very disappointed investors when they get their holdings valued. At this point, these investors will still generate very low returns but will be substantially less wealthy.
Adding salt to the wound, the Fed is now unwinding its $4trn-plus balance sheet. The UK may raise interest rates whilst their economy slows, and even the ECB is likely to reduce their money creation as soon as next year. All of this should put pressure on yields to begin rising even further and faster. The risk-reward outlook for assets relying on fixed income valuations seems pretty skewed to the downside at present.
There are still plenty of assets with attractive fundamentals that can reward investors with a more favourable risk-return profile. For example, the fastest growing sector in the world is technology, already the largest in both North American and Asian equity markets and likely to drive growth for decades to come.
Given the UK and Europe have such small technology sectors in comparison, one of the best ways to benefit from this structural growth is through a global equity fund.
Industrials are also set to benefit from the rise in global economic growth. After a period of excess capacity and anaemic demand, capital investment is returning, helping to drive sales and earnings growth in the sector. The exposure set to benefit from these trends is more likely to be found in Asia and Japan where growth is really accelerating.
South East Asia (excluding China), South America, Africa and the Middle East all enjoy stronger demographic trends. Populations across these regions remain young whereas the average age of people in the UK, Europe and the US continues to rise.
In the absence of productivity growth, you either need a young population to expand the work force and increase economic growth, or you need immigration. The UK may soon have neither so may suffer relatively unattractive economic growth moving forward. The best growth stories are to be found further afield and with such a vast investable universe, there will always be high quality growth businesses at attractive valuations to be had.
Jake Robbins is manager of the Premier Global Alpha Growth fund