Should portfolio managers prepare for ‘the revenge of the rest of the world’?
Investors who had the sense to get equity exposure and keep the faith after the global financial crisis might have benefited from the long bull market. But with low inflation and low interest rates no longer being an economic given, they may not have such an easy time of it going forward.
“It's clearly the end of the buy-and-hold strategy, which was very positive for those who understood you have to be long growth stocks and bought 12 years ago,” Frederic Leroux, head of Cross Asset and a fund manager at Carmignac, a France-based global asset manager, told Wealth Professional in a recent interview. “Holding on from that point was the best way to make money. But it’s very different now.”
According to Leroux, a good way to get foresight into the coming years would be to look back to the multi-decade period between 1965 and 1980. That was the last long bout of extreme global inflation, which was ultimately subdued via a bold campaign of aggressive rate-hiking led by then-Fed Chair Paul Volcker. That inflationary episode was accompanied by markets that would oscillate between peaks and drawdowns, inversely correlated with the inflation dynamics that had become cyclical.
“The world was very different. Growth stocks didn't do well, pushed down by interest rates that were weighing on valuations. … Banks did ok, cyclicals did well. Commodities were striving,” he said. “It was the old economy at full speed. So, I think we should try unlearn what we learnt from the previous decade and figure out how things worked in the past.”
Unlike the steady-as-she-goes market of the past decade that lent itself to passive investing, Leroux says managers will have to manage everything cyclically moving forward with an eye on inflation. During the rising phase of inflation, managers have to quickly move towards short duration exposure in their fixed income portfolios. On the equities side, it would be apt to buy cyclical and value stocks, and jettison growth names. When disinflation comes, then it’s time to get back some growth names and go long duration on fixed income.
“These moves are just for a short-term period. You will just be there to do tactical trades,” Leroux said. “If you can manage to understand and feel the moment when you have an inflation inflection, both ways … you should do very well in the coming years.”
And while the past decade has seen the U.S. stock market dominate others thanks to its outsized exposure to winning growth stocks, there’s a possibility that higher interest rates and inflation in the future might disrupt the status quo as growth takes a beating.
“You have to anticipate that the financial flows will probably go from West to East – that is to say, from the U.S. to Europe, to Japan to the emerging markets,” Leroux said. “People will want to put their money on cyclicals and value names, which doesn’t really exist in the U.S.
“If you have this move from the US to the rest of the world – that is to say, the revenge of the rest of the world – compared to the past 15 years, you also understand that the dollar might become much weaker,” Leroux said. “We might see flows from the dollar to the euro, the yen, and the yuan. A weaker dollar means you must have a very strong emerging market universe, since EM countries would then be able to implement the monetary policy they need to maximize their growth.”
By and large, Canadian portfolios have limited diversification. Aside from the expected home bias, they are spread across Canadian stocks, including bank names, and commodities. The more adventurous investors also have a healthy helping of U.S. stock exposure. But with the prospect of a new inflation reality, global investment is poised to flow more toward Europe, emerging markets, and possibly Japan. The potential implication, Leroux said, is a reversal from North America’s dominance in global markets.
“Assuming emerging markets manage to outperform again after more than 10 years of underperformance, the yen could strengthen and provide some support to the Japanese equity markets,” he said. “You could also see more flows from the U.S. and toward investment in the European market, which is exactly the reverse of what we’ve been used to over the previous 15 years.”