Over the past few years, cyclical forces have had acute influence on markets. The world has become consumed by cyclical trends and discussion has focused on the impact of these cyclical forces on the outlook for both economies and investment markets.
We counter that these cyclical trends are now returning to more normalised long-term levels and it is structural growth trends that should be driving portfolio construction for the future.
In our view, cyclical pressures that spiked inflation over the last two or three years, caused by a global pandemic and the war in Ukraine, are broadly over. We are in a period where interest rates have normalised. If you look back over history, the median base rate in the UK has been around 5%, which is roughly where we are today. Without causing a deep recession and increasing unemployment, central banks around the world have brought down headline inflation.
They have achieved this because variables in the market have improved. These include global supply chains opening up while energy and food prices have come back down after the impact of Covid and the start of the war in Ukraine.
You can ask why central banks are not reducing interest rates given that headline inflation is moving down towards the magical figure of 2%. In our view, central banks are not cutting interest rates today because they are now more concerned with secular forces that we believe will keep inflation above 2%, maybe even 3% or 4%, for at least the next decade.
And what are these forces? De-globalisation, even though it is far from our favourite word, mitigating climate change, ageing populations and innovation.
Geopolitical risk has been rising over the past few years, certainly since Donald Trump became US president, and global trade started moving sideways during the global financial crisis. This means we saw globalisation starting to break down 15 years ago.
We have seen periods of globalisation followed by de-globalisation during the course of history, so what can we expect? To answer this, here are some more words beginning in D: disengagement, division and diversification.
Disengagement is all about the US, which has obviously been the leader in terms of the global economy, disengaging from the rest of the world. The US can do this because it has energy independence and food security.
Post the financial crisis, we have seen greater differentiation in the speed of economic growth between countries, with the US benefiting from being a leader in innovation. The power of innovation was shown when ChatGPT gained 100 million members within two months of its introduction.
The US has also benefited from demographics in terms of having a younger population than the rest of the developed world. An even greater benefit for the US has been flexibility in its workforce and the ability for people to move states for work.
The fragmentation in globalisation means we should expect central banks to have their own national agenda going forward and not raise and reduce interest rates in sync.
What does this all mean for portfolios? It brings us back to a strong case for diversification.
Admittedly, 2022 wasn't a great year for diversification. And a basket full of US equities, especially large and mega caps, would probably have been the best way to invest over the last decade or so.
We have seen very narrow leadership in recent years, developed markets outperforming emerging markets, and the rise of technology, passive investing and concentrated indices.
But one of the strongest forces in investing is reversion to the mean. The US certainly has its strengths at the moment, but you have to pay for it. If you want something cheaper, then you can invest in Europe at half the price. You can invest in the UK at almost a third of the price. There are cheap valuations to be had in emerging markets, Asia and Japan.
The challenge is that there are so many investment opportunities with attractive valuations at the moment. We believe the biggest opportunity today might be in income. The increased level of income means investors in a balanced portfolio can now reduce the risk they take to generate the same return from equities.
And if you're an active manager, you've got to be doing something different, but it is a very big call not to have a market weighting in the ‘Magnificent Seven’. Once we start to see some of the concentration reduced and a broadening of the market leadership, then active managers are likely to be rewarded in terms of their stock picking.
John Husselbee is head of multi-asset at Liontrust. The views expressed above should not be taken as investment advice.