To better ascertain the outlook for equity markets as global growth slows, investors might want to consider the impact central banks have on markets—especially since the financial crisis.
In general, central banks ensure financial stability in their respective nations, says Andrew Zimcik, portfolio manager at Connor, Clark and Lunn Investment Management. “Practically, this means ensuring inflation stays within a targeted band,” he said in a June 19 interview. “That’s often accomplished through changes to interest rates.”
However, the 2008 financial crisis ushered in a new era: “In the last 10 years or so, central banks have been experimenting with new tools to achieve their objectives and avoid deflation,” said Zimcik, who manages the Renaissance High Income Fund.
Part of that experimentation was zero interest rate policies. “When things started to turn sour, central banks across the world very quickly cut interest rates to zero,” he said. But slashing rates failed to get the economy firing on all cylinders.
The next tool that central banks turned to was quantitative easing—asset purchases of short-term, long-term and corporate bonds—as a way to inject liquidity into the financial system and increase the money supply.
The aim was to “raise inflation at the same time as keeping interest rates low, with the hope of stimulating economic growth,” Zimcik said.
Arguably, it worked. “Global growth did pick up, although it remains quite sluggish, and we’re back at a pretty comfortable spot where we definitely averted disaster.”
Injecting liquidity into the financial system was positive for equity markets, which are back at their long-term trend after 10 to 15 years of weak returns following the tech bubble, he said.
“Another way to think about this is that central banks intentionally made bonds expensive by pushing down interest rates,” Zimcik said. “As investors saw less opportunity in short-term government bonds, they slowly moved up the risk curve from investment-grade bonds to high-yield bonds. When that trade was crowded out, they moved into equities and real estate and infrastructure.”
Gradually, the price of investments increased, because “everything is ultimately priced off the risk-free rate, which has been intentionally manipulated to be low by central banks,” he said.
Stocks may no longer be cheap, but Zimcik said price-to-earnings multiples, for example, don’t help predict the next market correction; however, they do help predict long-term returns.
“When stocks are expensive after adjusting for the cyclicality of earnings, which they are now, the 10-year return tends to be quite muted,” he said.
Because of this expectation for lower market returns, “investors need to think hard about their assumptions and expectations and make sure that they aren’t stretching too far down the risk curve,” Zimcik said. “Be reasonable about your portfolio expectations and invest with the mindset that the next 10 years are probably not going to look like the last 10.”
He added that, at minimum, investors should be aware of the possibility of recession in “the not-too-distant future.”
They should also be aware of the potential for increased volatility. In the last decade, volatility was dramatically reduced as central banks gradually pumped money into the financial system—a side effect that isn’t sustainable.
“Talk to your clients about what the normal is, and the fact that stocks do go down a third of the time and that’s OK,” Zimcik said.
With higher volatility, he expects stability to trade at a premium, so his strategy is to look for companies with strong balance sheets, sustainable dividends and defensive business models.
“This is our focus,” Zimcik said, “and one reason why we believe the fund will continue to perform well even when the markets are misbehaving.”
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