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Andrew Zimick, portfolio manager at Connor, Clark, and Lunn Investment Management.
Given how important central banks are to equity market returns, I thought a little bit of context here would be worthwhile in terms of their impact on equity markets and why. Let’s start with a quick refresher of the mandate of central banks. Globally, the mandate of each nation’s central bank will vary slightly. Generally speaking, they’re responsible for ensuring financial stability in their respective nations. Practically, this means ensuring inflation stays within a targeted band and that’s often accomplished through changes to interest rates.
In the last 10 years or so, central banks have been experimenting with new tools to achieve their objectives and to avoid deflation. Let’s rewind to the financial crisis for a moment. When things started to turn sour, central banks across the world very quickly cut interest rates to zero. However, they also quickly realized that cutting rates to zero was not going to be enough and more had to be done to get the economy firing on all cylinders again.
This of course led to asset purchases or quantitative easing, and this was first accomplished through short-term bonds and then long-term bonds and corporate bonds, and on it went. The idea, of course, was to inject liquidity into the financial system and increase the money supply. The idea there is that this would raise inflation at the same time as keeping interest rates low with the hope of stimulating economic growth. Arguably, this worked. Global growth did actually pick up, although it remains quite sluggish and we’re back at a pretty comfortable spot where we definitely averted disaster. The question here is what happened to financial markets as all of this played out?
Injecting liquidity into the system has meant that equity market returns had been quite good and, as a result, equity markets are now back at their long-term trend after 10 to 15 years or so of weak returns following the tech bubble. Although economic growth has been OK, certainly well below trend, financial markets have benefited significantly since a lot of that money went into the markets rather than the real economy.
Another way to think about this is that central banks intentionally made bonds expensive by pushing down interest rates. 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, and the impact is that everything’s expensive. This happened pretty gradually as the price of everything rose because everything is ultimately priced off the risk-free rate, which has been intentionally manipulated to be low by central banks.
While stocks are no longer cheap—arguably they’re expensive—it’s important to remember that looking at, for example, price-to-earnings multiples is an extremely ineffective way of judging the timing of the next market correction. However, they tend to be very good at predicting 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.
What does this mean for investors? Number one, we think it’s very reasonable for investors to expect lower market returns in the next 10 years. This means that investors need to think hard about their assumptions and expectations, and make sure that they aren’t stretching too far down the risk curve. 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 years. At a minimum, we need to be aware that there’s quite possibly a recession in the not-too-distant future.
Number two is expect market volatility to increase. One of the impacts of central banks gradually pumping money into the system is that it had the side effect of dramatically reducing volatility in the markets. This is clearly not sustainable, so we think it makes sense to 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.
Finally, number three: as we see more instability in the financial markets, we expect stability to trade at a premium. This includes more stable companies that have strong balance sheets, sustainable dividends, defensive business models. Just like growth stocks trade at a premium when economic growth is muted, stability tends to trade at a premium when stability is muted (i.e., there’s higher volatility).
This is our focus in the Renaissance High Income Fund, and one reason why we believe the fund will continue to perform well even when the markets are misbehaving.