Forget the market noise: Focus on value and the long-term

Sometimes it seems the economics profession operates in a parallel universe. There are confident forecasts for economic growth, inflation, and interest rates - which with hindsight, have a more than mixed track record.

Complex discussions about topics like the so-called neutral rate of interest, something which is unobservable in the real world, can bamboozle investors. When it comes to markets, there is a tendency to say markets “are wrong” – equity traders are too exuberant, while bond traders are too pessimistic.

Unlike investors who try to take a long-term view, economic commentary is all too often, too short-term focused. Investors of course need to try to understand the economic environment but the focus should be on value and long-term return expectations, not “what the market should be pricing in”. With developed economies now entering a period of falling interest rates - without the recession that many economists had forecast - focusing on the long-term is more important than ever.

To be fair, it seems to have become even more difficult to truly understand modern economies’ complexities. The pandemic had a fundamental impact on supply chains and demand patterns. It led to changes in the way labour markets work, and of course, some businesses did not survive. Technology has also been a disruptor, allowing significant changes in work patterns, communications, and research. 

Evolving economics

Demographics are also important. The reality is that most large economies have an ageing population, and birth rates below the replacement rate, meaning low or negative population growth. The rise in immigration resulting from climate change and geopolitical-driven displacement has also complicated the labour supply situation. It is not clear that national economic statistics can fully capture all these complexities and changes. The ritual of analysing every monthly economic data release to the nth degree sometimes seems rather futile. Financial asset prices, like any prices, are determined by supply and demand and there is more to that than just the reaction to the latest retail sales number.

Despite this complexity, economic cycles don’t seem to have the same peaks and troughs they had in the past, largely because economic policy and globalisation have delivered lower levels of inflation and more flexible economies. Most of the disruption to economic growth in recent years has come from shocks which few people could have anticipated. The absence, so far, of the oft-predicted 2024 recession is an example of how difficult it is to apply old models to the new economy. Interest rate hikes just did not have the anticipated impact on growth. But the cycle is still alive and the experience of the last couple of years – with inflation rising sharply in 2021 and 2022 – is that deviations from long-term trends can happen and these are reflected in financial market developments. This gives active long-term investors plenty of opportunities to seek healthy risk-adjusted returns.

The new normal

Today the post-pandemic surge in inflation is behind us. Central banks reacted by raising interest rates which in turn reset valuations and risk premiums across financial assets. Drawdowns in equity markets were recession-like and bond prices had to respond to the end prolonged period of easy money. We are well through that now and looking forward; it seems that some element of long-term equilibrium has returned. Central banks have slowly started to remove monetary restrictiveness and are on track to returning to a more neutral stance. Economic growth remains positive, close to trend in the developed world, despite uncertainties around the US election, China’s weakness, and geopolitical disruption.

It was hard to avoid negative returns in 2022 and 2023. Bonds were unable to offset losses in equity and other assets as they had to respond to the new monetary reality. Today, however, diversification should be a core principle of portfolio construction. The interest rate outlook is clearer. If, as I expect, inflation does settle down close to 2% in developed economies, nominal interest rates can move close to levels that are currently priced in. A medium-term target of US rates at 3%, a little higher in the UK and 2% in Europe, represents a steady state to which we could well be heading. Economists don’t like to condone market expectations and will point to all the risks to associated with such expectations. But alternative scenarios or risk events with indeterminant probabilities of being realised are not helpful in building long-term portfolios.

Lower rates are already helping householders looking to refinance mortgage debt and companies to manage their overall debt service costs. Meanwhile, megatrends like the energy transition and the development of generative artificial intelligence are creating huge opportunities for capital reallocation and earnings growth. Interest rates moving to neutral, inflation easing further and companies with solid balance sheets that are generating earnings growth are all factors which support a positive view on returns for a diversified portfolio in the coming years.