Savers and investors tend to focus on the short term, and these days there are plenty of concerns to keep them busy. The impact of Britain’s momentous decision to leave the European Union, the testy US Presidential elections and central banks’ policy manoeuvres to forestall an economic hard landing are just a few of the worries weighing on investors’ minds.
Yet, to invest successfully in a rapidly changing world, it is just as important to understand the longer-term forces that could impact returns.
This means keeping a close eye on economic growth, interest rates, inflation and corporate profits – the four long-term drivers of investment returns – as well as geopolitical risk and technological innovation.
The vicious cycle
The main challenge for economies today is reviving consumer demand. This is daunting given that an increasing share of income is going to more affluent households, which are more likely to save than spend. And because business investment follows consumption, there is less demand for capital. Thus, we have a vicious cycle of lower growth, higher saving and lower investment.
What are the potential implications for investors?
For one, interest rates – the primary source of return for savers and income-seeking investors, and a key driver of asset values – are likely to remain depressed for longer as savings outstrip investment opportunities.
Adding to the downward pressure are the excessively high levels of debt across the developed and some emerging markets since the financial crisis, as well as tighter regulation, which has forced businesses and the financial sector to deleverage.
Investors should expect lower returns in the foreseeable future
As benchmark rates on government bonds stay depressed, yield premiums on corporate debt are likely to remain low too, especially for higher grade bonds. This, in turn, is pushing investors to accept riskier bonds.
Equity returns, too, are likely to be suppressed in a world of low growth and subdued interest rates. This is because long-term returns are driven by growth in corporate profits as well as the premium investors are willing to pay on those expected profits.
Over the longer term, earnings growth is highly correlated with economic growth and investors are normally unwilling to pay higher premiums for expected corporate earnings when they are not so sure about future economic prospects. Investors should therefore expect lower returns in the foreseeable future.
Accepting riskier times
Today, those seeking a return equivalent to what a bank deposit would have generated a decade ago will have to invest in a diversified basket of income-generating assets, such as investment-grade corporate bonds, higher-risk/high-yielding debt, alternative assets, such as real estate investment trusts, and stable dividend-paying equities.
It is likely investors will also have to accept growing geopolitical risks, as the influence of the US wanes and world power becomes multi-polar, bringing a greater risk of conflicts as well as rising barriers to trade and the free movement of people, capital and technology.
The rise of protectionist parties and agendas across Europe and the US is a warning sign, and the Brexit vote in the UK merely the latest manifestation of this evolving trend. If it continues, it could roll back decades of hard work in fostering global trade and investments, which has lifted billions of people out of poverty and boosted prosperity through increased productivity.
Rising middle class opportunity
Investors will need to watch closely how the current trend unfolds, staying alert for factors that could reverse it. For instance, increased spending by the rising middle class in the developing world, or reduced pensions saving in the developed world, could be a potent driver of growth going forward.
While household debt continues to rise worldwide (the surge in auto and student loans in the US is just one example), there is significant scope for millions of households in emerging Asia and other developing economies to increase borrowing. This could be a key driver of consumption, while disruptive technologies could boost productivity, yielding innovative solutions to global problems and generating immense wealth.
Adaptability and agility will be key ingredients of an investor’s success in these uncertain times
And of course, the trillions of dollars in investment which are required to build modern infrastructure in the emerging markets, and replace aging facilities in the developed world have the potential to drive growth for decades to come.
So while the present environment of heightened risk warrants a balanced and diversified allocation to an array of income generating assets, investors need to be alert to the longer-term growth opportunities and capitalise on them as they arise. Adaptability and agility will be key ingredients of an investor’s success in these uncertain times.