Investing Has Become Much More Difficult
If your investment portfolio has been struggling recently, it might be time to rethink your strategy. It may well be that what has worked during the past ten years in investing is what won’t work during the next ten years, while the investments that haven’t worked during the past ten years in investing may be what will work better during the next ten years.
Put simply, it might be time to follow the advice of George Costanza from Seinfeld, who famously said, “If every instinct you have is wrong, then the opposite would have to be right.”
It’s worth exploring why that might be the case with investing today.
Globalization to Deglobalization
Globalization seems to have peaked, and deglobalization has begun what looks to be a multi-year trend. Companies are reshoring production while countries are trying to figure out how to be more energy independent. Capital flows are also deglobalizing. China is no longer funding U.S. budget deficits by purchasing U.S. Treasuries, while the United States is making it more difficult for U.S. investors to invest in unaligned countries. At the same time, Russia and China are creating a coalition of countries to trade in local currencies rather than using U.S. dollars as an intermediary currency. All of these trends will influence interest rates, currency exchange rates, and inflation.
Declining Commodity Prices to Increasing Commodity Prices
Ten years ago, commodity prices were extremely high, and companies were investing enormous sums of money to increase the production of those commodities. As they say in the commodity markets, the cure for high prices is high prices. New supply flooded the market, and commodity prices declined until they hit rock bottom in March 2020. Since then, commodity prices have begun to rise, but they haven’t risen enough or for long enough for companies to invest in new production. Unless investment and production in commodities grow rapidly, the next ten years will likely represent a decade of rising commodity prices, which will influence consumer demand, corporate profit margins, and interest rates.
Low Inflation to High Inflation
Inflation has enjoyed a long slumber until 2021, with the average inflation rate generally remaining below 2% per annum for a decade until 2021. Today, inflation is at a 40-year high, and there are compelling reasons to expect that high rates of inflation are likely to persist. Among those reasons are the deglobalization and increasing commodity price trends discussed above. In a high inflation rate environment, interest rates are likely to rise, and P/E ratios are likely to fall, much like they did in the 1970s, with important implications for the stock market, the bond market, and the real estate market.
These trends are likely to persist for years, which means that the investment implications are likely to persist too.
Treasury bonds that pay a fixed income have been a terrific investment over the past decade. As interest rates have declined, bond prices have increased in turn, allowing bond investors to generate an attractive return until bond yields bottomed in 2020. If inflation persists, which seems likely, bond yields will likely need to continue to rise, which means that prices will likely need to decline. Furthermore, inflation is still well above the rate of interest that Treasury bonds are paying, which means that investors in Treasury bonds are getting paid a negative return after adjusting for inflation. Treasury bonds might be useful for a tactical trade, but, as a long-term investment, it seems like a poor idea.
The stock market in the United States has been the best-performing stock market in the world over the past decade, driven by stock buybacks and a bubble in technology stocks. The bubble in technology stocks has already begun to deflate. U.S. stocks should see a lot of pressure going forward due to higher interest rates, compressing profit margins, and falling P/E ratios. It would not be surprising at all to see the U.S. stock market be an underperformer versus the stock markets of other countries going forward.
Passive investing and growth investing are probably also due for a comeuppance. Passive funds tend to own more of those companies that are the most overvalued. That’s why the S&P 500 Index is dominated by overvalued growth stocks such as Tesla
. At the same time, high inflation and rising interest rates can be toxic for growth stocks that have elevated P/E ratios, while value stocks which already have compressed P/E ratios are more likely to outperform on a relative basis. Unlike the last ten years, the next ten years seem like a good time for active managers versus passive funds, while could very well outperform growth investing after a decade of underperforming.
Alternative investments have been all the rage over the past decade. Venture capital, buyout funds, and real estate funds have raised an enormous amount of capital and have done well due to low inflation, declining interest rates, and a growing bubble in technology stocks. With high inflation, increasing interest rates, and a deflating bubble in technology stocks, these alternative investment strategies are generally going to struggle to generate the kind of returns that investors have generated historically.
The Japanese stock market has generated about half of the return of the S&P 500 Index over the past ten years. But Japanese stocks are inexpensive, well-capitalized, and have a lot less capital expenditure requirements going forward related to reshoring as compared to U.S. companies. In addition, Japan is probably one of the most politically stable countries in the world, and it is likely to remain that way. Japanese stocks seem like a good bet to outperform U.S. stocks over the next decade.
Ten years ago, emerging market stocks were overvalued and, as a result, emerging stocks have gone nowhere over the past ten years. However, no emerging market stocks are undervalued. Asia seems likely to outgrow the rest of the world going forward, while South America is full of commodities that the world needs. While emerging market stocks have been a terrible investment over the past decade, that trend seems likely to reverse going forward.
The gold price has also gone nowhere over the past ten years. During the next ten years, the fundamental environment for gold looks quite attractive. Inflation is rising, commodity prices are rising, and stocks and bonds are likely to generate much lower returns going forward. Meanwhile, U.S. deficits are likely to continue increasing, and foreign central banks are accumulating gold as foreign currency reserves. Unlike the last ten years, the next ten years seem like a good time to own a meaningful allocation to gold.
Most importantly, the investing environment has shifted from easy to hard. What worked before is not necessarily what will work going forward. It’s important to understand how the macroeconomic environment has changed and what that means for your investment portfolio going forward.
This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management.