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Long-term investing is about the belief that fundamental value exists and that asset class returns tend to mean revert to their equilibrium level and rotate around it, within regimes. Every regime is defined by its mean/equilibrium, based on economic and credit cycles (and depends on a number of factors, including monetary and fiscal conditions). Detecting market inefficiencies and misalignments around these trends is the essence of active management. Among the reasons behind the current misalignments are excessive risk taking (especially in the credit market) induced by Central Banks’ quantitative easing policies, inefficiencies due to the retreat of research coverage in some areas of the market (ie, Japan) and the emergence of crowded trades in relation to the “benchmark-sation” of the markets (with a high concentration of risk in certain components of the indexes, typically large/giant firms and in the sectors represented). Although these distortions may result in significant challenges for investors, they also open opportunities for active managers to add value for the long term.
With a long-term perspective, macroeconomic variables are the main drivers of interest rates and earnings growth and therefore of the asset returns. Among these variables, the most important with a long-term view are: demographics, productivity growth, debt dynamics and changes in labour force and in capital formation. We think that the underlying trends affecting these variables (ageing population, sluggish productivity growth, high debt) point to a low interest rate at equilibrium and to equity returns (and earnings growth) around the long-term trend (about 6.5% for the US market). This will translate into lower return potential for a balanced portfolio in the future compared to the last 10 years.
With a shorter-term perspective, the current regime shift is a key topic, given we stand now at a critical juncture. On one side, there is the temptation to see an extension of the cycle in the US and an upward trend in earnings; however, we also see signs of a maturing cycle: global growth is at peak, global liquidity is expected to diminish, and leverage is creeping up in a context of high debt. Low interest rates make high risk asset valuations more sustainable (with stretched situations in some area of the market, such as growth stocks). However, we should consider that most of the monetary component of returns (falling rates) is behind us, and unless we see a structural increase in productivity growth (not on the radar), we can expect equity returns to be back to long-term averages. While the current phase of strong economic growth and relatively benign Central Banks still favours some risk exposure (equities attractive vs bonds, and bonds are expensive), we acknowledge that the medium term could prove more challenging. The era of ultra low volatility is coming to an end, and investors should start to prepare portfolios for the next, less benign, phase, recalibrating risk. Value and quality are themes to consider in this phase as well a flexible approach to duration, combined with an active allocation of the duration bets across the different curve segments (slicing duration bets).
Reconciling the short-, medium- and the long-term investment landscape is key for investors to enhance long-term returns while managing the investment path. To achieve this, investors should focus on maximising long-term opportunities (by getting exposure to well-remunerated risk factors and avoiding poorly remunerated ones) while mitigating the downside when the cyclical downturn materialises and keeping in mind that liquidity management will be key.
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