At this time of year, the financial media often carries articles advising retail investors on optimising the return on their money in the year ahead. The golden rules for a sound investment are not written in granite. Some analysts argue that the current global economic and political context calls for a different rule book for 2023.
Many will be familiar with the often-repeated investment mantras like “buy the dip when stocks go down” or “find shelter in government bonds when growth worries mount or recession hits”. These strategies have admittedly served retail investors well for the past several decades. But we must admit that they have not worked in the last few years.
Those whose work involves economic analysis in defining investment strategies must be familiar with ‘Great Moderation’ – a 40-year stretch characterised by steady economic growth and subdued inflation. This backdrop has vanished and is unlikely to reappear anytime soon.
The present global economic scenario that emerged with the pandemic is characterised by production constraints caused by changing dynamics that made globalisation the bedrock of free trade. The rewiring of the globalisation system has begun and the need to build more resilient supply chains means greater production costs.
Weak global political leadership has meant that central banks had to intervene aggressively to stimulate growth following the great financial crisis of 2008. Negative interest rates and quantitative easing deprived many retail investors of a decent return on their hard-earned savings. Central banks now realise that they have departed far too much from their primary mission to stabilise inflation at the two per cent target.
Balancing tactics to tackle high inflation while stimulating growth through fiscal tactics is challenging. Raising interest rates will harm growth, equities and government finances. Many EU member states are seeing their national debt soar as they struggle to stimulate growth in the short term. Capital and debt markets are adjusting to persistently higher inflation, which is not good for bonds.
Those who believe that soon the era of Great Moderation will return may be missing some uncomfortable realities. The demographic challenge facing western economies is reducing labour supply, affecting the production capacity of various industries, from the leisure and entertainment industry to those that depend on a constant supply of highly skilled workers. Robots can ease the pressure, but there is a limit to the potential of automation.
The realisation that the global economies need to shift to greener means of production is causing energy supply and demand mismatches, increasing production costs. This is not good for investors in the equity market.
The realisation that the global economies need to shift to greener means of production is causing energy supply and demand mismatches, increasing production costs. This is not good for investors in the equity market
The most likely prospect for 2023 is that most EU countries will continue to struggle with sluggish growth and high inflation, even if this will be lower than the peak in 2022. We may expect that central banks will again use the tools they used in the past decade to avoid deep recessions. They are unlikely to do so without risking denting their already damaged credibility.
The good news for investors is that most analysts are confident that 2023 will not be as bad from an economic perspective as 2022. But it will be unrealistic to expect that we will be returning to pre-COVID normality anytime soon. There are still too many geopolitical uncertainties that can prove any positive economic outlook wrong.
More clinical investors will want to find evidence of how much of the economic damage experienced in the last few years is reflected in market prices. Some analysts believe that equity valuations still do not reflect the likely damage ahead if economic developments take a turn for the worse. This risk may convince retail investors to be underweight in equities.
The bond market may not be the inevitable alternative for those who want to avoid capital destruction in the equity market. The good news is that those entering the bond market today are getting higher yields than those who did so a few years ago. Still, investors would do well not to lock their money for longer than a few years.
Short-term government bonds are appealing for this reason. If interest rates continue to rise to tackle the current high inflation, you would not want your money locked in either long-term sovereign debt or junk bonds that do not give a decent return for their inherent high credit risk.
Retail investors need to be more active in monitoring their portfolios by consistently calibrating their mix of investments to minimise the risk of capital destruction of sub-optimal returns.