The investment industry has been talking a lot about our position in the economic cycle and our proximity to a recession. In fact, I wrote about it last year with respect to interest rates and the economy.
The current situation remains somewhat tenuous, with ever-present geopolitical tensions, rising populism (and hence protectionism), slowing global economic growth, monetary policy that has lost its teeth at the current interest rate levels, weak productivity growth and demographic impacts felt in many developed nations, including Japan and much of Western Europe. While Canada is faring better than some G7 nations, it’s expected to see its economic growth decline from two per cent to 1.7 per cent over the next few years due to many of the factors noted above.
Some believe the current environment will lead to higher than expected inflation. G7 gross government debt sits at 120 per cent of GDP, a level that might cause many to pause. However, the debt servicing costs associated with this borrowing sit at two per cent of GDP, lower than the four per cent experienced in the early 1990s.
While certain countries are seeing inflation flowing through rising wage settlements, they haven’t experienced broad inflationary pressures to date. The risk to this scenario may arise from fiscal policy, which could spark inflationary pressures. The big caveat is that while many countries talk about using it as a tool — modern monetary theory, monetization, “helicopter money” — no major government has yet elected to do so. This includes Japan, where anemic economic growth and deflationary pressures are only ameliorated by a shrinking population.
What can investors do in this environment? An interesting article published by Partners Group in November 2019 stated “offence is the new defence.” (As an aside, this could be the Toronto Maple Leafs’ new mantra, but I digress.) I think this is an interesting premise and one worth further exploration.
With low interest rates, asset prices across public and private market asset classes have risen to levels not seen in many years and which many investors believe are unsustainable. In fact, there appears to be a disconnect between equity markets and economic prospects.
Investors, hungry for yield, have bid up purchase price multiples for core, operating businesses, real estate and infrastructure, as well as senior secured debt. Some investors would consider these assets priced to perfection and not in a great position to withstand an economic downturn. Assets or companies with few operational levers aren’t as likely to withstand a slower economic environment.
In the past, the argument has been that operating businesses with stable cash yield in non-cyclical industries would provide downside protection in an economic downturn. While this is true to some degree, the price paid for this cash flow impacts the total return. As well, many of these businesses are in mature industries that are affected by disruptive technologies. Instead, investors should focus on industries and sub-sectors that will benefit from growth and strong governance since these are more likely to do well.
The sectors cited by the Partners Group article included veterinary services and health care related services such as physical therapy. From a real estate perspective, properties that will benefit from employment and logistical growth should perform well, as will infrastructure that supports clean energy and energy delivery. The latter option is consistent with the current investor focus on climate change and environment, social and governance-friendly investments.
With the large amounts of money raised by all private asset classes, not every investor will be successful in accessing these opportunities at prices that make the investments profitable. I know I sound like a broken record, but investors have to ensure their managers are maintaining pricing discipline and are aware of how technological change could affect their portfolio prospects.
From an asset allocation perspective, maintaining a diverse portfolio — in asset classes, geographies, sectors, etc. — can help blunt some of the impacts of market events. Above all, good governance and an ability to act when required are becoming more important. Investors can’t shield their portfolios entirely, but they can take actions now that could make a difference down the road.