The forces currently at play to usher in the new financial cycle

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FIFI PETERS: The end of the current financial cycle is upon us, argues global investment firm Ninety One, and that end will probably lead to the developed world entering a recession. To discuss this and the forces currently at play to usher in the new financial cycle I’m joined by Iain Cunningham, the co-head of the Multi-Asset Growth Fund at Ninety One.

Iain, thanks so much for your time. Just help us recap until now what the current cycle is that we have been facing.

IAIN CUNNINGHAM: Hi there. Thank you for having me. I think we’ll think about the last financial cycle. And it’s important to note that typically financial cycles are quite different from [the previous one]. The financial cycle that we saw through the early 2000s was all about emerging markets, it was about commodities dealing. And then the last financial cycle – which we classified as the period up to now post the global financial crisis – has basically been a period where we’ve had a number of big-picture macro forces that have effectively weighed on both growth and inflation.

Just to highlight what those are, the first is within China. China moved from a fixed-asset investment-led growth model towards a consumption-led growth model. That caused headline growth to slow considerably. It reduced the growth and demand for commodities, therefore weighing on commodity prices. So that was a headwind to growth. It was a headwind to inflation.

In the US we saw a material household de-leveraging cycle post the financial crisis. We also saw European governments enacting austerity. So deleveraging generally caused, again, a headwind to growth and inflation. And then we also saw the likes of the shale-gas boom in the US weighing heavily on energy prices, then a disinflationary force.

And then demographics. We saw quite a sharp slowing of working age populations across certain major economies. So all quite disinflationary or headwinds to growth. And what this caused was it allowed central banks to maintain exceptionally easy monetary policy as they sought to attain their inflation targets, which were arguably unattainable in a period where there was notable disinflationary or deflation pressures.

This across a period of time allowed equity multiples to expand and bond yields to move lower, so we sort of had an expansion of asset valuations. Arguably through that period we borrowed some returns from the future.

It’s been an environment that’s been very good for certain things. What we have is the effectively clean money in many instances was very good for technological disruption. It was good for asset-light businesses. It was good for large-cap technology businesses, and it was very good for the passive industry in general, because asset valuations generally inflated.

I think as we move forward we see things potentially looking a little different as we move into the next financial cycle.

FIFI PETERS: Sure. Let’s talk about that difference, then, and the forces that are currently at play to usher in this new financial cycle.

IAIN CUNNINGHAM: I think probably the first thing to note is the starting point for asset market valuations. So to keep you in the US market what we’ve seen is until very recently, primarily last year, over the period since the global financial crisis we saw equity valuations move higher to levels that are historically relatively elevated, and we saw bond yields move to very low levels prior to this past 12 months.

Now when you have high stock valuations, you naturally have an environment where forward-looking returns are more depressed. So our capital market assumptions effectively model prospective returns over the next 10 years being roughly half of [those] realised over the past 10 years. That’s sort of our starting point. So a less easy environment just to generate returns in general due to extended starting valuations.

And then I think when we look at the major macroeconomic forces that have been emerging, and that are likely to continue to emerge and potentially accelerate over the next five to 10 years, the first of all of them is China. China’s rise: we’ve seen pushback on that from other parts of the world. So we’re seeing areas of de-globalisation for national security reasons. We’re no longer taking advantage of the lowest-cost labour around parts of the world. The reworking of supply chains is resource-intensive, it’s capital-intensive.

And ultimately we also see rising geopolitical risks causing a lot of defence spending – again which is resource intensive.

One of the big areas which we think has been changing is the transition towards net zero, so efforts to avert climate change. That’s probably going to cause one of the biggest investment cycles any of us will have seen in our lifetime.

Again, resource-intensive, capital-intensive, as we see the building out of wind farms, solar farms, electrical grids, the upgrading of vehicles, buildings and the like. All of this is being forced by regulation and subsidies.

And then the other one is within demographics and debt. So that big deleveraging cycle within the US economy that was with us for the last 10 to 15 years, we think is largely done. The big millennial cohort within the US, which is the largest cohort, is moving through household formation. So typically at that point in our lives as human beings we tend to take on leverage to buy houses and buy cars. The big challenge with all of this is it’s somewhat more inflationary, it’s more resource-intensive, it’s more capital-intensive. This comes at a time where we’ve seen significant underinvestment of resources [in] the past decade.

So what we think about the next five to 10 years could look quite different from the last five to 10 years, because you could see somewhat a higher and more volatile inflation impulse, which could cause more volatility in central bank rate-hiking cycles. Historically, that’s tended to cause higher asset correlations, so you can’t really rely on equity and bonds [being] as diversified as they were in the last sort of 20 to 30 years.

Typically the environment we’re talking about could cause notable changes in market leadership, so [we could see] more resource-intensive and capital-intensive businesses.

The picture I’m painting would mean that we can have quite a different market environment relative to what we saw in the last financial cycle.

FIFI PETERS: Which would mean what for portfolio management? I understand you manage the Ninety One Global Strategic Managed Fund. Therefore how does this different picture that you’ve just painted of what the next five to 10 years may look like mean [for] how the fund will be positioned in this era, and how you’ll account for risks as well as opportunities?

IAIN CUNNINGHAM: I think, given the starting point of lower expected returns, ultimately the challenge with lower expected returns is if you sit passively exposed to, say, equities and bonds, you are sort of accepting the prospective lower returns. Now, we ultimately think that there are things that you can do to aim to achieve higher returns in the environment that we’re painting.

We think using flexibility is one – being able to allocate to different areas in the world, given that we could see less synchronised financial cycles. As well [as], being able to move in and out of different asset classes, depending on where risk premier is present and where the economic cycle and policy are supportive at any point in time; and then doing that across as broad an opportunity set as possible. So across global equities, fixed-income markets and using currency to generate returns as well.

And then we think it’s very important to be focused on selecting the securities within the right area. We use what we call a longer-term structural stomatic roadmap, where we’re looking to identify areas where there are major tailwinds running through the global economy, and we’re ultimately looking to buy into companies that we believe will be beneficiaries of some of the longer-term themes that I’ve just discussed, in terms of how those are evolving and changing.

And then we think you need a pretty robust process to analyse the macroeconomic cycle and analyse valuations to allow you to flexibly allocate capital across different areas. So ultimately it’s going to be about using flexibility and it’s going to be about being very specific in terms of the types of businesses and assets you are investing in at the right point in time, rather than just allocating sort of passively and sort of benefiting from the tailwind of valuations or lower starting valuations previously, because those are not present over the next five to 10 years, given much higher starting valuations and therefore lower expected returns.

FIFI PETERS: All right. A really insightful picture that you painted there. Thanks for sharing your glimpse into the future as you see it at Ninety One, and how you are planning to navigate in it.

Iain Cunningham is co-head of the Multi-Asset Growth Division at Ninety One.

Brought to you by Ninety One.

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