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Low interest rates make equity valuations attractive and they could become even more attractive, according to R. MCFall Lamm Jr., Chief Investment Officer and Chief Strategist, Stelac Advisory Services. Many investors remain underinvested in equities under the presumption that a recession is imminent, he adds.

R. MCFall Lamm Jr. is a speaker at the marcus evans Private Wealth Management Summit June 2019, taking place in California, June 3-5.

What exactly is the new paradigm?

The new paradigm refers to the fundamentally changed investment world that emerged following the global financial crisis. Throughout most of prior history, private sector leverage increased virtually continuously year after year and decade after decade for most developed economies. Steady credit growth spurred higher economic growth as borrowed funds were put to work.

When the financial crisis came, economic agents rediscovered downside risk and found themselves over-levered. Private sector credit growth as a share of GDP ended as a result. Absent continuous credit growth, the result is a reduced economic performance. Central banks pushed rates to zero and engaged in quantitative easing to prevent collapse.

What are the growth implications?

Private sector leverage as a share of GDP remains lower than before the financial crisis, and the era of ever-rising debt-funded growth appears gone forever (or at least a generation). Accordingly, economic growth will depend much more on fundamentals such as productivity gains rather than credit creation, which implies a significantly slower pace of expansion than in the past. 

A natural consequence will be that inflation and interest rates will remain low. Furthermore, corporate profit growth, which depends on economic performance, will be correspondingly more modest. This will mute equity returns.

How can investors prepare for the new landscape?

Investors should expect lower investment returns in the future. This scenario is camouflaged at the moment by massive cuts in corporate income taxes in the US, which provided a once-in-a-lifetime regime shift surge in EPS. Equity exposure will still provide a risk-premium return several percent above bonds but with interest rates not reverting to levels that prevailed in the past, market performance will pale.

High-fee products are disadvantaged in a low-return environment. For example, if a risky investment provides a five percent pre-fee return, then it is only two percent for the investor after 2/20. In the pre-crisis era, it was not unusual for pre-fee returns to reach 15 percent, with the investor realizing ten percent after fees. Fees consume 60 percent of performance in the low-return situation and only a third in the latter. Low cost ETFs will be increasingly in demand and fee pressure on general partners will intensify.

It is also important to employ robust asset allocation as the business cycle is not vanquished in the new normal, especially with central banks struggling to adjust in a low rate world. This means avoiding multi-year product lock-ups, which restrict investors’ ability to make portfolio adjustments when really needed. 

What is the outlook for global growth?

We are now in the midst of a modest deceleration in global economic growth. It is not unusual for growth rates to fluctuate over the cycle and the current oscillation should be temporary in the absence of central bank error, deterioration in trade conditions, or a worsening of partisan politics. The new standard appears to be for steady-state real US growth of near two percent annually. Presuming inflation averages two percent, which is the Federal Reserve target, corporate profit growth will approximate nominal GDP growth of four percent. Growth in Japan and EMU will be closer to a one percent average due to stagnant population expansion and the fact that they remain mired in liquidity traps with zero rates.

As for China, the country has emerged as a mid-tier economic power. Growth will continue to slow as a natural consequence of the completion of its multi-decade surge that came after the migration to a more conventional model relying on private enterprise after its socialist quagmire. 

Where are the best investment opportunities?   

Many investors remain underinvested in equities under the presumption that a recession is imminent. There is no automatic time limit on how long expansions endure and this cycle is elongated due to its low amplitude. Some investors are also erroneously extrapolating from the crisis experience, where the recession was extraordinarily deep which is typical when financial panics occur. With huge banking system reserves and strict stress tests in place after reform, a repeat is very unlikely. When there is another recession, it is likely to be mild.

Low rates make equity valuations attractive and they could become even more so once investors realize that the end is not nigh. With Europe already experiencing three quarters of sluggishness, an upturn could be coming later in 2019. China has implemented both monetary stimulus (lower reserve requirements and rate cuts) as well as fiscal policy loosening (tax cuts and infrastructure spending). Chinese debt levels remain worrying, but the China story is not over.