The Next 10 Years
Turbulent times are here to stay. Intense and more frequent volatility will define the next decade.
The onslaught of market-making bad news seems almost a daily event. A gloomy picture of slowing economic growth, elevated inflation, and confusing fiscal and monetary policy has added a lethal mixture to the market’s performance.
Fiscal stimulus is sidelined, and monetary policy is constricting economic growth and entrepreneurial innovation. It makes for a gloomy outlook and an even more depressing long-term perspective. The next 10 years look more like a lost decade.
Economic growth depends on innovation and entrepreneurship. But venture capital and growth investing have dried up, at least for now. Rose-colored glasses have been replaced with doom and gloom projections on all sides. If the smart money is on the sidelines, and incumbent competitors are facing increasing regulatory pressure – whether it’s the regulatory policy on technology or restrictions on energy and mining, the forces that sustain economic growth look to be saddled and harassed by both government and financial markets.
The S&P 500 is down more than 20%, and bonds have lost almost 15% since January 2022. The tsunami of economic and fiscal data, ranging from inflation and job reports to every blurb from the Fed forces a short-term focus that misses the bigger point. Investors should be unconcerned with the here-and-now versus the longer-term trend.
Investing success depends on a long-term perspective. The long view is what matters, and understanding where the economy, critical strategic trends, and the markets will go takes discipline, rigor, and thoughtfulness. In other words, measuring what matters, predicting long-term outcomes, and keeping the fortitude to stand by those predictions in the face of near-term volatility.
Equities have consistently outperformed fixed-income securities for multiple decades. The traditional 60/40 mix between stocks and bonds seemed anachronistic, at best. Now that interest rates have risen significantly (5-year Treasuries are over 4% and high-yield debt yields have more than doubled in less than two months), this stock/bond allocation is getting some favor again.
Alternative assets, especially venture capital, private equity, and credit-based hedge funds, were believed to not correlate much with stocks or bonds. This is proving to be somewhat misguided because markets define potential exit strategies and liquidity, even if those investments are private, growth-oriented, or leveraged credit. Eventually, markets matter.
Crisis, What Crisis?
Will the next 10 years be much like the last 14 years – recovering from a market correction to have a long-term bull run? Perhaps, but opportunities are broadening and diversifying. This makes for some interesting investment ideas, but one thing is clear, the market downturn makes this a much more compelling starting point when putting new money to work.
2022 through September has been punishing, and many sectors have become cheaper than they have been for years. Of course, they may deserve to be cheaper, and distinguishing opportunity from correction is the key to any investment strategy.
Fixed income is providing a meaningful return for the first time in more than 15 years. Cheaper equity and higher-yielding assets are a potent combination that has not existed since before the financial crisis of 2008.
The best predictor for future performance is current valuation. Fixed income and higher-yielding securities are priced at very attractive levels, and current yields are unprecedented since the mid-2000s.
A 10-year horizon and this year’s price correction make equities compelling.
Past is Prologue
In the aftermath of the 2008 financial crisis, economic growth was slow and interest rates and inflation were low. Central banks engaged in a massive quantitative easing strategy. This potent mix ignited a valuation growth curve for growth-oriented companies (present values of far-off cash flows became much more valuable), and even long-dated bonds were more valuable. Additionally, some overlooked, yet extremely attractive investments have turned out to be higher-yielding BDCs, REITs, and high-dividend equities.
These securities entered a hyper-growth stage. While current market conditions stalled or diminished their valuations, these investments represent the best starting point for a long-term portfolio today. The same conditions exist. If one looks beyond the very near term, inflation, while still at 8% or more today, is likely to drop to 3% annually and maintain that level for the longer term.
High-growth company valuations have been significantly discounted, and over time as discount rates drop, their valuations are likely to increase substantially. Higher-yielding fixed income securities will be a standout performer as interest rates are reduced, the higher-yielding BDCs, REITs, leveraged loan securities, and high cash flow instruments, along with high-dividend equities, will prove extremely attractive and are currently available at bargain prices.
Post financial crisis, the environment favored a narrow group of stocks, namely the technology giants and other fast-growing, but not necessarily profitable technology-based businesses. Beginning in 2009 through the end of 2021, the S&P 500 returned over 15% per year. Technology stocks returned over 20% annually during the same time, and, although they are much more interesting now, energy stocks returned less than 5%. Fixed income yielded almost nothing. Sectors and choices matter.
Investment opportunities cannot be painted with the same brush from a long-term perspective. In the near term, everything is correlated and moves in unison, but distinctive opportunities separate and generate many different returns given a long enough time horizon.
Will this same strategy work for the next 10 years?
Cash-generating investments are likely to be extremely attractive in the next decade. More frequent and intense volatility adds greater uncertainty to any prediction, and while higher interest rates mean far-off cash flows are worth much less today when discounted back and securing financing is more expensive.
The combination of all this means that a winning investment portfolio should depend on high cash flow yielding investments from competitively sustainable entities.
There won’t be smooth sailing anytime soon, if ever. Uniquely, we are in an environment of structurally higher inflation and interest rates. That will likely continue to some degree over the next decade. However, 8% annual inflation is not likely to be around much longer.
A 10-year perspective is probably closer to an average of 3% annual inflation. That makes cash flow-generating investments today especially attractive. If one can withstand higher volatility, ignoring current market valuations can lead to attractive and superior longer-term performance.
The Fed is laser-focused on controlling inflation, so the “Greenspan Put” is off the table for now. It is a belief that central bank distorting quantitative easing programs also seems off the table, but that is a switch that is likely to be flipped quickly if continued recessionary pressures impact global markets and economies.
Perhaps the market will not be flooded with QE’s liquidity, pushing investors up the risk curve. But political pressure on central banks to revive economies will be strong and probably unavoidable. QE will come back sooner than most anticipate.
The Long-Lost Punch Bowl
Monetary policy is unlikely to provide the boost it did to financial markets since the previous financial crisis (the infamous “punch bowl”). The issue is whether monetary policy will remain a drag on stocks over the next decade. The last market cycle ending at the end of 2021 was overwhelmingly driven by valuation expansion.
Low-interest rates and QE were a substantial tailwind. Now, that momentum is disappearing and perhaps gone forever – perhaps even a headwind. Earnings growth, dividend yields, and cash-on-cash yields will matter more than ever. These choices will make the difference between superior performance and market-lagging choices.
Investments that return the most cash will be the most attractive. These include not only high-yielding equities but BDCs and REITs.
Alternative investments will generate superior longer-term returns, as well. Valuations are down substantially, which, as we know, the starting point of any investment defines a large component of an investment’s return.
The starting point is now much more attractive than it has been in over 10 years.
Along with high cash flow yielding investments, opportunities in technology and automation remain. Disruption is occurring in major global industries, including finance, life sciences, communications, and energy. AI, E-data, genomics, renewable energy, and many applications across sectors for machine learning and other artificial intelligence-based tools will enable new and disruptive innovations that will capture significant value widespread across many companies and sectors.
There will not be a single ecosystem of value, as we saw with Apple, Google, Amazon, etc. Value will not only be captured by the companies creating these technological innovations, but also by those using these innovations to be more productive, efficient, and competitive. Value creation will go beyond a narrow smartphone ecosystem or e-commerce and social media closed loops.
Providers of value and users of value will be the winners for the next decade. Those generating real cash flow and disruptive innovation will define the next decade.