Embracing long-term investment perspectives

Every year in October, Julius Baer’s senior research and investment management experts, along with selected external guests, come together for a two-day Secular Outlook off-site seminar to reassess the key trends in the global economy and capital markets. The seminar, which is an integral part of Julius Baer’s investment process, gives us an opportunity to take a step back from recent events and the daily news flow and examine where we stand in the grand scheme of things. As long-term investors, it is paramount to have a clear view of the structural forces at play in the economy and align our portfolios accordingly.

The transition from neoliberalism towards state-sponsored capitalism, a notion we introduced in 2019 for the first time, is now in full swing. This trend has been turbo-charged by the return of geopolitics. Today, we face a multipolar world, where strategic reshoring activities driven by national security concerns are gaining importance, facilitated by active fiscal and industrial policies. Fiscal dominance paves the way for a normalisation of interest rates at a faster-than-expected pace – a fundamentally healthy development in a capitalist system that creates opportunities. At the same time, we might be on the cusp of an innovation super cycle driven by the convergence of multiple technologies, including generative artificial intelligence, which could enable massive productivity gains throughout the decade. Meanwhile, China is in a balance sheet recession and is facing further structural headwinds due to very adverse demographic and economic developments.

Distinguishing between cyclical developments and structural changes

In last year’s edition of the Secular Outlook brochure, we argued that since first holding the annual seminar some 15 years earlier, the world had never changed as dramatically as it had in the preceding 12 months. We concluded that the war in Ukraine marked the end of the peace dividend. It was a watershed moment for investors, as it had a host of geopolitical, economic, and financial implications. In the presence of such a paradigm shift, all previous investor reaction functions needed to be re-evaluated and revalidated.

At the same time, however, we were very careful to distinguish between cyclical developments and truly structural changes. We noted that the challenge was compounded by the successive shocks of the Covid-19 pandemic and the monetary and fiscal stimulus provided in response, followed by the outbreak of the war in Ukraine. These shocks caused massive distortions in the economic and financial cycles and triggered inflation for the first time in decades. In the face of these developments, policymakers raised interest rates out of the realm of financial repression at an unprecedented speed and scale. Ultimately, the 40-year bull market in bonds came to an end, and the bursting of the bond bubble that started in early 2022 reached historic proportions in 2023.

Beneath the surface, the post-pandemic normalisation is making good progress and structural visibility, which was unusually low in recent years, has been gradually improving. In hindsight, we were right about our take on some of the formative events of recent years, resisting the temptation to draw hasty conclusions from them for the decade as a whole. Nevertheless, we expect macroeconomic volatility to remain higher than in the previous decade, fuelled by the new geopolitical situation.

The return of the cost of money

After the Global Financial Crisis (GFC), Western central banks began using ultra-low or even negative interest rates in combination with large-scale asset purchase programmes to prop up ailing economies. Such action was required to prevent deflationary tendencies as private sector agents were repairing their balance sheets. Put in historical context, both the US federal funds rate and the 10-year US Treasury yield reached record-low levels during that time. Over the past 150 years, the 10-year US Treasury yield has mostly hovered around 3%–5%, with a central tendency towards 4%. At the same time, the US federal funds rate has on average been slightly below 5% since 1954, when official Fed data first became available. In that sense, the recent moves have been a return to the mean for both measures.

In retrospect, the last decade has been an experimental period for monetary policy. The range of tools available to steer economic activity has expanded considerably during this period. The big question confronting investors is whether interest rates have moved sustainably higher or whether we will return to the realm of financial repression further down the road. With the 10-year US Treasury yield having breached the 5% threshold in October and short-term rates expected to stay above 5% going into 2024, it certainly would not be far-fetched to say that we are done with zero-to-negative interest rates, quantitative easing, and policies inspired by Modern Monetary Theory. However, we believe that such a conclusion would be premature. Fundamentally, we see insufficient evidence to justify interest rates remaining structurally ‘higher for longer’.

The private sector remains a net saver in most developed economies. The decline of private sector borrowers that began after the GFC continues, putting structural downward pressure on the cost of capital. Crucially, we also maintain the view that the ‘tail is wagging the dog’, i.e. given the exponential value of financial assets in relation to global gross domestic product, changes in asset prices still disproportionally influence the real economy. Given the sheer volume of financial assets and global debt, a continuous rise in yields could lead to systemic problems.

By and large, the fact that money has a price again is a fundamentally healthy development. While the normalisation of interest rates is painful in the short term, it is a blessing in the longer term. When money is cheap, or even free, there is a risk that economic agents will be less disciplined in how they allocate capital, e.g. by using it for potentially unproductive purposes such as speculation in financial assets and financing questionable business models that are only viable under generous liquidity conditions. In this sense, the return of the cost of money has a desirable disciplinary effect. We do not mourn the end of the era of ‘free money’. On the contrary, we welcome it as a necessary condition for reigniting creative entrepreneurial destruction and sustainable economic growth going forward.