How can investors find alpha in a slowing economy? Northern Trust Asset Management outlines its ideas for the next five years in a report that names private equity, hedge funds and high-yield bonds as likely growth opportunities.
The NTAM outlook is for 1.9% annual gross domestic product expansion over the next five years, following two years of Washington stimulus. The nation’s GDP growth last year was 5.7%. But now the hiking of interest rates by the Federal Reserve will likely lead to slow growth over the next five years.
“In our view, investors will see the past two years’ stimulus-boosted growth reverting to the previous slow form,” said Chris Shipley, NTAM’s chief investment strategist for North America, in an interview. The firm’s GDP “forecast marks a slowdown from the past five years but is still ahead of most other advanced economies. On top of that, our 3.7% China forecast also marks a slowdown from the past five years.”
Shipley continued, “slower growth is a global theme, the accumulated debt in the public sector in response to COVID represents incremental headwinds. Now we also have deliberate monetary policy aimed at slowing things down in effort to combat higher inflation, leading to higher interest rates. In addition, deglobalization and energy security concerns will drive investment that replaces existing infrastructure, potentially crowding out other investment and adding to inflationary pressures.”
Just because GDP growth may be slowing does not mean there is not opportunity to generate alpha from investments. NTAM pinpoints global private equity to lead all investment categories with a five-year annualized return of 9.6% slated.
Shipley explained, “private investments and private equity are hard to cleanly categorize as they are so broad across the capital structure, but historically there is a healthy return premium in the private equity space compared to equities. We believe that over the next five years this premium will persist, as a function of private equity being less liquid than other investment options.”
Further, the NTAM report projects hedge funds to perform well globally at 5.4%, in contrast to their muted returns of the last decade. Shipley said, “elevated volatility has the potential to bring higher return premiums after strong equity performance weighed on hedge fund relative performance over the past decade.” It’s important to note with hedge funds, like private equity, manager selection is key as returns can vary widely across managers and strategies.
The firm favors strategies featuring real assets, broken down into three categories: global real estate, global listed infrastructure, and natural resources/commodities. The report highlights natural resources as being particularly attractive given both near- and long-term commodity needs of the global economy, forecasting a 7.3% return for natural resources, 6.8% for global real estate, and 6% for global listed infrastructure.
Shipley said NTAM invests in real assets via the stock market, which entails “equity risk with natural resources and commodities being the most sensitive to inflation. Natural resources and commodities proved to be an excellent hedge against inflation in the first half of 2022.” He noted that global infrastructure and real estate offer good diversification benefits. Plus, he said, they “represent companies with more stable cash flows and carry higher dividend yields, making them attractive during periods of high volatility.”
NTAM likes high-yield bonds because they sport solid interest coverage ratios. In addition, they have reduced issuance, which should help their prices. A further advantage for bonds, the report said, is “higher yield starting points but capped by flatter global yield curves.
“Flat yield curves mean more dependence on coupon payments (versus price appreciation),” it said. “We expect high-yield returns to benefit from wider credit spreads amid stable fundamentals.”
In addition, the firm projects inflation-linked securities’ returns to be 3.4% in the U.S., 3.5% in Canada, 3.3% in the U.K., and 2.2% in Europe, signifying a hefty departure from near-zero and negative rates previously seen in these countries and regions. Japan is an outlier at 0.1%.
The firm writes, “today’s yield curves are mostly flat (taking away that “roll yield”), while our interest rate forecasts mostly match market expectations (reducing the potential for capital appreciation). All said, we expect returns to match yield to maturities.”
A major development, Shipley said, has been the shift from negative rates to positive in Europe. This “puts banks on better footing over time, which should prove helpful for an economy more dependent on the banking system as a supplier of credit,” he observed
Among the firm’s other projections are global high-yield and U.K. equities both returning 7.5%, and U.S. equities outperforming emerging market equities, 6% compared with 5.8%.
The report points out that for equity markets, historically high corporate profit margins face deterioration with inflation and a slowing economy. In addition, China’s zero-COVID-19 strategy increases the likelihood its economy experiences a slowdown, a risk for emerging markets’ equity performance.
The NTAM report also highlights the movement from globalization to regionalization, driven by energy and supply chain durability. Geopolitics are leading Western economies to reassess dependencies on strategic adversaries. They expect supply chains to be reconsidered as the focus shifts to resiliency and self-sufficiency.
When asked if the moving of supply chains will be net positive for job growth in the domestic economy, Shipley declared, “moving production is not a move to bring greater productive capacity to the U.S., but rather to limit supply chain exposure subject to geopolitical interference. This takes form in Europe moving away from Russia for energy imports, and the U.S. moving away from China.”
The report projects that inflation should moderate in the next five years, with forecasts of 3% in the U.S., 3.3% in the U.K., 2.8% in Australia and Canada, 2.6% in Europe, and 1% in Japan. “While we expect inflation to take time to move back toward central banks’ targets, we do believe the worst has passed,” said Wouter Sturkenboom, NTAM’s chief investment strategist for Europe, the Middle East, Africa, and the Asia-Pacific region.
Shipley added, “we do think there will be a return of the real return, and that the inflation will go down over the next five years, though there will be an elevated level of inflation relative to the previous five years.”
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