The underlying assumptions of the financial market have crumbled

At a time when long-held notions of the market are crumbling, holding a little bit of everything can make a lot of sense.Photo illustration by the Globe and Mail/iStockPhoto / Getty Images

Call it the end of an era. The past couple of years have torn holes in three ideas that investors once considered indisputable.

First is the notion that China is the long-term driver of global economic growth. Second is the belief that interest rates are destined to stay “lower for longer.” Third is the conviction that big U.S. technology companies are a good investment at just about any price.

This not-so-holy trinity of ideas dominated financial markets during the decade leading up to the COVID-19 pandemic. And why not? They seemed to sum up the state of the world.

Interest rates in developed economies had ticked relentlessly lower since the early 1980s. China had turned away from Maoism in the late 1970s and enjoyed decades of warp-speed economic growth. Meanwhile, a handful of big U.S. technology companies had established quasi-monopolies in key areas of the online economy.

People who bet on these three key trends tended to do very well. Imagine, for instance, a lucky investor who at the start of 2010 split her $100,000 portfolio three ways. She put one third of her money into an index fund that tracked the largest Chinese stocks trading on exchanges in the U.S. She put another third into an index fund that held long-term U.S. Treasury bonds (which go up in price as interest rates fall). She put the remaining third into an index fund that followed large U.S. technology stocks.

A decade later, at the start of 2020, her initial $100,000 would have swelled to nearly $280,000 – a solid return of about 10 per cent a year, driven nearly entirely by massive gains by technology stocks.

But since the pandemic began in early 2020? It’s been a wild ride. Our imaginary investor’s portfolio would have swelled even higher in the early days of lockdowns, as tech stocks rocketed to the moon. Then, as inflation ripped and interest rates started to surge higher, those gains would have evaporated. Over the past 12 months, she would have lost 34 per cent of her money and be back to about where she was three years ago.

Some people might see losses of this magnitude as an opportunity to buy into these beaten-up areas at reduced prices. But before you bet on a rebound, it might be worth considering how much the world has changed.

China’s fall from grace

Back in 2019, economists worried about China’s trade battles with the United States. Still, most were optimistic about what lay ahead and many saw China overtaking the U.S. as the world’s largest economy in another decade or so.

It was easy to make that case. China’s population of 1.4 billion provided a huge internal market for its domestic companies. Moreover, Beijing had managed the economy adroitly for more than a generation. It had created a system that funnelled capital into large-scale infrastructure projects, property development and export-oriented industries. Its emphasis on education and technology had spawned a generation of homegrown tech giants, such as Alibaba and Tencent.

High rise apartments under construction in Zhengzhou, Henan province, China, in January 2019. Years of frantic building have helped drive the country’s total debt to towering levels and resulted in a glut of apartments.THOMAS PETER/Reuters

The International Monetary Fund was optimistic about what the future held. In 2019, it noted that China had accounted for more than a quarter of the world’s economic growth from 2013 to 2018, twice the share contributed by the U.S. The IMF saw the Asian giant maintaining its jackrabbit pace of expansion until at least 2024, with annual economic growth significantly above 5 per cent.

Unfortunately, reality hasn’t come close to bearing out those rosy predictions. Ruchir Sharma, chair of wealth manager Rockefeller International, estimates that China’s growth rate will fall below 3 per cent this year. “Consensus forecasts have fallen short of recognizing the pace of China’s slowdown in recent years,” he writes.

Analysts at Capital Economics predict that by 2030, China will be expanding at a ho-hum 2 per cent a year, more or less the same as the U.S. Rather than becoming the world’s largest economy by 2030, as many economists predicted, the country now appears unlikely to catch up to the U.S. until 2060, if ever, according to Mr. Sharma.

What went wrong? One big problem is China’s faltering property sector. Years of frantic building have helped drive the country’s total debt to towering levels and resulted in a glut of apartments. “Real estate constitutes such a large share of China’s economy that a sustained slowdown could cause years-long stagnation akin to Japan’s lost decades since 1990,” writes Harvard economist Kenneth Rogoff.

China faces other challenges, too. Its labour force is aging and shrinking. Its zero-COVID policy continues to intermittently lock down many of its cities. Meanwhile, last year’s out-of-the-blue crackdown on the technology sector by President Xi Jinping is hobbling many of the country’s most dynamic firms.

On top of all that, Mr. Xi has effectively declared himself leader for life, a sign of the country’s increasingly autocratic tilt. Relations between Beijing and Washington have deteriorated into a frosty chill that resembles a new Cold War.

Small wonder that analysts at JP Morgan Chase earlier this year declared a broad swath of China’s tech sector to be “uninvestible.” The Nasdaq Golden Dragon China Index, which tracks Chinese stocks listed on U.S. stock exchanges, is now back to 2007 levels. Rather than being an unstoppable giant, the Chinese economy now looks increasingly fragile.

Rising interest rates

If China’s fall from grace has been a shock, so has an even more fundamental shift. For the first time in four decades, inflation has soared around the globe. So have interest rates. This is a brutal surprise for a world that for more than a generation saw inflation and interest rates both tick relentlessly lower.

To be sure, it was never exactly clear why interest rates fell so steadily from the early 1980s onward. People such as former U.S. Treasury Secretary Lawrence Summers argued that falling rates were the result of secular stagnation – a long-term fall in the rate of economic growth caused by slowing population growth, higher inequality and a reduced pace of innovation. Others, such as former Federal Reserve chair Ben Bernanke, attributed the decline in borrowing costs to a global savings glut caused by rising wealth around the world.

But whatever the precise cause of ultralow interest rates, the trend was clear. After the global financial crisis of 2008-09, households and businesses operated on the assumption that money was more or less free. For the next decade, interest rates remained stuck at levels that were the lowest in 5,000 years, according to Bank of England chief economist Andy Haldane. In the early stages of the pandemic, central banks reinforced this trend, slashing their key rates to zero in North America and to sub-zero levels in Europe.

The abrupt reversal of those ultralow rate policies over the past year is having a shattering effect. Soaring mortgage rates are eating away at home prices around the world. Higher borrowing costs are discouraging companies from investing in new factories and offices. Simultaneously, rising interest rates are punishing bond prices (which move in the opposite direction to interest rates) and stocks (because higher bond yields are making fixed income an attractive alternative for the first time in years).

This week’s report that U.S. inflation ticked down to 7.7 per cent in October has fanned hopes that the inflationary peak may have passed. However, it’s too soon to hope for central banks to actually start cutting interest rates. They are likely to remain vigilant until inflation has fallen back somewhere close to the 2-per-cent target policy makers have set. That is still a long way away.

“We have entered a regime of higher macro and market volatility,” economists at giant investment firm BlackRock Inc. write. They argue that “central banks’ singular focus on inflation” means policy makers will likely raise rates too high in the near term and “cause economic damage that markets are underappreciating.”

Traders work on the floor at the New York Stock Exchange in New York. This year the NYSE FANG+ Index of leading tech firms has dropped 40 per cent.Seth Wenig/The Associated Press

Tech’s big slide

One of the biggest casualties of this year has been the sector that was once regarded as the ultimate fortress – big U.S. tech companies.

Giants such as Alphabet Inc., Amazon.com Inc., Apple Inc., Microsoft Corp., Netflix Inc. and Meta Platforms Inc. (the former Facebook) used to grow revenue at double-digit rates while simultaneously spewing out profits. That was especially true in the early days of the pandemic, when a mass turn to working from home ignited a boom in remote shopping, video streaming and computer purchases.

This year has told a different story. The tech-focused Nasdaq Composite Index is down 29 per cent (as of midday Friday). The NYSE FANG+ Index of leading tech firms has dropped 40 per cent. Among individual stocks, Alphabet has lost 34 per cent, Amazon 42 per cent and Meta 67 per cent.

Rising interest rates may be partially to blame for the sudden aversion to tech. Investors can now reap decent rewards from bonds and dividend stocks, making the chancier future payoffs from tech investing less attractive.

Other factors may also be at play. Take growth rates, for instance. Investors appear increasingly skeptical that big tech companies can maintain their pace of expansion for years to come.

Some of these businesses, such as Meta, have so thoroughly dominated their original sectors that they now have to look to entirely new and risky frontiers – such as the immersive virtual reality known as the metaverse – for expansion possibilities.

In other cases, tech giants have grown so big they are now competing against other tech giants for growth opportunities. Consider, for instance, how Amazon, Microsoft and Alphabet are battling one another for a slice of the cloud computing market. Or how Amazon, Apple and Netflix are duking it out for streaming audiences.

Granted, these are all great companies and none are in danger of going bust. But hiring freezes at Amazon and layoffs at Meta, as well as job cuts at smaller tech companies such as Twitter Inc., Shopify Inc., Lyft Inc. and Stripe Inc., suggest tech is no longer invulnerable to economic downturns. Given that tech stocks are still significantly more expensive than the rest of the market, “the worst may not be over for U.S. big tech,” writes John Higgins, chief market economist at Capital Economics.

What comes next?

It’s tempting to bet on a revival of these trends. But a saner strategy may be to ask what advantage you typically gain from investing in big ideas such as the rise of China and U.S. tech, or the long-term fall in interest rates.

Perhaps not that much. An investor who put her money into a plain-vanilla index fund that simply tracks world stocks without making any active decisions about which sectors or companies to favour would have enjoyed average annual returns of about 8 per cent between the start of 2010 and today. That is nearly identical to someone who was smart and aggressive enough to place bets on China, lower-for-longer interest rates and tech stocks over the same period.

There is no guarantee that an indexing strategy will do as well over the years to come, but wide diversification at least guarantees your portfolio won’t be entirely devastated by a hot trend that has suddenly gone cold. At a time when long-held notions are crumbling, and it’s not clear what will replace them, holding a little bit of everything can make a lot of sense.

Minnie Arwood

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