On August 21, 2017, a total solar eclipse swept across America. This rare celestial event involved no uncertainty, so everyone was prepared for it. In ancient times, though, civilizations that could not understand the true nature of eclipses reacted in wildly different ways. Some thought such an occurrence required immediate action, like throwing rocks or shooting arrows skyward, to ward off angry gods or spirits devouring the sun. In other places, superstitious peoples saw the event as an omen to make amends or change course. Today, of course, it’s just viewed as a couple of minutes of cosmic coolness.
Unlike the laws of physics driving our solar system, our financial markets can surprise investors with moments of darkness, just as the Lehman bankruptcy did in the Great Financial Crisis (GFC). Fortunately, after enduring that cold moment of financial panic, we are again enjoying warm, sunny days of steady economic growth around much of the globe.
That perception could change quickly again. While the short-term future of financial markets is unknowable, four major secular trends are on a predictable course to increasingly weigh on markets over the longer term.
These trends were beneficial in their infancy, but are becoming dangerous in old age:
- Demographics: Aging populations in Japan, Europe, China, and the United States foreshadow a somewhat synchronized wave of retiring masses. Previously a positive force supporting the global economy, this demographic bulge of retiring workers will spend less as they draw upon their limited savings. Furthermore, with lower fertility rates in these regions, fewer active workers will be supporting retirees in the future. For example, in Japan, whose working-age demographic peaked in 1990, only one out of two people will be in the working-age group (age 15-64) by 2050.
- Fiscal Policy: To aid recoveries following the GFC, major governments adopted extraordinarily stimulative fiscal policies. When household and corporate debt is added to government debt outstanding, the picture of fiscal burdens worsens, particularly for China via its state-owned businesses. As a percentage of GDP since 2008, China’s non-financial debt has ballooned from 150% to 250%, now matching that of the U.S. With less capacity to tap credit for more fiscal stimulus, most countries like China will need to find other ways to spur economic growth. For the U.S., efforts to improve regulations and tax policies can help, but strong productivity growth is now a key missing ingredient.
- Monetary Policy: Since the GFC, the central banks of most developed markets have lowered short-term rates to zero—or even negative levels—to encourage consumers to pull forward tomorrow’s consumption. Central banks have also purchased an unprecedented amount of government bonds and other securities to force investors into riskier assets in search of yield. The Federal Reserve is now raising rates to thwart any inflation risk, while other central banks watch for possible negative side effects in this still-fragile recovery.
- Market Valuations:With these heavy-handed monetary and fiscal policies since the last financial eclipse, U.S. equity valuations are back at cyclical highs and long-term bond yields are near historic lows. Although a stock and bond portfolio can conceivably meet mid-single digit return expectations over the long term, little margin of error exists in these sanguine outlooks for scenarios of unexpectedly high inflation or economic stagnation.
With these trends looming overhead, are investors prepared for scenarios where stocks are down 20% or more? Recovery may be much longer, especially if bond yields are also rising. The key to investor success is to be able to stay with a strategic plan, however flexible, including steps for rebalancing and sufficient liquidity. Easier said than done. Meeting cash flow obligations to beneficiaries in periods of extreme market stress can be at odds with maintaining a balanced but sustainable investment portfolio.
- Apply a more skeptical view of assets at risk. More diversification within equity assets will not matter when such assets become more highly correlated in periods of global market stress. Also, the ability to secure external funding in the next recession will likely be at risk, like tapping a mobile taxpayer or cash-strapped alumni network. Reallocating equity assets to more reliable income-generating assets not dependent on selling beforehand may be a prudent precaution.
- Diversify with alternative strategies less dependent on stable economic growth or interest rates to improve odds of meeting both return objectives and rebalancing needs, even as equities and interest rates materially change. Liquid alternative strategies coupled with more illiquid hedge funds also pursuing less correlated strategies can fulfill that dual role sought by fiduciaries.
- Among liquid alternatives, consider emphasizing one to complement a traditional portfolio of stocks and bonds: trend-following strategies that can be long or short. These momentum-based solutions are designed to deliver positive returns in times of rapidly shifting markets, especially bear markets.
For you real eclipse chasers, the next total solar eclipse in the U.S. will happen on April 8, 2024, spanning from Texas to Maine. If you want to witness this once-disturbing phenomenon, plan ahead with hotel reservations and be ready to accept exorbitant rates. Pack an extra sweater to wear during that dark, cold moment, however brief. Preparing for the next financial eclipse suggests similar steps, but current trends make it prudent to pack appropriately for a longer stay. Just in case.