The trajectory for inflation and Fed policy, the odds of a “hard, soft or no landing” for the U.S. economy and the implications of the Fitch Ratings downgrade of U.S. debt are among the considerations influencing market sentiment. Although near-term developments are of undeniable importance to the direction of markets in 2023, most investors have a time horizon measured in years rather than weeks or months. Investors should focus on the long-term implications of recent developments, avoiding the temptation to overreact to short-term news.
Answers to the following five questions will provide important insight for long-term investors:
1. Will inflation return to the Fed’s 2% target and sustainably stay at that level?Although inflation is moving toward the Fed’s target, 2% may become the floor for inflation rather than the ceiling. Deglobalization, fiscal deficits, climate change and inflationary demographics are among the factors creating a more volatile backdrop for inflation. Although central banks spent much of the past decade trying to push inflation up to the 2% target, the next decade may be dominated by central banks worrying about inflation breaking above target levels.
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Consequently, the lows and highs in bond yields are likely to trend higher over time. With inflation rather than deflation a more persistent challenge, bonds will be a less reliable hedge against falling equity prices.
Long-term investors concerned about inflation should consider adding inflation-resistant investments such as real estate investment trusts (REITs), real assets, infrastructure and Treasury inflation-protected securities (TIPS).
2. What are the investment implications of the climate transition?The climate transition will present opportunities and threats for investors. Weak conventional oil capital expenditures will create volatility in fossil fuel prices, with spikes in prices a consequence of periodic supply shortages. Refinery capacity will be an issue, leading to additional supply squeezes.
Although alternative energy capital expenditures will be strong, alternative energy sources are unlikely to ramp up fast enough to meet current climate targets. Duplicative supply may be needed for longer than expected in order to complete the energy transition.
Investors should consider investments in both traditional and alternative energy, recognizing the uncomfortable likelihood of a protracted and costly climate transition. “Enablers” that support the climate transition, such as natural resources and companies that facilitate production efficiency, may also be compelling investments.
3. What is the implication of the Fitch downgrade for bond markets?Although the Fitch credit downgrade coincided with a wave of Treasury selling, prior downgrades of major-country debt have not had a lasting effect on yields. Recent jumps in yields have more to do with rising Treasury issuance, accumulated government debt and deficit spending.
In contrast to the corporate and household sectors, the U.S. government did not extend debt maturities while interest rates were low. The need to refinance government debt at higher rates will create strains for the U.S. budget and makes it likely that rates will not return to post-global financial crisis (GFC) lows.
With bonds still offering tepid yields relative to inflation, income-focused investors may need to supplement traditional bond holdings in the search for yield.
4. What is the outlook outside the U.S.?European and Chinese stocks remain at relatively inexpensive valuations after more than a decade of mostly lagging performance relative to U.S. equities. Europe faces near-term challenges as the export-driven economic bloc faces headwinds from weak demand from China and continuing adaptation resulting from the loss of cheap gas imports from Russia.
Longer-term, however, the end of fiscal restraint and adaptation to the changed geopolitical environment will create interesting investment opportunities. Rising defense spending and the need for industrial efficiency and energy security in a world of higher prices and less reliable sources of natural gas will create investment opportunities for European industrial companies. European banks may also become more appealing in an environment in which negative interest rates are no longer a constraint.
Despite near-term challenges, there are also compelling investment opportunities in China. Market leadership is likely to continue to change in China, with the social media leaders of the post-GFC period giving way to leaders more in line with state interests, such as semiconductors, artificial intelligence (AI), health care and electric vehicle infrastructure.
5. Will AI live up to recent hype?Excitement over AI turbocharged returns for stocks thought to be at the leading edge of AI development and adoption. AI is potentially transformative technology, but investors should be realistic about how quickly its growth potential will be realized. There typically is a long lag between technological progress and the commercialization of new, innovative ideas. Even if AI is as transformative as many experts suggest, it may be several years before it contributes to meaningful growth in productivity.
There are many ways to invest in AI. Enablers, including major cloud providers and semiconductor makers, that will drive the calculations behind artificial intelligence will benefit from AI adoption. Cybersecurity is going to become of central importance as AI becomes pervasive.
Industry adoption will also create opportunities for companies that effectively deploy AI. Wealth managers, insurance underwriters and power grid managers are among the companies exploring greater use of AI to enhance productivity.
As is the case with most disruptive technologies, today’s leaders may not be tomorrow’s winners. There are some well-entrenched businesses that will be net beneficiaries as they incorporate AI. However, others will be faced with an entirely new competitive environment.
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