From March 2009 to the beginning of 2022, we saw a highly unprecedented bull run in the stock market. This has been driven by the central bank’s quantitative easing (QE), low-interest rates, and strong corporate earnings.
Even the COVID-19 market crash, and its 30% decline from February to March 2020, couldn’t stop this bull run. The market quickly recovered and hit new all-time highs just a few months later.
However, past performance is no guarantee of future results. In this case, the opposite may be true, as years of unsustainable QE, stretched valuations, and high debt levels will eventually take their toll.
Low economic growth ahead
A Schwab report notes that US equity valuations are still rich, as markets have priced in robust earnings expectations. Defying those expectations, economists expect 2.3% annual GDP growth over the next ten years, compared to a historical average of 3.1% per year.
Today’s high stock prices mean lower returns without a proportionate increase in future earnings. This is one of the reasons that an article by The Economist suggests that Gen Z can expect “dismal returns” on their investments.
While previous generations enjoyed meaningful wealth-building through investing in stocks, next-generation investors will have to contend with mediocre growth and asset prices that are already elevated.
High inflation and rising rates
While low economic growth is a headwind for stocks, inflation may be an even bigger problem. Following the ease of geopolitical and COVID-related pressures, inflation has reduced from its peak of 9.1%, but it is still highly elevated.
This comes as no surprise to economists, who predicted the inflationary consequences of quantitative easing to a T. Further, former central banker Charles Goodhart predicts that inflation will stay high as we enter an era of worker shortages.
Today’s inflation is well above the Federal Reserve’s target of 2%, and The Fed has made it clear that reducing inflation will be a higher priority than supporting asset prices. As a result, rates are rising faster than previously expected.
In addition, The Fed has begun tapering its asset purchases, and other central banks are following suit. This reduction in quantitative easing will take away one of the keys supports for the market and is likely to cause a recession, according to JPMorgan’s CEO.
Global risks
While the 2010s saw rising international and political divisions, to be sure, the first decade of the 21st century was comparatively far more volatile, considering 9/11 and the 2008 financial crash. In that context, the 2010s were a period of stability and prosperity.
But 2020 quickly broke that trend, and we are now facing a new era of geopolitical risk. This includes the potential for large-scale conflict between Russia and NATO, technology decoupling between the US and China, Gulf tensions, and more.
A rise in geopolitical risk has historically been bad for stocks, leading to higher uncertainty and risk aversion levels. Worse for markets than one-off events like COVID-19, a prolonged period of geopolitical risk could lead to a “new normal” of lower returns.
Declining productivity growth
One of the key drivers of corporate earnings is productivity growth. Channels like technology and enterprise allow businesses to do more with less, leading to higher profits.
However, global productivity growth has been declining due to automation, secular stagnation, and deleveraging. A more recent Oxford study also finds declining labor and capital input.
US worker productivity fell the fastest in nearly 75 years in the first quarter of this year. While declining productivity has had little effect on share prices, it is a long-term risk that could lead to lower profits and stock prices.
Too much debt will hurt returns
Tying in with declining productivity, surprisingly, is the high level of debt in both the public and private sectors.
Since the Kennedy administration, a “credit inflation” policy has been used to stimulate economic growth. This has fueled declining productivity by manipulating incentives and led to high levels of debt, which may reduce returns.
As Ray Dalio notes, rising debt levels are worrying on multiple fronts. Following “the creation of enormous amounts of debt,” governments print money to pay off the debt, which leads to currency devaluation. This can cause extreme political unrest, with “irreconcilable differences” between parties that “substantially hurt the world economy.”
Investors should be aware that the long bull run we have seen over the past 13 years is unlikely to repeat. While there are always exceptions, the current market environment is characterized by low growth, high inflation, rising rates, declining productivity, growing debt, and increasing geopolitical risk.
Fortunately, the stock market is not the only game in town. There are a variety of other asset classes that can provide diversification and potential upside in this environment. Private equity, venture capital, and hedge funds consistently outperform the public markets and offer protection from some risks inherent in stocks.
A stronger private market
Institutional and high-net-worth investors have long known the advantages of investing in the private markets. These include higher potential returns, lower correlation to public markets, and reduced volatility.
That’s why UHNWIs invest 50% of their portfolio into alternatives, while endowments invest 59%—a substantial majority. In comparison, the “mass affluent” hardly invest in alternatives, with just 6% of investable assets allocated to the class.
The reason for this is simple: private markets offer superior risk-adjusted returns. On average, private equity funds generate a 19% net IRR, while the S&P 500 is projected to return an average of just 6% annualized over the next decade. With over a three-fold difference, it’s no wonder that institutions are turning to private markets.
Of course, not all private market investments are created equal. There’s a far wider dispersion of returns in private markets, which is why manager selection is essential. While top-quartile PE funds return around 30% net, many bottom-quartile funds lose money.
Further, accessing these opportunities is often difficult for individual investors. The best private market deals are typically only available to large, well-connected institutions that can commit large sums of capital. These so-called access-constrained funds tend to achieve superior returns, but individuals had little hope of getting in on the action until now.
Investing in private markets
Gridline is a digital wealth platform that provides access to a curated selection of top-performing private market funds. With minimum investments as low as $100,000, Gridline enables individual investors and their advisors to build diversified portfolios of private market assets.
Gridline’s mission is to open up access to these top-quartile investments, which have historically been available only to sophisticated family offices and endowments. By doing so, individuals can invest transparently, efficiently, and at a lower-cost. To get started with Gridline, click here.