When I was growing up I remember being struck by the relationship between growth and decay in woodland. Growth is facilitated by decay, because it liberates nutrients for the more vigorous to re-use. As mature trees age, their vitality ebbs away and rot sets in. Over time, it is the collapse of ancient trees that starts the process of bringing through the more vigorous, by releasing nutrients for subsequent generations. But even more importantly, the gaps left in the canopy allow light to flood down to the less mature, helping the most vibrant enjoy a period of unusually rapid growth. Decay comes together with growth, in a balanced mix of maturity and vitality.
In corporate forests, growth and decay tends to come through in seasonal waves. But few of the sedentary and overstretched are culled when markets are going well, so overall there’s too little corporate decay during periods of growth. But there’s a period of catch up during recessions. So corporate forests fluctuate between growth and decay, and therefore they too have a sustainable mix of maturity and vigour.
That is until globalisation altered the usual seasonal pattern, and initiated a perennial period of growth. In an ever-rising market, if anything, risk comes to look benign. So, the longer the growth period, the more that company takeovers force companies to take on more risk in exchange for possibly better returns. And alongside this, a long period without recessions left the corporate sector ever more dominated by the sedentary and vulnerable. So, prior to 2008 a culture of fragility and gigantism often came to flourish within many of the fastest growing industries.
The sheer scale of the Global Financial Crisis when it came, underlined just how deeply entrenched this monoculture had become. The combination of financial over-optimisation along with corporate overstretch had become so entrenched that it endangered the viability of the entire capitalist system when tested. Injections of cash by Quantitative Easing (QE) and record low interest rates to stimulate the economy may have saved many companies from failure during the 2008 setback, but inadvertently it also smoothed the way for the culture of financial fragility and over-maturity to persist in most industries other than in banking.
Up to 2016 this government and central bank stimuli may have boosted company share prices, but this has not been matched with a regular economic recovery. The corporate forest remains dominated by the vulnerable and sedentary whilst the financial climate is benign, especially when it is combined with a rising stockmarket. And alongside this many companies are developing an unhealthy reliance on ultra-low borrowing costs.
So holding back the more vibrant companies for decades, has distorted the corporate landscape, and has driven the world economy into stagnancy. Extraordinarily low bond yields don’t just mean it is less costly for companies and governments to borrow – they also imply that the outlook for economic growth and future returns will be very modest. If nothing changes this could persist for years and decades. The world economy could easily slip in to a long period of stagnancy, in a similar fashion to that of Japan.
Most assume that our collective attitudes remain largely unchanged. But they can fluctuate far more than the majority appreciates. There has been an unsettled attitude to globalisation for a while, but until recently few appreciated that it had already passed its high-water mark. With the benefit of hindsight, we can now see that Brexit, and the election of Donald Trump, in the context of a radical change in our collective thinking.
The electorate are choosing to inject political change to break the current economic stagnancy. Those politicians who want to stick with the status quo are being ejected in place of others that advocate change. Brexit wasn’t a one-off event, but just a demonstration on how much the social trajectory had changed. The election of Donald Trump is yet another.
Indeed, now that politicians are beginning to recognise the new direction of travel, we can be more confident that the economic trajectory will change too. Inevitably this will lead to the regular economic cycle of recession and renewal to return. Corporately this involves a period of challenge, when the financially fragile and commercially overstretched will be tested. Companies will then be able to move beyond the long period of benign and plentiful liquidity into a temperate and seasonal woodland with alternating winters and summers.
This transition will demand an equally radical change in our investment strategies.
For example, over the boom, plentiful growth meant there was little need to differentiate between the winners and the losers – because there was so little corporate decay – and because the winners were so predominant. So, funds that have been constructed to match an index, referred to as “index funds” or “passive funds” generated attractive returns for years and decades.
But index funds carry a fatal flaw over the longer term. Passive funds are insensitive to stock specific risk, and therefore only generate a good return when markets are flying. With the electorates hardening their attitude against globalisation, the previous trends have now come to an end. Going forward there will a severe penalty for holding companies that are financially fragile. The positive drivers of passive strategies that have been in place for three decades have now ended. And the radical change in our social attitudes demands an equally radical shift in our investment strategies.
Going forward investment strategies will need to be a lot more selective to be successful. Funds will need to select individual holdings with a combination of promising prospects and plenty of financial resilience. Every stock in the portfolio will need to be well positioned to generate a return even at a time when market indices may not be rising.
In summary, the forthcoming changes in markets and asset allocation offers professional investors an active hand in funding those companies that have the best opportunities. Reallocating money to those companies will enhance the prospects of those that will benefit when the woodland canopy opens up. These changes will not only come through in more attractive returns for savers and investors, but also in participating in the extra growth of these companies.
With globalisation in retreat, this is the time when the investment industry is unusually well placed to have a greater opportunity to be socially useful. Anticipating and adopting to investment strategies that are well positioned for the future, won't just deliver attractive returns to clients. The success of these strategies will also be measured in the wider ranging metrics of additional employment, better domestic growth and extra tax take for governments.
Gervais Williams, Fund Manager of the CF Miton UK Multi Cap Income Fund, CF Miton UK Smaller Companies Fund, Miton Income Fund, Diverse Income Trust plc, The Investment Company plc and Miton UK MicroCap Trust plc.