Markets are headed for a decade of austerity as the ‘game of macroeconomic musical chairs’

Markets may be headed for a decade of austerity, Research Affiliates wrote in a note.
October’s equity correction signaled that the economy was normalizing under high interest rates.
Tighter monetary policy will pull down asset prices, while inflation is likely to stay elevated.

Economic resilience has helped investors weather this year’s uncertainties better than most had hoped. But now, a cycle of normalization places markets at an inflection point, as a decade of austerity starts to take over, Research Affiliates’ Chief Investment Officer Jim Masturzo wrote.

According to him, the corrective slump that hit markets in October was a potential sign that the economy is transitioning away from post-pandemic distortions, such as high savings that have largely been consumed.

“We see the current selloff as a potential inflection point in the transition from a decade of abundance to one of austerity,” he said.

That will ignite pain for equity and long-term fixed income markets, as prices respond to an increasing cohort of risk-off investors.

It marks a major shift in the investing environment. Before the Federal Reserve sharply increased rates to a 5.25%-5.50% over the last year and a half, markets enjoyed an era of ultra-low interest rates that followed the 2008 financial crash. 

“While no one stopped the music for the better part of the last 15 years, this game of macroeconomic musical chairs cannot go on forever,” Masturzo said. 

Now, tighter monetary policy in a period of high deficit spending mean US Treasury yields will continue climbing.

“Higher rates are also expected to lower asset prices, unleashing a vicious cycle of lower capital gains and similar tax receipts that the government relies on for revenue. Lower government revenues, in turn, create the need for more borrowing, causing annual budget deficits and the national debt to spiral even higher,” Masturzo added.

Despite the Fed’s best efforts, he noted that investors should also prepare for elevated inflation to stick around for the long term. Commodities will be the key driver of growth, especially as demand for them grows from both fossil fuel and renewable energy sectors.

For investors looking to get ahead of these headwinds, Masturzo noted a handful of asset types: Safe havens, such as gold, real estate, commodities and some digital assets are attractive as current US debt levels will only get in the way of reducing inflation. 

Meanwhile, with real interest rates expected to remain positive, bonds will be a compelling investment. However, Masturzo suggested Treasury Inflation-Protected Securities as a more reasonable purchase.

For equity shareholders, value stocks will pay off better than growth investments, as valuations become a more important consideration. 

Investors should also keep an eye out on emerging markets, as Masturzo expects the dollar to depreciate with time. Developing economies are also better suited for the upcoming decade:

“EM policymakers raised rates earlier and got inflation under control with less fallout than in past episodes. The emerging markets enjoy access to commodities in high demand, providing a natural base of growth, and their capital markets are poised to rebound from oversold conditions due to years of under-allocation,” he wrote.