Investment View - July/August 2022
For those of us who remember the 1970s and 1980s, the last few months have had a much too familiar ring to it - inflation rising, interest rates rising, energy costs spiralling ever higher, industrial unrest, wage demands and strikes in the UK, recession looming around the globe and Russia challenging world peace. It is a very troubled world, with almost all asset classes under stress as the economic conditions are assessed and appraised. These are uncomfortable times for all investors.
There are many experts willing to make predictions and offer direction. That noise is very confusing, unsettling and often very wrong. The only thing that is clear is that no one can predict the path out of the turmoil. Although some use hindsight, it is a luxury not afforded to many, and not to us.
It is hard to believe that in early December, Christine Lagarde, the president of the European Central Bank said it was unlikely eurozone interest rates would increase next year, calling the current rise in inflation a passing “hump”, but adding that the European Central Bank would act swiftly if needed to staunch the increase in prices. Despite eurozone inflation hitting a record high of 4.9 per cent in November, well above the ECB’s target of 2 per cent, Christine Lagarde still said it was likely to have peaked and would decline next year. Inflation in Europe was reported at 8.1% in May.
Jay Powell, the US federal reserve chair and Janet Yellen, effectively the US chancellor, spent much of 2021 saying inflation was “transitory” and likely to abate once Covid specific factors such as supply chain problems and outsized demand for goods over services returned to normal. Both have now changed their view with Powell now saying recession for the US is not inevitable but possible. That comment was seen as a surprise and European markets declined. Surprise - where have they been? Any news just now tends to create declines.
In late spring last year, Andrew Bailey, the Governor of the Bank of England sought to calm financial market fears over rising inflation. The Governor said he thought upward price pressures would prove temporary. He said that it was important not to over-react to a rise in inflation that was likely to prove temporary during Britain's economic recovery from the COVID-19 crisis. A few months later, Bailey said the reasons the central bank thought inflation would not prove to be persistent were "well-founded”. “It is important not to over-react to temporarily strong growth and inflation, to ensure that the recovery is not undermined by a premature tightening in monetary conditions," he said in an annual Mansion House speech to leaders of the financial services industry. The consensus is the Bank have been much too slow in recognising action was needed. The brakes are on now, with the smell of burning rubber in the air. The Bank of England has now warned that Britain risks a double-whammy of inflation above 10% later this year and possibly a recession.
Other central banks are also scrambling to cope with a surge in inflation, which they initially described as “transitory” when it began with the post-pandemic reopening of the global economy, before Russia’s invasion of Ukraine pushed energy prices even higher.
The US stock market is suffering its worst start to any year since the Great Depression with shares on the S&P 500 down 22.3pc on a total return basis. Bonds are also suffering and declining.
It is extremely rare for the two main asset classes to fall in tandem like this. Since the 1990s, shares and bonds have been “negatively correlated”, which means that when one goes up the other goes down and vice versa. Indeed, there have only been three years in the past century when bonds and equities both declined simultaneously. The first was in 1931, when a currency crisis resulted in the UK being forced to abandon the gold standard; the second was in 1941, when the US entered the Second World War. These were seismic events. The third time was in 1969. That was when the US Federal Reserve, after letting prices spiral out of control, finally switched into inflation-fighting mode. Interest rates went through the roof. It worked and price rises started to slow but not before the economy had been pushed into a steep recession. The lack of growth combined with sky-high rates resulted in a period of negative returns for both equities and bonds.
It is not surprising with the continual doom-and-gloom headlines this year that markets have swung collectively towards pessimism. Inflation is at a 40-year high, and economic growth looks to be slowing. The World Bank says that the global economy may in fact suffer 1970s-style stagflation. Jamie Dimon, CEO of the largest US bank JP Morgan, warns of an “economic hurricane,” while Goldman Sachs’ CEO is bracing for “unprecedented…shocks to the system.”
What can we do? Well, if you’re Warren Buffett and Charlie Munger of Berkshire Hathaway, you’re buying a net $41 billion in equities in Q1 of this year, despite myriad challenges we might face. At the annual “Woodstock for Capitalists,” there was a back-to-basics reminder from The Sage of Omaha of how to tune out the noise. “To give up what you’re doing well because of guesses about what’s going to happen in some macro way just doesn’t make any sense to us.” Many fund managers share that sentiment and are following that road, which is an uncomfortable journey just now with many struggling to stay the course.
Most wars, despite the tragic and devastating human toll, don’t have much of an impact on stock markets: In the period since 1941, including Pearl Harbour, the Vietnam War, the first Gulf War and so on, the market went up on average 7.2% in the following six months and 12.7% in 12 months. Moreover, history has shown that higher oil prices eventually decline. It’s a self-correcting solution in and of itself. Realistically, the core inflation issue is still Covid-19 normalisation, which is bound to happen in fits and starts, and over time, until China finally re-joins the world economy. China is once again being viewed as offering significant opportunities as covid restrictions ease. We are wary of that conclusion but understand the sentiment.
As long-term investors working with proven fund managers, we would not attempt to predict what global GDP will look like in 2022 or 2052 or whether inflation is here today and gone tomorrow. Time and again, the best line of defence has been to dig in and support funds that seek businesses with attractive underlying economics that have a sustainable and predictable stream of earnings. Then, ascribe to it a valuation that is both realistic and sensible. To quote Thomas Edison: “Opportunity is missed by most people because it is dressed in overalls and looks like work.”
It is not the case that changes will not be taking place within portfolios. However, managers are already making changes within their funds to reflect and benefit from the moves in the global economic landscape. Valuations have reduced providing opportunities. The bigger changes are likely to be the greater inclusion of more alternative asset classes. This includes increasing exposure to infrastructure, albeit it carries a risk of government interference, resources, including energy and agriculture and perhaps property. We are investigating a property fund that combines direct property with property equity holdings that navigated the suspension of property funds during the pandemic very satisfactorily with only a very short period of closure.
This does not mean bonds are dead. Bond managers are seeing opportunities appearing and believe value now exists. The commentators continue to write bond obituaries. We will see who is right. Recovery will take time.
The best investors are patient, look through near-term weakness and keep an eye on the long-term prize. If you’ve done your homework on valuation and long-term earnings predictability; you’ve separated fact from speculation in a systematic and analytical way, the rewards will come. Difficult markets are not to be feared. As uncomfortable as it might feel in the moment, and as dire as the outlook might seem, you will always be better off with optimistic resolve and a clear investment roadmap.
Indeed, the best investment returns are conceived in down markets, only to be realized during more buoyant times.
The above article is intended to be a topical commentary and should not be construed as financial advice. Past performance is not an indicator of future returns. Any news and/or views expressed within this document are intended as general information only and should not be viewed as a form of personal recommendation.