Investing in risk assets over the last six months has been a miserable affair for everyone involved – particularly in some corners of the market where we have seen an utter collapse in share prices. We wonder, however, why this should be such a surprise for so many investors.
The evidence would suggest that many investors have become conditioned by the environment that had prevailed for over a decade, with a smooth road to higher prices for equities and most financial assets. The world’s key central banks have had a specific goal of lower yields on financial assets since the great experiment of quantitative easing commenced. We have been in an era that has been less about investing capital and more about deploying capital in the beneficiaries of the great inflation in financial assets.
This era even had its own language: SPAC, FAANG, meme, NFT, crypto, FOMO and so on. We live in a world where artificial intelligence is developing rapidly and can join the dots within larger data sets much better than humans can, and we will no doubt underestimate the degree of future advances in this area.
All investors are now faced with a new challenge. Policymakers no longer have our back and inflation rather than the price of risk assets is now their number one priority. The road ahead is not going to be so easy.
Three steps for the road ahead
It may be easy to become gloomy after the drawdown of the last few months. But we believe there are plenty of reasons to be optimistic about the prospects for compounding your future capital from today’s levels, if you consider the following three steps.
1. Recognise we have shifted to a different road type
We are constantly being asked to differentiate between volatility that is just short term in nature and a signal of change. This is our suggested approach: always be open-minded to new information that could undermine a thesis. The thesis is that we are seeing a regime change.
Inflationary trends are now greater than they were in the past given the scale of monetary creation over the last decade. In the shorter term there will likely be a period of easing pressures as the pending rate-induced recession commences and supply chain pressures ease. However, on balance, structural energy undersupply, labour market constraints and military expenditures will all contribute to sticky inflation at rates likely to be above the 2 to 3% ideal for central banks. Risk-free rates will therefore remain at higher levels.
Secondly, geopolitics will likely remain problematic as the battle for technology hegemony between China and the US and the struggle for military supremacy in Ukraine are likely to be prolonged. The free flow of capital across borders should no longer be taken for granted, the cost of borrowing in the world’s reserve currency will likely stay high and we need to be prepared for an increasing shift from actors, such as China, moving away from the US dollar as the currency of external trade in the years ahead.
In short, we believe that growth in the broader economy will be less certain and more cyclical, and as a result the cost of capital will not return to the low levels we saw in 2020 to 2021.
2. Realise this new road may be best travelled with different vehicles
When there is a regime change, there is a high probability there will be new leaders. As a reminder, the leaders over the last cycle were information technology, consumer discretionary and energy; assuming they will automatically return as market leaders is a brave call. Our personal intuition is that new leadership is likely to emerge this time given the scale of surplus of capital that has just been allocated to the winners.
3. Improve your probabilities by sticking to a few enduring principles
Invest in price makers versus price takers
It is not just the price of assets that has had favourable tailwinds over the last decade, but also profitability. Profit share as a percentage of GDP has been at record levels in most economies, and this has conditioned investor behaviour, with recency bias leading many to assume this will remain the norm. In the decade prior to 2021, about half of the improvement in profit margins for US manufacturers was down to lower interest costs and taxes. While lengthening of debt duration may dilute the impact of rising rates, there is now a headwind for interest costs, and taxes are similarly heading upwards in many economies.
Gross margins are also being challenged by rising labour inflation, a shift to more local and higher cost supply chains, rising raw material input prices and – particularly for those sectors previously benefiting from Covid-related revenue boosts – negative operating leverage as sales decline. On average, times are getting tougher for businesses, and franchise strength is being tested more fully. Where products and business models are unique, dominant or gaining share, the scope for passing on costs to customers and sustaining volume growth is greater.
Ensure capital funding is sustainable
The cost of debt is going up, and as is always the case, its availability could become more irregular. The change in dollar-denominated debt is much greater than in other currencies and given its reserve currency status, this raises the global cost of capital. Self-funding growth (high free cashflow) and balance sheets with appropriate and long-duration debt, in our view, will be better placed to keep investing through the pending down cycle. Cash-burning, profitless business models likely won’t pass the test.
Focus on justifiable valuations
We have learned through bitter experience that the penalty for investing at inflated prices and a lack of future cashflows is onerous. Compounding of capital from levels that can be politely described as “frothy” is difficult. When the music stops, falls of 80-90% are common for the frothy crowd, and more often than not they stay down as profitability remains a dream rather than reality.
Where we find future quality winners
If you are a more seasoned investor, none of the above should be particularly surprising. The next key question will likely be: where are you investing your capital within global equities? Companies on a unique journey of improvement that can attain and sustain high returns on invested capital over the next five years or more have always been the best starting point, in our view.
Will Low is a portfolio manager on the Nikko Asset Management Global Equity team