28th November 2022 – Going into 2022, debate was raging over whether inflation in the system was transitory or more permanent. Our concern at the time was that financial assets weren’t pricing any risk that inflation could be back in the system.
As we now know, the transitory viewpoint faded over the course of 2022. Central Banks raised rates aggressively, causing sovereign and investment grade bond markets to have their worst year ever. Deflation-era winners such as technology and secular growth equities came under heavy selling pressure while relative leadership in equity markets passed to sectors in the defensive and value spaces. Energy linked commodities and equities soared.
Moving into 2023, debate has now shifted to the inevitable fall in inflation from elevated levels. In the eyes of many commentators, this would signal a peak in US interest rates, allowing the Fed to ‘pivot’ away from tightening and firing the starting gun for an aggressive risk-on rally.
While inflation is likely to moderate from the current peak levels, this is different to achieving target inflation. Deflationary versus inflationary pressures in the financial system are a function of changes in input costs, labour, and demand.
Deteriorating Chinese demographics, as well as rising geopolitical tensions, means less ability to outsource to cheap labour sources. Developed markets are witnessing labour shortages because of generational shifts in working patterns, albeit it is not yet clear how permanent those changes will be.
Meanwhile, the pandemic and the invasion of Ukraine ensure that fiscal spending will focus on ensuring security in its widest sense – covering energy supply, defence spending and supply chain resilience. This is likely to drive a capex cycle, made more urgent by energy and raw materials supply failing to keep up with demand (partly due to the desire to reduce carbon intensity in response to climate change). This supply-demand imbalance can only intensify, as China progressively unlocks from its Covid control orthodoxy.
As a result, while we believe the market is right to expect a pause in the rate hiking cycle, we’re wary of expecting a fast pivot because we believe there are more structural drivers of inflation in the system.
For three decades, investors in developed markets have enjoyed tailwinds on the journey from interest rates above 15% to near zero by early 2022. As interest rates neared zero, the valuation-anchoring effect of a positive risk-free rate disappeared for long duration assets justifying elevated multiples for growth equities, and historically low yields in the fixed income world (30% of global debt had a negative yield in 2019). Performance in both assets was exceptionally strong.
Central banks are now taking liquidity out of the system in their efforts to combat inflation. The era of ‘free’ money is over.
What does all this mean to us as investors? Near-term, the risk of recession is present. Multiples have fallen this year as discount rates have risen, but we’re yet to see real weakness in analysts’ earnings estimates. The early part of 2023 is likely to be dominated by assessing the degree to which they will be revised down versus what is already in the price. Cyclical sectors have been already marked down severely while defensive sectors have held up much better despite rising input cost pressures.
On a longer-term basis, we expect a high ongoing cost environment. In that context, pricing power will be crucial and the ability of individual management teams to navigate the complexities of a more deglobalized operating environment will be a real differentiator. In a higher rate environment, absolute levels of debt at the corporate level become much more important in assessing risks, while cash on balance sheet begins to be an interest-bearing asset, providing earnings support.
Above all, the risk-free rate is now imposing a cost of capital. Companies will need to be able to evidence cash returns – not long-term promises.
Valuation is back as a risk factor, having been largely abandoned as interest rates hit the zero-bound. With the market moves we have witnessed in 2022, our teams across asset classes are seeing opportunities being offered. The Fixed Income team is starting to see value returning to their market, but with higher rates of interest, careful analysis of credit risk is vital. Our Asia team has seen the China market de-rate significantly from elevated valuations and are now seeing selective opportunities with the overall market trading back at 1998 valuations. UK and Europe remain unloved by global investors but have significant exposure to industries set to benefit from changing market dynamics at attractive valuations (which under-pinned relative performance during 2022 despite very difficult macro and political backdrops).
The over-arching message from all the teams, however, is that relying on market-driven returns (beta), or factors, is likely to be less effective than in the previous decade. Instead, stringent analysis of financial and non-financial metrics, engaging with management to understand corporate strategy and valuation discipline, will be the key driver of returns. This is a rich environment for fundamentally driven active investors.