08 April 2022 | Simon King
Thoughts on 2022: Ordinary People
One of the major issues that prevents financial markets from being totally perfect in pricing assets, is the inbuilt biases and views of market participants. The on-going march of quantitative and indexed strategies may have improved this situation somewhat, but the investment industry as a whole still tends to lack an understanding of and empathy with “ordinary people”.
This is particularly pertinent at the moment, when we are facing an unprecedented cost of living increase, which will inevitably have a disproportionate impact on the lower strata of all economies. Whatever your individual political hue or your views on whether a general decline in living standards is necessary in the short-term, it is very important to assess the impact of these stresses on all parts of the economy.
We have argued for some time that developed economies were due a reset, as a result of three decades of over-consumption and a lack of productivity improvements. Governments and central monetary authorities have consistently “kicked the can down the road” since 2009, and it could be claimed the scale of current challenges is the result of the problem being allowed to fester. No government has been prepared to be honest with its electorate in highlighting a short-term reset as the price of longer-term prosperity, instead promoting inflationary policies which they naively believed they could control if inflation got out of hand. The impacts of inflation, lower spending power and reduced economic growth are not well understood, as evidenced by the current hunt by investors for perfect inflation-proof assets. The truth is they simply do not exist. There are however, various areas that can mitigate some of the effects of inflation, but they require proper individual analysis rather than a broad-brush asset class approach. We are very much focussed on finding these opportunities.
Although we prefer to concentrate on developing our own thoughts and ideas when we build client portfolios, and therefore subscribe to a select group of research providers, we do pay some attention to the vast output of the wider investment industry and the financial media. At best, it is often hopelessly short-term and at worst, thoroughly confusing, but even against this low bar we find the current commentary particularly misleading. We strongly disagree with the notion that history will be a reliable predictor of the future. Words and phrases such as “traditionally”, “correlated”, “largely” and “typically” appear with alarming regularity. We maintain our long-held view that there is no playbook or Dummies Guide to the next five years. What has gone before has not been predictable. Therefore, our starting point for the next five years is unprecedented, due to the highly correlated performance of virtually all asset classes, the valuations of assets on both a relative and absolute basis, and the macroeconomic position we find ourselves in due to Covid and the Ukraine.
It is worth expanding on this macroeconomic position, which virtually all developed countries are now wrestling with. Inflation is rampant and until the global supply side adjusts to the new patterns of localisation and dual supply, there is little that can be done about it. On the demand side more of the world’s population want more of the things that developed economies have regarded as their own, and they can afford to pay for them. Unless there is a marked improvement in global productivity, which is unlikely in the short-term given the anaemic level of investment we currently witness, then the only outcome is continuing rising prices. To be clear, we do expect the rate of inflation to come down, but there is a higher inbuilt structural component that the market is choosing to ignore. Against this background the traditional policy response is simply to raise interest rates, choke off demand and prices will stop rising or even fall. Unfortunately, this has only ever been successful in solving demand induced inflation and not the more supply side variety we have discussed.
To make things worse we are still experiencing the dampening effects of Covid on global economic activity and growth, and Ukraine has introduced a geopolitical influence in addition to this, the vast majority of short-term economic news flow is negative. Central banks and governments, the two being no longer mutually exclusive, are therefore in a total quandary. Having woken up to their responsibility to protect consumers and not just markets, they have chosen a reactive “wait and see” strategy, which has already proven costly and will be even more so if they continue with it. There has been plenty of words from the Fed on decisiveness and signalling, but their “all mouth and no trousers” approach is becoming increasingly ineffective.
In terms of policy response, we are mystified as to why virtually 100% attention is being focussed on increasing interest rates. We have been criticised for being too simplistic in arguing that Quantitative Easing (QE) in its various shapes and forms, and the overload of liquidity that it has produced, is the main reason for rampant asset price rises and now painfully high levels of inflation. We acknowledge this has been exacerbated by the supply side impact of Covid and now geopolitical instability, but this has been the petrol thrown on a fire started as far back as 2009. It is clear to us that Central Banks should be looking to move to a period of sharp QE reduction alongside a measured interest rate policy. Liquidity simply needs to be taken out of the system, so that we can get to whatever the “new normal” is going to look like and then start dealing with it. Central Banks and governments appear paralysed by a fear of the unknown ie they have no idea how economies will react; they are obsessed with protecting asset prices and they dread any type of recession. They were emboldened to launch two huge rounds of QE by the financial crisis and Covid and received deserved plaudits for doing so. They need to be equally bold on the way out.
Even though we expect a continuingly challenging market backdrop for the next few months, as in all periods of change, new investment opportunities present themselves. Japan continues to intrigue us. We have found numerous high-quality companies with excellent international market positions trading on very low valuations. We remain convinced there are genuine changes occurring in the Japanese market around better corporate governance and more efficient capital management, both of which will increase returns to shareholders. We see the domestic Japanese economy as dull, rather than in terminal decline. Yet both the Japanese equity market and, more worryingly the Yen, continue to weaken. We believe this trend will reverse as the market starts to appreciate Japan’s defensive qualities in terms of a robust economy, with attributes not available in other developed economies.
We have discussed our views on de-globalisation in previous pieces and although we are not quite as jingoistic as some, we recognise it will be a feature in the short-term. As such, we are attracted to economies that have the ability to generate their own domestic growth. Obviously, the US is one such area, but the smaller one that is interesting is India, with its attractive demographic profile. It does, however, have to tread carefully with its decision to tacitly support Russia. The real conundrum remains China, where we are convinced it has the ability to generate and manage a decade long period of substantial growth. Its methods of achieving this may not be popular but if it is successful, it will have profound effects on the balance of global economic and political power. In a more divided world, there will be a genuine chance for China to establish a real alternative to US domination. Perversely the Ukraine situation presents it with a whole host of short-term opportunities, which we have no doubt it will quietly exploit to the full. We are keen to participate in this growth but remain wary of direct investments, due to poor corporate governance and transparency. Our preferred path is through funds run by local fund managers, and we continue to attempt to identify suitable candidates.
The UK market is also of some interest, due to its continuing lowly valuation. To be clear, we are attracted to the companies rather than the UK economy. The outlook for the latter remains challenging with the long-term effects of Brexit having been largely obscured by Covid eg UK trade levels on both exports and imports remain significantly below pre-Brexit levels. Coupled with a weak Government balance sheet and a lack of investment, this means the UK is very reliant on a strong pound to keep moving forward. The UK stock market is however, constructed of many international, high-quality companies that mostly trade at substantially lower ratings than their global peers. Private equity and trade buyers have exploited this with a swathe of takeovers and eventually traditional investors will take note.
We apologise if this piece sounds overly pessimistic, but we feel it is a realistic outlook. We are not gloomy on the medium- and long-term outlook, and we have an entrenched view that the human race, and most types of economies, have an innate ability to change and adapt. There will be many industries that produce very high levels of growth in whatever economic conditions they are presented with eg Healthcare, Clean Energy, and genuinely innovative Technology. As a society we simply need to acknowledge where we are actually starting from, be bold and proactive in our decision making, and be equitable and swift in addressing the inevitable problems and unintended consequences we create. Against this backdrop there will still be many opportunities for profitable and exciting investments, and it is our task to identify these for our clients. In technical terms it will be about identifying true alpha, rather than relying on market beta. Translated into plain English: we will no longer be able to rely on a rising tide carrying all ships.
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