Too much gloom, not enough evidence of doom
Despite headlines, there’s not enough evidence necessitating a decrease in portfolio exposures to equities.
Whilst things appear gloomy and may deteriorate a little further at the broad market level, that’s about the extent of it. To speculate about bottoms or bounce backs or presume the current situation will be the new normal, means loading up significant risk into portfolios.
Looking beyond the near term, we see things surprising investors and commentators on the upside.
Some equity sub-sectors and many companies continue to thrive in turbulent macro conditions. Many firms (not just commodity-related businesses) have seen profits, sales and margins expand despite the prevailing macro factors. Markets initially treat all stocks the same when things turn gloomy - until they don’t.
Many of the drivers of current pessimism are already shifting.
Factors driving this view:
1. Recessions generally last between 12-14 months; markets look forward six months, thus price this in well in advance.
Markets respond negatively when entering times like now, only to perform positively once in them. Dips do correct overexuberance in some firms by punishing the financially unhealthy, yet they also temporarily penalise the strong - for a while.
2. Bounce-backs occur without warning and generally when things look bleakest.
Evidence shows missing turnarounds at their beginning has a significant and permanent impact on portfolio returns. The triggers for them are virtually impossible to time and occur when gloom peaks. The ensuing underperformance lasts forever unless additional portfolio risk is added to try and recoup the impact further on. Almost every bounce back occurs in the opening days and weeks. In this light, even tactical allocators face an insurmountable task of reacting fast enough once one considers the processes behind the scenes in shifting managed funds.
Happily, modern history shows us that expansions easily outnumber retractions, and the size and length of the expansions are far greater.
3. Inflation’s key drivers are mostly falling.
A big inflation driver is fuel prices, and they have already fallen a third from their highs despite OPEC+ reducing output. Petrol remains high for a bit longer due to cartel price manipulation and decades long massive underinvestment in production by fuel companies. Another often touted negative is ‘logistical bottlenecks’ from COVID-19 and increased online purchasing. These have been easing for many months now. Shipping container pricing has fallen significantly with more to come as the global shipping fleet expands and facilities adapt. The question is, what will shift inflation up significantly again, for next year’s inflation to remain even as it is now? Wage pressures are not enough to replace oil as a driver.
So, what’s fuelling present market anxieties? The central banks. During the pandemic, central banks were initially too slow to respond to inflationary pressures and are now having to aggressively play ‘catch-up’ to reduce systemic pressure and bloating. Unemployment will rise as a result. This too shall pass. A lot of the central banks’ negative views are already factored into bond and equity pricing because markets look forward at least six months. Interest rate rises are creating the desired slowdown in economies.
Whilst this is punishing companies reliant on easy, cheap external capital, importantly it will not for the strong ones riding global megatrends. These do well in spite of macro settings by in large.
Same, same but different
The time to carefully examine manager style blends in equities has never been more important given the above, and not just at industry sector levels. Letting go of the outdated Value versus Growth paradigm, creates room for other styles that better target tomorrow’s winners even if recession occurs.
In times like this, some things are the same and a few things are, importantly, different. In recessions, earnings usually go down, yet markets are forecasting a 4% rise. Should earnings lift, things will flip fast.
Cash on the sidelines remains high. Once this shifts, watch the result on equities. Additionally, PUTs on individual stocks are at record highs. Both are strong precursors.
An easier way
Not all stocks follow the ‘market’. Insync seeks stocks that do well irrespective of the macro-economic situation at hand. It’s known that stock prices follow earnings per share (EPS) over time. We select the sustainably growing ones via our proprietary company evaluation filters, and must also enjoy long-run global megatrends (tailwinds). Only a handful of companies globally meet both criteria.
It is better to be in quality growth assets now than unnecessarily load up portfolios with additional timing risk by trying to gauge when the turn will occur, as up or down, these stocks go well.
Events often deceive investors
Commodity pricing today is not where most think it is. Even grain prices have fallen, along with fuel and most metals. The Russian invasion reminds us to beware of reacting to one-off, event-based dramas, and having experienced a rare ‘two in a row’ its distorted reality.
- Grain is a problem mostly for the least developed nations;
- Winter in Europe will pass, as will gas and fuel spikes;
- The Russian invasion will end, and;
- When something becomes scarce, risky, or too expensive, it gets replaced by substitutes or demand for it falls. Energy is a prime example, and a permanent decoupling from Russian energy and the acceleration to non-carbon fuel sources is well underway.
Fact versus fiction
Headlines and sentiment surveys rarely reflect reality; indeed, it's usually the reverse. In New Zealand for instance surveys are gloomy; yet New Zealand’s manufacturing output has risen to all-time highs, spending is up, dairy is strong, exports strong, service sectors are thriving, construction robust, tourism rebounding, employment pressures moderate, transport is going strong, government debt is ok – all despite interest rate hikes and a $2.65/L fuel price.
Property prices and construction activity are more subdued in line with all asset classes not just in NZ but globally as rate rises are producing the desired effect.
Importantly, in the US despite fuel rises and interest rate increases, disposable income has only reduced by -3.6%. This is well short of what’s needed to drive harsh recessionary times.
Finally…
It’s tempting to time asset allocation moves based on what has already occurred and the consensus headlines. Holding cash is equally a folly. Doing either is actually adding large dollops of downside risk. If employing a strategic asset allocation to your models, reacting to event-induced turmoil is not strategic.
Whilst inflation is peaking before heading down, markets are now trying to anticipate what impact higher interest rates will have on the global economy and corporate earnings. Beware of market-wide assumptions and expect a lumpy ride near term.
History proves that when investors keep focused on the growing earnings power of quality companies, they find that their stock prices follow.
John Lobb is portfolio manager at Insync Funds Management.
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