Thrift and abstinence are rarely recognised as advantageous attributes of contemporary investment management. In the current dynamic, digital world of conspicuous consumption and instant gratification, such pragmatic peculiarities regularly attract sanctimonious scorn from those at the vanguard of innovation and change. Such ‘constraining characteristics’ invariably attract maximum vitriol during periods of excessive exuberance when prevailing valuations get unwarranted. Yet thrift and abstinence feature prominently in long-term sustainable wealth creation. Perhaps even more so in wealth preservation! The sobering reality of the past twelve months simply reinforced that yet again “it’s not different this time”. Economics, commerce, business, social interaction, and lifestyles constantly change and adapt, but when reflected in valuations of equities and bonds, what consistently matters most are profits, cash flows and interest rates. Unfolding financial events throughout 2022 looked no further than the past for vindication. Anyone remotely familiar with previous periods of inflation induced policy tightening understands the consequences such actions have on prevailing market insanities. For seasoned investors well versed on macroeconomic history, the song remained very much the same.
With prices rising at the fastest pace in forty years, inflationary pressures were already well established long before the Russian invasion of Ukraine in February 2022. Escalating conflict between two key global commodity producers poured fresh fuel on the fire of soaring food and energy prices, but the developed world’s mutating inflation problem harboured deeper historical heritage. Twenty years of central bank-orchestrated financial repression was about to be exposed as the untenable sham it always was. Since time began, printing money bequeaths inflation. Having effectively monetised each and every financial crisis this century, huge unsustainable debt legacies were about to become increasingly scrutinised through the lens of rising bond yields. With spiralling debt-servicing costs inherent in higher interest rate and inflationary conditions, spending without restraint comes with serious economic and financial consequences. As the penny dropped, the retrospective wisdom of policymakers and politicians alike has proved deafening.
Collectively experiencing an epiphany of belated inflation realisation, consensus opinion has abruptly disposed of ‘temporary’ and ‘transitory’ from the popular lexicon. Hitherto transient inflation is allegedly now in danger of becoming entrenched, so drastic action has ensued. Throughout 2022, policymakers embarked on the most brutal series of interest rate hikes for over fifty years; it was hardly surprising significant wealth destruction occurred. Fixed income markets endured a torrid twelve months without their buyer of last resort (governments). Investors, understandably, remain fearful of nominal fixed returns being eroded in an inflationary world. Beyond bond markets, the myth of non-profitable growth companies constantly performing in a rising yield environment has also crumbled in the face of adversity. The price of money has gone up and the crushing weight of history has closed in. When liquidity contracts, such unproven investment requires strong stomachs. We are yet to find out just how strong.
Refusal by G7 countries to recognise macroeconomic realities and Covid-induced distortions contrasts with the progressive policies being pursued elsewhere in the world, where fiscal and monetary restraint has generally prevailed. Indeed, the stark contrast between reactive interest rate rises throughout 2022 in the debt-dependent developed world and proactive monetary tightening enacted in 2021 across the developing world couldn’t have been more pronounced. With local interest rates free to price risk accordingly, pre-emptive policy actions in Asia and Latin America prevented undue inflationary concerns, providing a platform for perhaps imminent monetary easing sometime this year. Apart from the arguably overvalued technology sectors in China and Taiwan, most emerging markets appear attractively valued relative to growth prospects. International risk appetite remains unsurprisingly paralysed given events unfolding elsewhere, but subdued sentiment can rapidly change. China’s end of year U-turn on Covid policy undoubtably enhances prospects for the country and region should consumer demand accelerate, and domestic property markets stabilise. Unburdened by punitive debt obligations and free from unrealistic expectations, Asia and Latin America have emerged relatively unscathed from the financial havoc unfolding elsewhere.
Looking forward, as the financial world obsesses about predicting ‘peaks’ in inflation and interest rates, it seems very few are prepared to consider the wider picture. The compulsion to firmly hang onto the belief in a return to the ‘2% mean’ of the past decade remains all consuming. Yet wishful thinking is seldom based on tangible substance. In a nutshell, history is littered with examples where printing money fuelled inflation. For those familiar with it, “inflation is always and everywhere a monetary phenomenon”, so is it really any different this time? Quantitative easing proved an opium for asset prices and a smokescreen for deeper economic distortions which it created, and which would eventually manifest themselves. Now the inflation quantitative easing caused is the inflation that has ultimately killed it. Such naïve monetary policy is no longer sustainable under evolving economic circumstances simply because G7 government balance sheets are close to breaking point. What follows next could potentially become the most significant change to monetary policy since the early 1980s. Should fundamentals be free to price risk going forward from here, the long-overdue end to printing money has broad implications for long-term equity multiples (lower), prevailing bond yields (higher) and optimal stock selection. Yet returning to an environment of equity valuations based on profitability, cash flows and dividends, not to mention free market-based pricing of bonds, should be welcomed by disciplined investment funds focused on delivering unwavering mandates for shareholders. Against this backdrop, emphasising quality, real assets and broad global and sector diversification remains a fundamental priority. And lest we forget, a constant reminder to ourselves to always “ken the richt side o’ a schilling”[1]
Find out more at www.murray-intl.co.uk
[1] “ken the richt side o’ a schilling” (Scots for “knowing the value of money”).
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