It’s easy to feel bearish given the number of challenges investors are confronting.
Fire, flood, pandemic, inflation, war, rising interest rates and market volatility are dominating the headlines.
But as President Kennedy once noted, in the Chinese language the word "crisis" is composed of two characters, one representing danger and the other opportunity. Some disputed his linguistic accuracy, but this anecdote speaks volumes!
While Perpetual considers that investing over the past decade was easier, with all equity markets rising from March 2009 lows, investing in a predicted “dangerous decade” of higher volatility, inflation and geopolitical uncertainty will be harder.
Perpetual believes there is always value to be found somewhere in the market, even if finding it takes careful research. There will always be opportunities for investment managers.
As shown in the chart below, Consumer Price Inflation (CPI) is at 40-year highs in the US and Europe and has now rippled across the ocean to Australia.
While central bankers hoped inflation would be “transitory”, it has been higher for longer than expected.
As policymakers change course, it’s worth investigating what happened more than 40 years ago.
While it’s easy to write off the 1970s as entirely an oil-driven event beyond our control, it is worth reminding ourselves that before the oil crisis first struck in 1973, the US had already had a serious inflation shock. The first was 6%+ inflation in 1969-70 as President Johnson’s Great Society anti-poverty program led to price rises.
Although inflation subsequently fell again, the next President, Richard Nixon, promised a massive Family Assistance Plan (FAP) offering families $1,600 each per annum funded by $24 billion in deficit spending (a lot of money in 1972). He also took the US off the gold standard in 1971.
Today, the FAP appears to us to look a lot like the COVID-19 stimulus and by the time of the oil price hike in October 1973, CPI was already 8% and rising.
The creation of OPEC in 1973 allowed the major oil producing countries to constrict oil supplies in 1973 and 1978, which sent inflation even higher, similar to the impact of the Ukraine war today.
However, the point is that CPI had already been fuelled by two separate discretionary fiscal stimuli before the oil problems arose and inflation was in a rising trend, embedding higher and higher inflation expectations.
While many thought those inflations might have been temporary or would go away, they snowballed into permanent inflation, higher expectations and a price-wage spiral.
Today, the COVID-19 stimulus and Ukraine war seem, in Perpetual’s view, like a repeat of the events of the 1970s. On top of these, there are also new inflationary risks to worry about.
Globalisation, which has helped lower prices for decades, is under threat as the shock of COVID-19 disruption leads businesses to eschew globalised “just in time” manufacturing supply chains for more expensive but secure “just in case” local manufacturing in case trade links break again. The last time globalisation fell apart, in 1914, trade didn’t grow again until 1945.
Geopolitical tensions appear to be on the rise, clearly in Ukraine, but also in the Asia Pacific region, with international relations theorists expecting the 2020s to be a “dangerous decade”.
Perpetual believes that decarbonisation of the global economy is a laudable goal and has strong global momentum, but it will also come with higher prices for many products incorporating the rising cost of carbon. Carbon is everywhere.
Even ageing might, in our opinion, prove inflationary as large parts of our workforce shift from the working and saving phase of their life to retirement and drawing down on their capital.
US Federal Reserve Chairman Jerome Powell, after initially dismissing inflation as transitory, has shifted to a more hawkish posture in recent months. There are fears that higher inflation may become “anchored” in consumer minds and lead to a wage-price spiral that is difficult to control, or even to stagflation (rising inflation even during a period of economic stagnation).
Perpetual considers that the lesson of the 1970s is that allowing a series of inflation events, including policy errors and oil supply constraints, to fester can result in high and entrenched inflation expectations.
While equities are the breezy optimists in financial markets, often racing ahead of economic reality, bond markets are the sober and conservative realists.
The “bond market vigilantes” are usually the first to warn of trouble ahead. It is said that when the bond and equity markets disagree, the bond market is right about 90% of the time.
As shown in the chart below, bond yields began to rise in late 2020 from below 1%, rising through 2021 and have surged in 2022 to over 4%.
At first, equities remained largely buoyant into April. The ever-rising yields kept the fire to the feet of equities into May and June until the S&P500 Index (a key barometer of US stocks) finally lurched into a bear market.
While small-cap tech “concept stocks” took the brunt of the pain, Perpetual considers that many large-cap growth stocks remain pricey and could have further to fall.
[Editor’s note: Do not read the ideas in this story as recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article].
As always, there are gems in the chaos. At Perpetual we like to avoid what we consider to be low quality companies, which we define as those with poor business models, no earnings, too much debt or which are badly managed in our opinion.
In this environment, stocks of interest to Perpetual may include those which could benefit from food and energy inflation or that mine green metals like copper, nickel, rare earths and cobalt which are required to fuel the rise of electric vehicles.
Some businesses also benefit from rising rates, like insurers as their investment returns rise. With long locked-down consumers looking for experiences, we also like parts of the travel and tourism sectors.