Although markets are likely to remain volatile, there is light at the end of the tunnel for investors.
Starting with a war in Europe, 2022 was a year most investors would rather forget.
Putin’s invasion of Ukraine led to massive spikes in energy and food costs at a time when post-pandemic supply-chain bottlenecks were already putting substantial pressure on global prices.
Central bankers, mostly with mandates to manage inflation, were faced with the very real prospect of a rampant cost-price spiral. Unusually, they also faced the unenviable task of trying to rein in wage growth expectations at a time when unemployment in most major economies was at extremely low levels. The scope for error was, and still is, great.
Against that backdrop it is unsurprising that most financial assets took a major hit during the year. The protracted era of “free-money”, when interest rates seemed to be on an ever-declining pathway, came to a screeching halt. Having been negative in many countries for several years, real interest rates (the rate of interest after inflation) ballooned as risk premia rose (the amount by which a risky asset is expected to outperform the known return on a risk-free asset).
The effect of higher rates was particularly acute in highly-valued growth areas such as technology, where many former highflying stocks experienced massive drawdowns. Even companies such as Microsoft and Alphabet (the parent company of Google) were not spared. The technology-heavy NASDAQ index entered a bear market (when a stock market experiences a sustained period of falling prices) in May, and the sell-off subsequently extended to the wider market, with every sector and major region down materially by the end of September. The only sector to deliver a positive return was energy.
At the time of writing, headline inflation rates in many countries are still high or increasing. There are legitimate fears that central bank actions may not be sufficient to counter rising wage demands and there is talk of a return to the stagflation (stagnant growth, high inflation) of the 1970s.
However, although the price shock of 2022 is somewhat comparable to that era, it is notable that underlying inflation (often referred to as “core inflation”) already appears to be moderating. This will likely continue over the coming months as easing supply chains, higher borrowing costs, squeezed consumer incomes and falling house prices serve to cool the global economy and dampen demand.
Against this backdrop it is conceivable that wage demands will also moderate. Many observers point to the ongoing labour shortages in many countries and rapid increase in strike action as reasons to be cautious about wage inflation. However, we suspect that labour flexibility will improve as economies slow. Companies will undoubtedly postpone hiring and trim workforces. Indeed, there are already clear signs of this in the technology sector, where management rhetoric has suddenly caught up with economic reality.
In addition, it is possible that the participation rate, currently at record lows, will increase as non-participants, such as many over-50s, decide to re-enter the workforce. Finally, it is likely that the recent trend toward labour substitution through automation will accelerate meaningfully, particularly given recent technological progress. In short, whilst a return to mass unemployment looks unlikely, it is entirely possible that a rise in vacancies, coupled with a modest increase in the number of participants, caps wage costs in the future.
Ongoing economic slowdown seems inevitable given the above, but fears of a deep recession may prove unfounded, at least in some countries.
With unemployment so low, consumers in are better able to weather higher costs. Government action to provide support with energy bills also cushions that impact too. It is notable that household balance sheets, which benefitted from a considerable build-up of savings during the Covid-19 pandemic, provide a buffer for many consumers (although clearly not sufficiently for the poorest income groups).
The picture is similar in the corporate sector, where leverage is relatively low and of longer-than-average duration.
Overall, the above suggests to us that, while material economic challenges remain, inflation may be less entrenched and the economic downturn less severe than many envisage. This is potentially most likely in the US, which is effectively self-sufficient in energy, benefits substantially from the fact that nearly all major commodities are priced in US dollars and has positive immigration. In Europe, including the UK, the picture is unfortunately much more nuanced.
Recession or not, earnings estimates will have to come down. One of the interesting features of the current market cycle is that while share prices have collapsed, earnings have so far mostly been remarkably robust. The reason for this is pricing. On both sides of the Atlantic, companies have put through price rises with impunity: Pepsi had +17% positive pricing in the third quarter, for example, while in Europe Louis Vuitton and Nestle both had double-digit price uplifts with little immediate impact on volumes.
In these specific cases revenues may well hold up, since consumers appear willing to pay up for premium products. However, for many companies it is only a matter of time before negative elasticity kicks in and demand starts to fall. Early indications from the likes of Amazon and Target in the US, or M&S, H&M and Primark in Europe suggest that consumers are already cutting their spending. Revenue and margins (excluding energy companies) look likely to fall in 2023, creating a proper earnings downgrade cycle that is yet to be fully reflected.
Finding the bottom may sound counter-intuitive given the above, but our view is that the current bear market has nearly run its course. Albeit with the caveat that volatility is likely to remain elevated for some time to come.
Consensus S&P 500 earnings per share of $225 and $235 still look somewhat high, and we expect these to be revised down steadily over the coming months, with the trough to occur in the third quarter of 2023. But stock markets always look ahead, typically discounting a trough in earnings six to nine months ahead of the actual trough. That suggests that the recent bounce in global equity markets (the Dow index had its best month since 1976 in October) was not without logic, although we do believe the recent rally to be something of a false dawn.
In the very short-term, there may be some further disappointment to come, as profitability pressures become more apparent.
We haven’t dwelt on ongoing geopolitical risks, such as further escalation in Ukraine, the possibility of further reduction in Russia’s gas supply to Europe, or China’s stance on Taiwan. These are potential “Black Swan” events that are binary in nature and impossible to predict with any certainty. Any one of these possibilities would be extremely bad for global markets. One must hope that common sense will prevail.
Regardless though, the events of the past year will only serve to strengthen certain trends that were already apparent before the current crisis. Security – national security, energy security, food security, cyber security (to name but a few) must now be considerably higher on government and corporate agendas than in the past decade. Russia’s exploits have proven that energy dependence on an erratic partner can be disastrous. China is likely to remain a much more rational, measured player than Russia, but President Xi’s agenda is clearly expansionist.
We see a wave of spending being directed by governments and companies toward achieving greater security of supply: whether through investment in renewables; re-shoring or re-locating production facilities; supporting new methods of food production; or protecting industries that are strategic in nature such as semiconductors, software, or bio-technology. A polarisation of sorts between the West and the East seems inevitable in these areas.
We are focused on companies that can prosper in a challenging environment and do so with a reasonable level of risk. Many of these are in the areas outlined above, where structural growth rates are clearly higher than they were.
Equally though, as the bear market matures, our research is taking us to several areas that have been out of favour for some time, such as Japan.
We will leave you with the startling revelation that, thanks to low wage inflation and a highly competitive currency, it is now cheaper to hire a software engineer in Tokyo than it is Bangalore.
There are always opportunities somewhere in the world.