Challenging times

Since late last year, we have consistently expressed our view that 2022 would likely be a more challenging year for investors, whilst still retaining an overall positive stance.

The logic for this view was simple. We had just experienced a number of very strong years and annualised returns were running above our longer-term expectations. We also knew that policy was turning incrementally less supportive and that historically rising interest rates have resulted in a period of volatility or ‘digestion’.

Nothing has really changed in our view since, but matters have moved on somewhat in recent weeks, particularly when it comes to interest rate expectations.

When we look back through history, we can see the equity markets are not really all that troubled by rising interest rates, beyond some initial weakness into the first interest rate increase of the cycle. This makes perfect sense, as interest rates are likely going up because the economy is recovering, and earnings are strong.

However, history also tells us that when interest rates are increasing at a more rapid pace, like we are now almost certainly going to see this year, the market has struggled, with marginally negative returns observed in the year after the first interest rate increase in the cycle. Whilst markets may continue to recover, this increasingly ‘feels’ like where we are today.

Through much of last year there was an expectation that inflationary pressures would moderate as the economy reopened and supply chain challenges were resolved. It is clear now though that inflationary pressures have become more persistent. The war in Ukraine has added to this inflationary challenge, with many commodity prices seeing significant increases.

Whilst it is likely that inflation is peaking at the moment, it is very clear that central banks are concerned about inflation becoming more embedded and the US Federal Reserve, in particular, has communicated a number of rate increases. As a result, the US 10-year bond yield is now around 2.7%, having started the year at c.1.5%.

This may not seem especially high in the context of history, but the move has been very quick and thus it is not surprising that we have seen some weakness in equity markets this year.

In particular, we have seen weakness in what investors term higher quality companies. These are generally considered to be businesses that earn higher than average returns on capital, as a result of competitive advantages such as brand, operational excellence and scale.

Over the long term, investor returns should converge to the underlying return on capital our investments generate, so if we can find businesses that can earn sustainably high returns, we should invest in them.

However, there is always the question of valuation, and we should expect such businesses to trade at a premium to the market and thus perhaps be more sensitive to rising discount rates.

Right now, we are seeing quite meaningful weakness in the share prices of higher quality companies. I won’t get into individual stock specific commentary in this note, but quite a number of really well-run businesses have experienced 20%+ share price declines this year. Whilst for the most part these businesses are continuing to deliver good returns, the share prices have been under pressure due to rising bond yields.

At first blush, this makes sense. Higher quality companies are often valued on their durability and ability to earn high returns over the long term. To assess value today we need to discount future cash flows at an appropriate rate, so all things being equal higher bond yields should weigh on valuations.

However, all things are not equal and higher quality companies with pricing power should also see higher revenues in a more inflationary environment, provided inflation does not remain too high and create disorder in the economy.

History shows us that it is only when inflation persists above 5% that we see a negative valuation impact on the overall market. Right now, inflation is closer to 8% but as we look out over the next few years, we see that inflation expectations are closer to 3%. So provided inflation moderates, in line with expectations, it should not provide a significant headwind to valuation from here, unless bond yields move materially above inflation, which is not something we expect.

Today, as a result of the decline, we see a number of really well run, dominant businesses trading on c.4% free cash flow yields, which certainly seems like a pretty attractive entry point.

I should stress though that I am not trying to call a bottom here. If bond yields continue to rise, we may see further valuation pressure. There is also the notinsignificant risk that higher interest rates will meaningfully slow the economy.

It is quite obviously the intent of central banks to slow growth and take the inflationary ‘heat’ out of the economy. This is done with the intent of extending the economic cycle rather than ending it, but we must recognise that the economy is likely to be quite sensitive to interest rates.

We should, therefore, recognise the risk of a more meaningful slowdown, which may present a more challenging backdrop for corporate earnings over the next few months.

As to how markets may ‘behave’ in such a scenario, we can’t really know. We do know that historically markets have experienced more significant declines during economic slowdowns, but we have already seen notable declines in parts of the market over the past year.

Equity market valuations have also fallen quite a bit of late and are quite reasonable now, with the world equity market trading on a forward earnings yield of c.6%, suggesting long-term investors should earn good returns from this point, at a time when interest rates are likely to remain below inflation.

We also know that trying to time our entry and exit is extremely difficult and most people will get it wrong.

Furthermore, it is possible that inflation has peaked, that the major move higher in bond yields is behind us and that corporate earnings will surprise positively over the coming weeks. Investor sentiment also appears quite depressed right now, which has often been a good contrarian indicator.

This may seem like ‘on the one hand or on the other hand’ type analysis but the outlook from here is more nuanced than it has been for two years now. It may seem repetitive to keep making this point, but being able to look through these periods is a key advantage for long-term investors.

2022 is proving a more challenging year and quite candidly we can envisage a number of scenarios right now.

Following very strong gains in previous years, this is not especially surprising, and we believe it is important to recognise that equity markets may be in for a period of further volatility.

Of course, volatility is a part of investing and the fact that investors earn good returns over the long term is in effect ‘compensation’ for having to withstand more difficult periods.

Our answer to the current challenge, as ever, lies in our research process and our commitment to long-term investing and thinking.

As always, please do not hesitate to contact us to discuss our views further.

Ian Quigley
T: +353 1 2600080
E: ian.quigley@brewin.ie

www.brewin.ie

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