Investing during a crisis

In our first note of 2022, we stressed the need to temper expectations after a very favourable period, noting that we expected the coming year to be ‘bumpier’.

Well, it certainly has been a weak start to the year and the very disturbing events in Ukraine have understandably added to concerns.

We have seen a notable decline across equity markets, with many high-quality companies down 20-30% and a number of broad market indices now down double digits from their highs. So why is this happening and what do we make of it?

Looking back at our January note, we remarked that ‘perhaps an inflation overshoot and fears of a faster pace of interest rate increases could cause a temporary derating of markets (i.e., decline) but if this happens it will likely prove an opportunity’.

Well, that was certainly the reason for the initial correction we saw into mid-February, before the very recent escalation of the crisis in Ukraine, which has understandably caused a great deal of concern this week.

In this note, we shall address both concerns, first looking at the impact of rising interest rates, before discussing the recent tragic developments in Ukraine.

In January, we commented that a number of our preferred companies had experienced a re-rating in recent years, i.e., valuations had risen, and that it wouldn’t surprise us to see a period of consolidation, allowing time for earnings to catch up with valuation expansion.

Consolidation is perhaps a euphemistic term for a correction, but we are now clearly seeing this. A number of our preferred companies have reported very good earnings, but their share prices have declined, which may seem puzzling. This is the process we were referring to, whereby valuations are compressing after a period of strong share price appreciation.

As noted above, it is the concern over inflation and rising interest rates that, in our view, acted as the initial catalyst for this year’s correction. Whilst interest rates are set to remain below inflation for quite some time, which we believe is supportive for equity markets, it is not unusual to see volatility as interest expectations shift.

Whilst we do not wish to be dismissive of the risks, in particular in light of what has happened in Ukraine, it is not unusual for equity markets to experience 10-20% declines, it is simply part of investing.

If there was no volatility in equity markets, returns would converge to the risk-free rate, which is effectively zero today. Volatility is part of investing and long-term investors get compensated for this volatility with higher returns.

Of course, the situation in Ukraine is another very significant factor we now need to consider. From a humanitarian perspective it is deeply disturbing and shocking, and I think it would be wrong for us to offer a strong view on how events will unfold.

From an economic perspective, the now-likely recession in Russia as a result of sanctions, is unlikely to have much of an impact on global growth, given that Russia’s economy only represents c.1.8% of global GDP. The rising oil price is, however, a concern and should the oil price continue to increase it will impact demand, so we are sensitive to this risk.

The major risk to markets right now from this crisis is the increase in uncertainty. When uncertainty increases, the risk premium increases. That is to say equity valuations fall to reflect the additional risk, as investors require higher potential returns to compensate for the higher perceived risks.

Whilst the economic impact is likely to be limited, it is this uncertainty that is impacting markets right now.

History does tell us that markets have been resilient during periods of crisis in the past, such as the Cuban Missile Crisis, the Iraqi invasion of Kuwait and 9/11, and the impact of these events on the economy and markets were much more fleeting than you might expect.

We hope this doesn’t sound too sanguine and it is in no way an attempt to diminish the extent of the crisis in Europe, which could clearly deteriorate further. Every crisis is different, and we can’t know how this will unfold. However, we believe it is instructive to look back on prior crises when considering today’s events.

We absolutely recognise that declines like we are seeing right now can feel unsettling, but they are part of investing, and we will see many 10-20% declines during our investment journey. Indeed, we will also see the occasional 30% plus decline, like we saw in 2020.

Clearly our portfolios are declining at the moment, but we view that decline as temporary. History tells us that high quality assets will deliver good returns over the long term, if we invest at reasonable valuations, and as a result of today’s uncertainty valuations have become more attractive for long term investors.

In January, we highlighted that the forward earnings yield (the inverse of the price/earnings ratio) for the world equity market was 5.5%; it is now 6.1%. We have noted previously that this is a reasonable proxy for future after-inflation returns, so following the recent decline it is evident that potential returns have now increased.

Naturally when we go through these periods, investors wonder how deep the correction will be and how long it might last. The answer is unfortunately we don’t know and the developments in Ukraine add to uncertainty right now.

Our advantage, as long-term investors, is that we can ‘ride out’ these periods, in the expectation of good longterm returns. History is once again a useful guide here.

We know that the bigger corrections or bear markets have occurred when we’ve had a recession, resulting in a decline in earnings. Outside of recessions, corrections like we are seeing now are generally limited to 10-20%.

This is not to say we can’t have a recession and it is likely that the economic data will be a bit confusing, as the economy continues to re-open and fiscal stimulus recedes.

However, on balance we believe that, in spite of the tragic events currently taking place in the Ukraine, we will not see a recession later in the year but that the future trajectory of energy prices will be important in this regard.

This is not to be insensitive to the unfolding tragedy in Ukraine, which deeply concerns all of us, and we have to recognise that events could clearly deteriorate further and have a more significant impact on the economy and markets.

However, as my colleague Guy Foster, our Chief Strategist, remarked in a recent commentary, experience has shown that disinvesting at times when investor sentiment is already weak, as it is right now, is unwise.

During times like this, it is important to emphasise the diversified and quality nature of our portfolios and that our biggest advantage, as long-term investors, is our time horizon.

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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