Probability

With equity markets starting the year strongly, it is somewhat tempting to cast aspersions at the consensus forecast that we will see continued weakness at the start of 2023 with a potential recovery in the second half.

However, this would be myopic and disingenuous. The reality, of course, is that nobody knows how markets will perform over such short time horizons and any forecasts should be considered in a probabilistic manner.

The challenge with probabilistic thinking, however, is that it can sound very ‘wishy-washy’ and unsatisfactory. We simply don’t like hearing qualified opinions, with probabilistic outcomes; we want to hear precise predictions, we want commentators to tell us what is going to happen – not what might happen within a range of probabilities.

Since the start of this year, we have observed that market trend evidence has become more supportive and that markets are ‘behaving’ in a manner more consistent with an ongoing recovery. This has made us slightly more optimistic.

However, we can’t know what is going to happen and, whilst we see an encouraging shift in some indicators we track , we also remain concerned over the impact of the dramatic move in the cost of money (i.e. interest rates) over the past year and the effect this will have on the economy.

It is amazing that this time last year German bunds were trading on negative yields and are now c.3%. This rapid increase will no doubt ‘leave a mark’, with leveraged assets likely most vulnerable. Indeed, we have already seen this with the performance of real estate investment trusts, which experienced 30-40% declines in 2022.

Of course, with 3-4% yields now available from government bonds, investors are asking why bother with equities at all? This is a valid question, when one considers that the forward earnings yield (earnings/ market capitalisation) for the world equity market is c.6%. Why endure the extra volatility for an additional 2-3% return?

However, this ignores the fact that government bond income doesn’t grow with inflation whereas corporate earnings should, at least for higher quality companies with pricing power. The correct comparison is to compare the after inflation return from bonds to the potential return from equities and then ask whether we are getting a sufficiently high potential additional return from equities to compensate us the volatility and risk.

Whilst inflation remains uncomfortably high, longer term expectations suggest c.2.5% inflation (interestingly this does suggest inflation will remain higher this decade versus the last) which implies a 0.5%-1.5% real (after inflation) return from government bonds. This can then be compared to a c.6% earnings yield for equities or perhaps more accurately 3-5% earnings yields (equivalent to 33x or 20x P/E) for higher quality companies with pricing power and durability.

To use an example, today you can buy a 10-year German bond on a 2.7% yield or you can buy Diageo on a forward P/E of 21x or an earnings yield of 4.76%. For the bund the after-inflation yield will likely be marginally positive while we can be reasonably confident that Diageo will be able to grow its earnings at least in line with inflation and thus the earnings yield can be considered real.

Returning to the topic of probabilistic thinking, there still remains the question as to how certain we can ever really be, even if we have high confidence over the outlook for companies like Diageo.

Over the past decade or so there has been an interesting shift away from thinking about economies and markets in a scientific or deterministic manner towards an acceptance that markets are complex adaptive systems more akin to what we see in the natural world.

This line of thinking would suggest that prognostications about the future are actually pretty naïve, especially the short-term future, and that we should be very wary of any adviser offering definitive short term views.

At the same time, we also don’t believe we can simply throw our hands in the air and say “well the future is complex and we have no idea what is going to happen”. We need some guideposts or process when managing money.

Ultimately, I believe this debate concludes on focussing on what we can know and investing in a manner such that the odds of success are in our favour. We must also accept that there is much about the future and investing that we can’t possibly know.

Whilst market history isn’t very long it is a useful guide here. For example, since the early 1900s the US market has delivered just under 10% per annum returns. Perhaps more importantly, we can also see that markets are rarely down over any 5-year periods and when we extend our time horizon out beyond 10 years the odds are overwhelming in our favour.

This simple backward-looking analysis, suggests long term equity investors should have a very favourable outlook for US markets with a high probability of success.

Of course, this is backward looking but when we ask why the market has delivered this return, we can see that it has been supported by dividends and earnings growth.

If you believe this will continue, with a capitalist economy supporting growth and good corporate governance protecting shareholder rights, there is little reason to believe the future will look much different from the past, even if there are grounds to believe returns might be slightly lower than the past based on valuation.

This logic can be extended further to investing in direct equities, property, or other assets. All the time asking how we can place the odds of success in our favour, and it explains our preference for investing in high quality, durable businesses like Diageo.

To challenge ourselves on this topic, however, regular readers will also know that we believe that the economy is undergoing a number of technology-driven changes, ranging from healthcare to the energy transition.

So there remains the potential for less-established companies, which we typically do not invest in, to drive or at least contribute significantly to overall market returns. The probability of success may be lower for an individual company in higher growth markets, but the impact of the successful companies could be significant.

Investing in early stage or higher growth businesses is very challenging and this is why we invest in strategies or funds that invest across industries like healthcare and energy transition because we believe partnering with a specialist who is investing across a portfolio of companies increases our odds of success.

When looking at other assets, such as infrastructure or property, key questions include how confident we can be about the durability of cash flows and if leverage is applied, as it can be for these strategies, what could happen to leverage ratios during periods of market stress.

Naturally after a challenging 2022, we would prefer a ‘kinder’ 2023 and there are plenty of studies that show that historically after very challenging years subsequent years can be quite strong. We are also encouraged by the improvement in some of the marketbased indicators we monitor and, from a contrarian perspective, the general sense of caution amongst investors today is welcome.

However, we can’t know what will happen over the short term, and we shouldn’t suggest we can. Perhaps inflation will come down quickly and the economy will avoid recession or perhaps it won’t, and corporate earnings will experience pressure as the economy slows or enters a recession.

We believe focussing on what we can determine with a reasonably high probability is the right approach. This process inevitably leads us to invest in what we believe are high quality, durable assets and to partner with specialists in certain markets where outcomes are likely to be wider ranging or volatile.

It almost goes without saying that having a longterm mindset is also paramount. With time horizons seemingly becoming shorter and shorter, this is a true advantage.

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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