The fast view
- Post the Global Financial Crisis, we experienced an era of cheap money, which distorted the cost of capital and favoured excessive risk-taking.
- The return of persistent inflation has forced central banks to hike interest rates aggressively, bringing an end to ‘free money’.
- Many businesses had positioned themselves for a low-rate environment and now that the tide has turned, some are ill-prepared for higher rates.
- We are avoiding these businesses, rather investing in select high-quality healthcare and consumer, semiconductor, and leisure companies, amongst others.
- Despite tough conditions, high-quality businesses with exceptional fundamentals should come into their own.
When I started my career in the investment markets in 1995, high positive real interest rates were the norm. That all changed when the Global Financial Crisis hit during 2008, ushering in the era of easy money. For the next decade and a half, markets operated within a false equilibrium, where near zero or negative interest rates and quantitative easing distorted the cost of capital, which in turn encouraged excessive risk-taking. When economies and markets tanked during the pandemic, policy makers provided massive stimulus measures to help alleviate tough financial conditions. But persistent inflation has brought an end to the ‘new normal’, as central banks across the world have been forced to hike interest rates aggressively to restore price stability.
During restrictive financial conditions, financial ‘accidents’ are more likely to occur. Many businesses had positioned themselves for a low-rate environment and now that the tide has turned, some are ill-prepared for higher rates. Non-profitable technology companies have come under pressure. We have also witnessed turmoil in the global banking sector, with the collapse of Silicon Valley Bank and Signature Bank, and the bailout of Credit Suisse.
Fed sticking to its guns
Despite these developments, the Federal Reserve (Fed) is committed to raising rates to lower inflation. It has been able to stick to its guns by making additional funding available to financial institutions to prevent banking liquidity/solvency issues.
Rising interest rates have been a major headwind for markets. Investors continue to focus strongly on when the US will reach the point at which inflation and the federal funds rate will converge. While global inflation has been a real worry, the health of corporate earnings deserves closer scrutiny.
A gloomy economic outlook
Manufacturing activity has been contracting sharply in the US, reflecting the gloomy economic outlook. The bond market is also signalling that it is expecting a significant downturn in economic activity this year, as evidenced by long-term rates being much lower than short-term rates. The difference between 10-year rates and 3-month rates is the steepest it’s been since 1981.
Cyclical businesses are feeling the pressure. As companies start losing volumes, their pricing power will suffer, impacting their earnings growth. While a recovery in economic growth in China could provide some relief, it is going to be a tough year for company earnings.How deep is in the earnings trough?
Figure 1: Average global sector earnings percentage change during previous earnings recessions
Source: Citi Research, Global Equity Strategy, October 2022, Market: MSCI ACWI.
Global EPS recession dates: 31 Jan 2008 – 29 Jan 2010; 27 Feb 2015 – 31 Oct 2016; 31 Mar 2020 – 30 Nov 2020.
The chart shows that during difficult market conditions the energy, financials, materials and consumer discretionary sectors typically experience a far greater hit to profits compared to other parts of the market. It’s not to say the energy sector will experience such violent moves, but we are avoiding these sectors in our portfolios. We have exposure to high-quality healthcare and consumer staples where earnings are more resilient during economic downturns. But these sectors generally have lower levels of growth, so investing in other high-quality opportunities that offer long-term growth is key.
Semiconductors – attractive structural growth trends
Semiconductors – also known as chips – are the brains of all modern electronics. We find them in smartphones, tablets, PCs, data centres, autos and more. Semiconductors have attractive structural growth trends – with some predicting the industry will top US$1 trillion by 2030.1 But because of inherent cyclical risks, it is important to seek out companies with sound business fundamentals and compelling long-term growth prospects.
In Europe, we like ASML, which is a key portfolio holding. It focuses on the lithography step of the chip-making process, which is almost like a high-tech photocopier. ASML’s extreme ultraviolet light (EUV) machines – about the size of a single-decker bus, at a cost of US$150 million – have become precisely what chip makers need to print smaller circuits while increasing capacity and speed. In the EUV era, ASML is no longer just a dominant supplier, but rather a monopoly, created through technological brilliance and innovation, as opposed to the more traditional mergers and acquisitions route.
The world’s largest contract manufacturer of chips, Taiwan Semiconductor Manufacturing Company (TSMC), is another portfolio holding in this growth sector. The company posted strong financial earnings earlier this year. Even though the chip industry is experiencing a cyclical downturn, TSMC still expects some growth in 2023. Its long-term growth profile remains firmly intact. Against a backdrop of difficult financial conditions, TSMC maintains a strong financial position. The company has an excellent credit rating, and its balance sheet is healthy. TSMC has not needed external funding to finance organic growth.
Experiences making a strong comeback
Coming out of the pandemic, the growth in the leisure sector has been robust, reflecting people’s pent-up demand for holidays. Consumers are choosing again to invest money in experiences over goods, which has benefited the leisure industry across the board. This year, we are also seeing a recovery in Asia’s travel industry, particularly from the Chinese, with the lifting of Covid restrictions. The devastating impact of the pandemic wiped out many players in the hospitality industry, so it’s not quite ‘business as usual`. Although the industry still has its challenges, there are good valuations and growth on offer for discerning investors despite recent gains.
Booking Holdings, an industry-leader in online travel, has been a mainstay in our portfolios. The company is well positioned to capitalise on the recovery in the leisure sector, and it has provided an upbeat forecast for the year. Room nights booked in January were 26% higher than 2019 levels, and the online giant is expecting percentage growth for gross bookings in the low teens compared with 2022 levels.
In conclusion
Now that the ‘free-money’ era has ended, it’s time to dust off the old investment playbook and revisit the good, old-fashioned principles of investing. We are going back to a world where fundamentals matter. Valuation and energy were last year’s theme, but we don’t believe they will drive the stock market performance this year. The problem with businesses that are merely cheap is that their valuation does not protect you when the fundamentals change for the worse. Cheap shares can be very risky in a difficult market environment.
We expect balance sheets and earnings to take centre stage this year. Geopolitical uncertainty will prevail, but inflation is likely to moderate as demand cools and companies and individuals repay their debt. The global companies we hold are well positioned to navigate the tough macro environment. Their strong pricing power and low debt levels are a powerful buffer against restrictive financial conditions. The fundamentals of these high-quality companies remain strong. We are confident about the runway for growth and the ability of these companies to compound their cash flows. Despite tough conditions, there is money to be made – high-quality businesses with exceptional fundamentals should come into their own.
Two decades at the helm
Co-Head of Quality, Clyde Rossouw, has had an illustrious career in the investment industry, spanning close to 30 years. Ninety One Opportunity Fund investors have benefited from Clyde’s depth of experience. He has steered the Fund successfully through choppy investment waters since taking up the reins as portfolio manager in 2003. The Fund has consistently beaten inflation. Over the last 20 years, it has generated an annualised return of more than 13% for investors.
Source: Morningstar, dates to 31 March 2023. Performance figures are calculated NAV-NAV, net of fees, in rands, A class. For more information, visit the Ninety One Opportunity Fund page on our website.
1 McKinsey, April 2022.
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