Jun 9, 2023
For the past decade and a half, markets have 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 this, as central banks across the world have been forced to hike interest rates aggressively to restore price stability. Some businesses are ill-prepared for higher rates, as we saw in the banking sector in the first quarter.
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 or 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.
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.
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 above shows that during challenging economic conditions the energy, materials and financials sectors typically experience a far greater hit to profits compared to other – higher quality – parts of the market. It’s not to say definitively the energy sector will experience such violent moves, but we avoid these types of sectors and focus on areas with greater resilience, such as high-quality healthcare and consumer staples companies.
Furthermore, although it is still not clear when the rate cycle will ease, it is notable that quality has historically outperformed as a style in the years after a hiking cycle has ended. As the economic outlook comes under increasing pressure – which may ultimately lead to rates being lowered – quality companies’ earnings and cash flows should prove to be more robust, as Figure 1 illustrates.
Figure 2: Where should investors go when the Fed ends its hike? History suggests quality equities
Average returns after Fed hiking cycle ends, 1989-2022 (%)
Past performance does not predict future returns; losses may be made.
Source: Ninety One, with data from FRED Economic Data, St. Louis FED and Morningstar Direct. Calculated from 31 August 1984 to 31 March 2023. Returns are calculated from the month when the Fed stops raising rates for peak rates periods in 1984, 1989, 1995, 2000, 2006 and 2018.
Yet it is fair to state that sectors such as staples and healthcare generally have lower levels of growth, so investing in other high-quality opportunities that offer long-term growth is important to balance a portfolio. Semiconductors, for example, have attractive structural growth trends – with some predicting the industry will top US$1 trillion by 2030. But because of inherent cyclical risks, it is important to seek out companies with sound business fundamentals and compelling long-term growth prospects. Dutch company ASML1 provides the machines that are critical in the semiconductor manufacturing process and its monopoly position in the market has translated into an order book above 40-billion euros – a record for the company – offering long-term visibility.
Coming out of the pandemic, the growth in the leisure sector has been robust, reflecting people’s pent-up demand for holidays. Booking Holdings, an industry-leader in online travel, is well positioned to capitalise on the recovery in the tourism space, and it has provided an upbeat forecast for the year. Room nights booked in Q1 2023 were 26% higher than equivalent 2019 levels, and the online giant is expecting percentage growth for gross bookings in the low teens compared with 2022 levels.
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. 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.
1 This is not a buy, sell or hold recommendation for any particular security.
General Risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.