Fear & Greed – A Market Update

The Fear and Greed Index, produced by CNN business, is a barometer of market sentiment over the recent past, as it provides a quick snapshot of where we currently sit. As we have said before, global equity markets tend to fluctuate between these two extremes, as rising markets lead to FOMO (the fear of missing out) and share price falls encourage people to sell – FOLE (the fear of losing everything).  Whoever said stock markets were rational clearly did not have a very good understanding of human nature.

We currently sit at around 50 – on a scale of 0-100 – which is probably an accurate reflection of a year ahead that looks “interesting”.

How have the last few months been?

Most markets finished the year on something of a high, led by the US market, which has set a number of all-time highs.  By contrast, emerging markets (in general) and Asia (in particular) have struggled, buffeted by geopolitical winds.

This is despite the emergence and dominance of the latest version of Covid, Omnicron.

Just when I thought it was safe to go back in the water!

Indeed.  The numbers of new infections is reaching record highs and, coupled with the numbers self-isolating, is creating disruption.  New restrictions are being applied across Europe – especially for the unvaccinated – with some countries reintroducing quarantines and travel restrictions.  However, the signs at present are that, although this new variant is very much more infectious than earlier versions, its toxicity is lower.  So, while there has been a dramatic surge in the number infected, this has not been accompanied by an equally sharp rise in hospitalisations.

Perhaps this marks another step on the journey of Covid from being pandemic to endemic, in the same way that the Spanish Flu outbreak after the first world war lives on in the annual flu outbreaks we experience.  This would certainly be welcome, so that we can get back to worrying about something else for a change.

Like what?

Well, the most prominent issue at the moment is the rate of inflation, which is running at levels not seen for many years.  We have talked before about the supply disruptions caused by Covid and to these we can add the spike in the price of both oil and gas.  In the UK, the latest year-on-year inflation rate as measured by the Retail Price Index showed inflation running at 7.1%, although the Consumer Price Index excluding food and energy was somewhat lower at 4.1% – which would be fine, except, of course, we all need to eat and heat!  It would be easy to blame this all on Brexit, although the reality is that this is just the cherry on top of an unpleasant cake.  Eurozone inflation is running at 5.0% and US inflation at 6.8%, so the same pressures exist globally.

Inflation is just a measure of a rate of change, so one would expect some of these pressures to begin to abate over the months ahead.  There are already signs that the oil price has reached a short-term peak so, unless you see the price of petrol at the pumps going up by a similar amount again, there will be a natural slowdown in the inflation rate.  However, this is not to say that prices will begin to fall, so maybe we are all just going to have to get used to things costing more.

Moreover, many businesses have found the last few months extremely challenging, as cost pressures have risen.  The mark of a good company is the ability that they have to pass on these pressures to their end customers, either in whole or in part – poor companies providing commoditised products have little ability to increase prices.

What will be done to control inflation?

Almost inevitably, interest rates will rise and this is certainly the message being broadcast by Central Banks like the Bank of England, the US Federal Reserve and the European Central Bank.  The question, then, is not whether rates will rise, but by how much.  This is important not just for mortgage rates or what one can earn on cash deposits, but for the interest rates that governments have to pay on their now very high borrowings.

To put this into some context, a year ago the UK government could borrow money for 10 years for around 0.3% per year.  As investors, it clearly made little sense to tie money up for ten years with such paltry – and sub-inflation – returns.  As the saying goes, this is not so much risk-free return as return free risk.  Today, the ten year bond rate here is around 1.2% which is clearly higher, but gives you some sense about where interest rates are likely to go – higher, but nowhere near the kind of rates that we saw in the 1970-2000 time period.

What implications do higher interest rate have?

Higher interest rates are typically used to tame inflation by slowing the economy, easing the upwards pressure on prices by reducing demand.  However, at the moment, the problem is partly driven by demand as economies open, but also by supply shortages.  Raising interest rates is not going to affect the price of food and domestic gas, as these are essential items, and it won’t stop the chip shortages that are creating blockages across the supply chain.

One other factor with higher interest rates is the affect that it has on the current valuations of unprofitable companies, a particular factor for many young companies in the technology sector.  These are often valued using a technique called discounted cash flow analysis.  I am sure none of us want a lesson in accountancy, so we will keep this short, but essentially it looks at profits made in the future and then “discounts” them to today using a comparison with the risk-free return.  As interest rates go up, so too does the risk-free return, demanding a greater future return as compensation which, in turn, lowers todays value of those future profits.  Keeping it simple: higher interest rates means potentially lower share prices for growth companies.

Does this mean that Value companies are a better place to be?

Value companies – companies whose shares trade at a lower price relative to their fundamentals based on analysis – have underperformed growth companies for a long time, predominantly because interest rates have remained so low for so long.  Who would have thought almost fifteen years ago that interest rates would remain below 1% for such a protracted period?   The effects of the great financial crash cast a very long shadow indeed.

In the current environment, value shares have, unsurprisingly, performed far better, but I would hesitate to get too carried away.  Interest rates are moving higher, but it feels enormously unlikely that they will reach previous peaks.  In addition, as discussed earlier, inflationary pressures and rising interest rates are creating a challenging environment and, too often, there is a fine line between “undervalued opportunity” and “cheap and nasty”.  The solution is, of course, to try and maintain a balance in portfolio construction, as different investment approaches will prosper in different conditions.

What about Resource companies?

There is – quite understandably – a focus on sustainability and the kind of changes and challenges that lie ahead as we attempt to move to a carbon neutral economy globally.  However, the idea that we will no longer require natural resources is a little wide of the mark.  Wind turbines are not made from bamboo.  The rotor blades movement is not lubricated using banana skins.  The electricity generated is not fed back into the electricity grid using spaghetti.  We still use – and will for the foreseeable future – require natural resources in some form or other.  The key will be in the sustainability and recyclability of their output and in their ethicality in the spheres in which they operate.

Doesn’t this apply to all companies?

Absolutely.  We tend to think that companies who wilfully damage the environment, that have poor social policies and have poor standards of corporate governance do not make fantastic long term investments.  Yes, these are non-financial items prima facie, but they reflect fully on the role that companies have in the communities within which they operate and can have serious implications on their reputations and prospects.

Moreover, as investment research focusses more and more on the sustainability of companies’ business models, those companies that do not embrace the need for change are likely to find there is a very real financial penalty – their ability to raise capital will be both harder and more expensive.

Over the last couple of decades, almost all companies have become technology companies, as the systems and software that underpin management processes have become more complex and more deeply enmeshed into corporate structures.  In the same way, ESG factors are increasingly becoming one of the first considerations that progressive companies make when looking at short and medium term decisions and, as with technology, will only become more important over time.

What are the prospects for 2022?

This year is likely – hopefully – to be a rather different year to 2021.  As the Covid pandemic moves to its next phase, we are likely to see the number of restrictions begin to roll back and a gradual reawakening of global travel.  Vaccines and boosters may well be with us to stay, although likely to be restricted to the more vulnerable sections of society – rather like the flu jabs have been historically.

Geopolitical challenges remain with relations between the US, China and Russia strained amid simmering tensions in the Ukraine and Taiwan.  We are already looking at the next US election where our old friend, Donald Trump, is planning another tilt at the presidency.  Brexit is the gift that keeps giving, as challenges over the status of Northern Ireland show little sign of reaching a resolution and continues to poison relations between the UK and the EU.  Boris himself is showing increasing signs that his Teflon may be wearing a bit thin, leading to much talk of a new resident in Downing Street before too long.  There is a Chinese saying ”may you live in interesting times” – it is a curse rather than a blessing – and the year ahead certainly looks like being an interesting one!

That said, from an investment perspective, 2021 was a good year, with many markets hitting all time highs.  It is hard to argue that equities are seriously undervalued and so we would temper expectations a little for the year ahead as we battle some of the headwinds I have talked about here.  There are, as always, a number of companies, sectors and regions whose prospects look good and we remain confident that a well-diversified portfolio should continue to prove resilient and – most importantly – a decent hedge against inflation.  This has been true historically and we have no reason to think it will be different this time.

I look forward to our next meeting

Best wishes for a happy and healthy 2022

Posted in Blog.