When deciding to spend money to invest, only three things really matter:
- Benefit of the asset, for example its future cash generative abilities.
- Its potential for growth.
- Identifying an appropriate discount rate. This is used to present value the future potential of any asset allowing for comparison of options.
To be successful, asset managers must apply this technical approach together with a deep knowledge of the broader macro vectors that both influence and drive the “animal spirits” of markets. This is a huge topic, which we have tried to contain and make relevant for today, under the following headings:
- Interest rates
- Inequality, regulations
We hope to provide some insights into the variables that influence where and when to invest through time.
1. Inflation – what goes up and never comes down!
Inflation exists in the nexus of supply and demand, both of which are currently working in tandem. Some examples of inflationary pressures, amongst many, are:
Supply constraints: e.g. the excess stock of cars in the US was 77k on 31 December 2021 significantly lower that the rolling average of 1 million.
Demand: pre-Covid, 41% of US 25–64-year-olds could not cover an unexpected USD400 expense, after government Covid grants, now this is just 33%.
If governments spend and money supply is allocated efficiently to money generating assets, out of control inflation should not be the result. However, this is perfection, and it is worth noting that the US fiscal deficit increased to USD3.12 trillion in 2020 from USD1.4 trillion in 2008. The Fed and the Fiscus (Washington) worked in tandem with the Fed increasing money supply monthly by USD120 billion in 2021. Now after years of disinflation (declining rates of price increases), inflation has followed as illustrated in the chart below.
Chart 7: Inflation YoY%
Source: Capital IQ
Our next chart shows the direct effect of inflation for investors. When earnings yields turn negative in real terms (this is where the yield that the market provides drops below inflation), investors are no longer being compensated to hold equities. Either inflation must drop back or share prices must fall to incentivise security owners with higher yields or companies must earn more (grow) to ensure investors are rewarded for owning shares.
Chart 8: Earnings yields follow inflation – Inflation is rising
2. Interest rates – tame the beast!
“Interest rates are to the value of assets what gravity is to matter, if I could reduce gravity’s pull by about 80%, I’d be in the Tokyo Olympics jumping.” Warren Buffett (May 2021). When interest rates are low asset prices are unconstrained by gravity and climb, which they did in 2020 and 2021. When inflation spikes begin to emerge, the Fed generally starts to make noises about increasing interest rates and in January 2022, Jerome Powell stated that “I think there’s quite a bit of room to raise interest rates without threatening the labor market.”
Naturally interest rate changes impact returns, however there is a lag-effect. The chart below looks at the real returns following 10 interest rate cutting and hiking cycles over the past 50 years. As interest rates are cut one would expect an increase in the real return, however, the interest rate cutting cycle takes time to assist the market as the negative momentum of the economy and market stay in place for a while before the relief from lower interest rates set in. Similarly, a hiking cycle takes time to bite real returns – the momentum of a buoyant market remains intact for many months before interest rates slow the system down. We believe this is important as we feel that investors are too complacent considering the Fed’s intention to increase interest rates this year.
Chart 9: S&P 500 – Average real return post change in Fed funds rate (1960 to 2021)
Source: Iress and Northstar
3. Debt – the balance sheet enemy hidden in plain sight
Debt is surging and when that happens every 10 years or so, a financial crisis tends to follow, albeit not always in the timeframe expected. The following IMF chart shows just how much of an impact Covid has had on debt levels, with the GFC a decade earlier making for a sobering comparison.
Chart 10: Global debt levels
4. Demographics – the difficulty of trying to grow with the weight of debt
A vector that tightens like a vice as the decades pass. Population size and capability are the two key drivers of economic growth. It is a well-known fact that population numbers are on the decline in developed markets.
- A study has shown that when the 50–60-year-old cohort (number of people in that age group of the population) drops below the level of 40 to 50 year olds, GDP starts to decline. In addition, as retirees make up more of a population, they start liquidating their capital into cash, also acting as a drag on markets.
- Immigration has to an extent counteracted declining population growth in developed countries but working age populations are declining. The Japanese population is expected to decline 40% between 2020 and 2100 (126 million to 76 million), as an example. The Statista chart below shows the rapidity of the decline. Interestingly the US is one of the only developed countries still growing (i.e. birthrate of more than two per couple).
Chart 11: Developed market demographics
- Globally a middle class is arising in emerging markets (EM), which is encouraging.
- Does this mean that EMs are the place to invest? China’s rapid growth is a prime example, however caution is required. Despite Africa growing its population at a pace that far outpaces developed markets, implying that it has the potential to be the engine of global GDP growth for the next century, the top 10 countries of the past 100 years remain pretty much the same today and Africa has never been in that grouping. African countries have growing populations but their GDP growth fails to match their demographic advantage, capacity concerns are a fundamental issue, South Africa being a prime example, as noted in the budget by Minister Gondongwana.
5. Inequality driving regulation – restoring balance
Common prosperity in China, wealth tax proposals in the US and the multitude of labour regulations in SA are all attempting to restore balance against skewed wealth. Whilst we are all aware that SA has a terrible Gini coefficient(the ratio that represents the difference in wealth between the rich and the poor), this is a global challenge, and the chart below speaks for itself.
Chart 12: Wealth of the top 10 Global billionaires relative to country GDP levels
Sources: IPS analysis of Forbes’ live billionaire list and World Bank: UN Population estimates (as of 18 Jan 2022) versus select country GDPs, 2020
There are very real-world implications to these governmental initiatives or wealth interventions on asset prices in the market, Tencent (the driver of Naspers, Prosus) being a good example. Its share price decreased 40% between February 2021 and December 2021.
Valuation and conclusion – perfection ahead?
Markets appear to be hoping for a smooth, open highway of growth. The car is running well, but potentially starting to overheat and the traffic police (Central banks) are out to slow things down:
- S&P margins, which are an important element to the Earnings (E) component of the Share Price (P)/E equation, are at all-time highs. Whilst technology and efficiency have helped improve the profitability of US firms, given time competition will extract its toll.
- Current low real yields tend also to predicate market corrections historically.
- The Cyclically (C) Adjusted (A) P/E ratio (CAPE) attempts to smooth out the basic P/E ratio, which exists only at one point in time. The CAPE creates a longer-term rolling ratio, smoothing out for example the base effects of depressed earnings followed by profit bounce backs. The S&P CAPE is not too far off 2000 highs.
These assessments are certainly useful clear warning flags about markets and stocks in general. How do we navigate these markets where there is potentially nowhere else to invest (TINA)?
- Scan across bourses globally and seek to identify opportunities in areas that that are relatively better priced.
- Understand the relative valuations across different asset classes and invest in those where the risk versus reward balance is in our favour – see our framework below indicating which assets are meeting their required return hurdles (in red).
- Be cautious to simply buy an index, particularly when markets are high. Indices are an average, which is not perfect, for example most people think they are above average. Some companies will be overvalued and some undervalued – undertaking consistent accurate research assists to avoid overvalued companies and directs us to better valued businesses.
- Invest in quality companies with strong balance sheets which are able to withstand inflation and interest rate hikes and that have established future cashflows that are not all weighted in the future.
Currently our funds are positioned according to the following chart. For example, in our Northstar SCI Managed Fund, towards the end of last year, we reduced offshore equities and increased SA bonds. Following the recent boring but safe SA budget, we hope that investors will better appreciate SA bonds – we believe that these will generate strong returns for us.
Chart 13: Expected returns vs hurdle rates
Source: Northstar, Iress, JSE, Capital IQ & Bloomberg
Events such as Covid and currently the Ukraine crisis can throw spanners in the works, but having a long-term strategic plan and using quantitative and qualitative tools to constantly assess the many variables that shape the investing ecosystem, ensures consistent long-term outcomes for patient investors.