For sale: a disorientated, disillusioned but undefeated market

Forays into hitherto unknown territory and the end of a golden age have left global markets disorientated

I started my career in 1993, working in fixed-income markets. These soon turned particularly sour, as the great bond massacre of 1994 brought heavy losses for anyone caught holding long-term debt. But rapidly, bond yields moved back into their historical downtrend and maintained it until the end of the 2010s, against a backdrop of relentless deflationary pressure. Throughout this long period, the US consumer price index (CPI) never got higher than 7%. But the latest CPI puts US inflation at 8.5%, a level unseen since 1982. This is just one example of numbers moving into unknown territory and this phenomenon accounts for much of the nail-biting going on among investors at the moment.

Bonds no longer look all that safe

Who would have thought you could lose so much money on top-rated, liquid, sovereign bonds in strong currencies? In the last two or three years, however, losses have sometimes been severe. For instance, the Swiss Confederation 2049 4% bond has lost a third of its face value. This, for a triple-A rated bond that is liquid and denominated in the mighty Swiss franc…

What is more, while diversified portfolios have often used these long-duration securities as a counterweight during equity bear markets, this is not the case today. Basically, everything has changed… Admittedly, central banks, with the Fed to the fore, led us into some bad habits. Since the 1998 LTCM crisis, the Fed has almost systematically adopted an expansionist policy, in some cases to an outrageous extent when danger loomed. And all too often the other big central banks followed suit. For many, Mr Powell’s current stoicism is a surprise. We are in unknown territory.

Commodities matter again

Commodities, the relics of an ancient economy that seemed obsolete in the age of virtual reality, are violently reminding us that what they actually are is raw materials and that their price fluctuations and availability can be critically important. Suddenly, for a number of reasons, the time of plenty, with instant access to energy, mining and agricultural resources, seems to be under threat, with the obvious effect of a rise in prices and, in some cases, a squeeze on supply. And producers, although sometimes hampered by supply chain and logistics problems, find themselves suddenly in favour, a fairly novel situation. Once again, we find ourselves in unknown territory.

Price, the forgotten factor

Everything is inter-related: commodities, inflation, central banks and interest rates. One indirect consequence of their interplay is the return of a basic factor in investment: price… Not absolute price, but value gauged by how expensive or affordable an asset is. Higher interest rates automatically reduce the value of future financial flows through the discounting effect and therefore undermine the highest-priced assets.

One consequence of the ever more accommodative stance of central banks has been to mask the importance of value. This effect reached its apotheosis in the record prices for many speculative niches of the financial markets, such as crypto-currencies, start-ups or young, promising but unprofitable companies going by names such as Moonshot, Spacs, Meme, etc. Without reaching such extremes, almost all the Growth stocks became overvalued and hence vulnerable to a renormalisation of interest rates. This is what has been happening since the fourth quarter of 2021. While growth stocks had consistently outperformed for the past 15 years, this cycle is now in doubt and we find ourselves once again in unknown territory.

The uneven ground of “value” investing

Long periods where “growth” stocks outperform, such as the one we have just lived through, are relatively comfortable: besides returning attractive performance, holding nice familiar growth stocks is reassuring. Companies generate regular profit growth, post healthy balance sheets, and, in most cases, escape violent shocks in their business markets. In contrast, periods when “value” stocks are outperforming, such as we have seen since the turn of the year, are anything but comfortable. By the nature of their businesses, most companies in the “value” universe face plenty of volatility in supply costs, selling prices, cost of debt, etc. In fact, the market variations of cyclical “value” stocks are often far more chaotic than those of their defensive “growth” peers. This investment approach is made all the more complex as many investors have never before seen such a reversal of performance, having only entered the markets over the last 15 years, to see growth stocks outperform.

The welcome surprise of major international stocks

With no reliable road map, investors, like ancient travellers exploring a “terra incognita”, risk losing their way in the unwelcoming deserts. Fortunately, there are some welcoming, fertile, oases where they can shelter: “major international stocks”. This asset class enjoys the competitive advantage of scale: with no geographical or sector constraints, such firms are continuously and dynamically being recycled. The leaders change, disappear and reappear from one moment to another. It is very different from what happens in a closed market, whether a region, country, sector or style, and it is why the big global indices show flattering curves over the long term. And it is therefore a source of hope. The corrections we are now seeing are significant, even if markets have not yet seriously downgraded values. Increasingly, we are seeing areas of value pop up, unlike in recent years when we have seen, instead, one area of overvaluation and speculation after another. True, this is yet another foray into unknown territory, but this time it is a good thing.