Analysis for Wealth DFM from the Global equity team, Nikko Asset Management
Sitting on a beach feels like a distant prospect in Scotland at this time of year as the temperature struggles to get much above 5 degrees centigrade and the rain continues to fall. An ability to look forward to better times and remain optimistic is invaluable. These attributes are no less helpful when investing in equities. Whilst you can get an unpleasant surprise from misjudging the direction of the tide while enjoying your picnic, the consequences for misjudging the direction of the liquidity waves look more pronounced than ever as we enter 2022.
Recent pronouncements, including the most recent minutes from their policy committee meeting, suggest that the US Federal Reserve (Fed) are keen to hammer home the message that they remain in control of inflation (and that bond investors are not). They certainly have the weapons at their disposal to bring prices under control again, but their choice of weapon will be critical if they want to do so without sparking significant asset price volatility.
Whilst tapering ongoing liquidity injections is fairly uncontroversial, actually withdrawing liquidity would likely prove more problematic for asset prices, given the tight correlation observed in recent years between equity markets and the size of the Fed’s balance sheet. Interest rates are a more vexed issue still. Even if inflation does moderate in 2022 as some of the short-term impacts of COVID-19 on supply chains ease, real interest rates will likely remain deeply negative—stimulating spending and investment. All else being equal, the Fed would probably like to get rates to at least neutral, but this would require several rate hikes from here. With US government debt running at around USD 29 trillion, it remains unlikely that hiking the cost of servicing this debt would be acceptable to politicians—especially in an election year.
Equity market leadership of late is reflective of an increased realisation that the tide is shifting. High beta equities and those with relatively high leverage continue to underperform, as do more speculative investments such as IPOs, cryptocurrencies and concept stocks with unproven business models. Quality and cash generation are becoming more valuable but there is evidence of some divergence here too. The divergence has been characterised as being between value and growth, US and ex-US and COVID-19 winners and COVID-19 losers. Whatever the correct cause, share prices are reacting fairly violently.
The early stages of any market rotation can be somewhat indiscriminate, with hastily assembled buckets of stocks often trading together based on only superficial similarities. This is especially true when the starting point for the rotation is extreme by historical standards (as in this case). Rotations are often the most brutal at the start of the year too.
We are not saying that style rotation or factor-based investment are wrong or unfair. That would be seriously stretching the truth and exposing us to legitimate charges of double standards. After all, some of our holdings have doubtless benefitted from this in recent years. We have regularly taken profits in holdings when our research suggested that the share price had become detached from the underlying cash generation. The prevailing market direction suggests that we have not done this enough, but in the vast majority of cases, we continue to believe that our investments are appropriately valued over the medium to longer-term. Price discovery could take a while longer, but it seems to us that self-sustaining cash generation is likely to become more rather than less valuable if the Fed is really changing tack.
This is even before you consider some of the macroeconomic risks that exist at present. There are various issues that we continue to monitor. These include questioning China’s ability to meaningfully curtail real estate trading without damaging investor confidence and the impact of worker shortages on economic growth in most major economies—especially if increasing immigration is seen as political suicide.
In conclusion, when share prices are being whipped around to such a pronounced extent, the temptation is to take action, regardless of one’s conviction in it. Experience teaches us that it is normally best to resist this urge and focus instead on the principles of Future Quality investing. Returning to the beach analogy from the start of this piece, we will soon find out who gets caught out if the liquidity tide goes out. We remain confident that strong cash generation is the best protection against such events.