Pieter Hundersmarck, Flagship Asset Management’s Global Multi-Asset Portfolio Manager
Three major themes are driving the current volatility in international stock markets.
The first is the market’s concern around the extent and duration of US inflation and, linked to that, the policy response of the US Federal Reserve. US interest rates are the primary driver of global interest rates and have far-reaching effects on all asset markets.
The second is the market’s concern around a weaker earnings cycle in 2022. Investors fear that stretched supply chains, rising wages and pricing pressure may all feed into weaker earnings from the pandemic-fueled highs of 2020 and 2021. With many stocks trading above their long-term averages, a fall in expected earnings would lead to material share price declines.
The third theme is the geopolitical risk unfolding in China and Russia and their related effects on international stability. An unpredictable global environment impacts sentiment and investor confidence. Fears that Russia may unsettle energy markets and China may do the unthinkable towards Taiwan all play into this unpredictability.
Taking each in turn:
Inflation and the Federal Reserve
The Fed is in charge of managing price stability and maximum employment. While initially believing inflation to be transient, the Fed now believes it will be more persistent, and that interest rate increases are warranted. The Fed Fund Futures are signalling that the market believes they will raise rates in their March meeting by roughly a quarter of a percent (25 basis points).
While this is expected, subsequent moves beyond the initial 25 basis point hike are anyone’s guess. The two largest unknowns are the speed and the ultimate level that interest rates in the US will reach. The speed is important: if the Fed hits the brakes on the economy too swiftly, it will lead to unnecessary distress and uncertainty, and if they raise rates too slowly, they risk inflation becoming a self-perpetuating cycle.
The Fed has stated it believes the peak of the hiking cycle to be between 2 and 2.5%. To reach this level, the glide path needs to be well communicated, and crucially, the conditions present in the economy need to warrant interest rate increases to that level.
The Fed’s task is not an easy one. The volatility in markets is testimony to the fear that the Fed may act incorrectly. If the Fed raises rates into a slowing economy, as many fear may be the case, it will be a disaster for all asset classes.
A weaker earnings cycle in 2022
Global supply chains were built on just-in-time delivery and smooth geographic consumption patterns. They have also depended on a predictable flow of trade between the US and China.
Economies re-opening and massive amounts of fiscal stimulus have dramatically increased the ask on global supply chains since the first half of 2021. Much of the impact is expected to be temporary, but key areas like semiconductors and commodities are less likely to be sorted out shorter term.
According to FactSet, 60% of S&P 500 companies are citing the negative impact of labour costs for Q4 on earnings calls. Key pinch points remain in hospitality, trade and logistics-related industries, all of which feed into a cycle of wage inflation that is difficult to break.
Missed earnings expectations (such as those seen at Goldman Sachs, Netflix and Peloton) are adding to the worry that all is not well. The reasoning is that if you can’t do well in times when the Fed is printing money, and interest rates are at all-time lows, you’re probably not going to do well when those conditions change.
Geopolitical Risks
Currently, the risks around a conflict between China and Taiwan seem remote. Practically an invasion of Taiwan looks unachievable without an enormous loss of life (on both sides) and immediate pariah status for China. However, the risks have moved from ‘near zero’ to ‘remote’ rather swiftly as China has asserted itself more aggressively in the past five years.
The prospect of Russian aggression towards Ukraine looks less remote. Like Xi’s obsession with Taiwan, Russian president Putin has made clear his ultimate goal of unifying Russia and Ukraine. And he is backing it up with troops and ‘red lines’ that western nations would never accept. The consequences of Russian sanctions on global energy and commodity markets will be negative and will stoke further inflation.
Nothing is ever certain. There are only degrees of uncertainty.
Markets are a reflection of our humanity. We enjoy and will pay more for certainty, and this is echoed in investments. There’s almost a petulance to this claim though: nothing is ever certain. So, we are left trying to contemplate the changes in the uncertainty continuum, moving from ‘slightly uncertain’ to ‘highly uncertain’.
And what shares to own in this environment? Think long-term, and look carefully at what businesses are in your portfolio. Because that is ultimately what a share is: part ownership of a business. Be sure your portfolio of businesses can still thrive in a world with higher interest rates, a drop in the market PE multiple, and more headwinds than tailwinds to their earnings streams in the year to come. If not, your capital is at more risk than it should be.
This doesn’t mean that you should go and buy tobacco and beer stocks or traditional consumer staples stocks. Most of these trade at high multiples, have diminished opportunity sets and far too much debt on their balance sheets. It will suffice to find businesses with low gearing, trading at a fair multiple in relation to their prospects and with structural (rather than purely cyclical) growth prospects.
Dick’s Sporting Goods (DSG), a recent addition to the Flagship global portfolio, is one such example. While US consumption may flatline, DSG has an enormous opportunity to increase its ecommerce sales and leverage its existing infrastructure to do so, thus boosting its margins. The Company has little debt and trades at an undemanding multiple of 11x this year’s earnings.
Ubisoft, a French video gaming company, is another example. Gaming is a traditionally defensive revenue stream. Ubisoft has a number of new initiatives in mobile and AAA games that will allow revenue to grow irrespective of macro conditions, supply chains or interest rates. The Company trades on less than 3x sales, which is very cheap in relation to its prospects.
Be choosy, and be active
Global stock markets have been vulnerable to interest rate changes for over a decade, and this is hardly the first article to point this out. If the current volatility presages a bear market, it pays for investors to be selective about the stocks they buy. This means making hard decisions on what to hold and what to sell, and keeping some cash on the sidelines.
The extends to being selective about your unit trusts as well. Unconstrainted worldwide flexible funds – as well as good hedge funds - will thrive in this environment if their mandate allows. A focus on absolute return, rather than relative return, is paramount.
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