Fight or flight?
Global markets came under severe pressure over the past few days. The inflation genie is not getting back in the bottle voluntarily and will have to be forced in by central banks. Investors therefore must adjust their expectations for interest rates, company profits and the margin of safety that is appropriate in the current environment. Nonetheless, when there is a big correction, the first question serious investors should ask is not “should I sell?” but rather “should I buy?”
This goes against the fight or flight instinct. We still perceive threats very instinctively with the part of our brains that evolved at a time when lions or snakes were common and deadly risks. Financial risks are not life-threatening, but our brain can still perceive them as such, until the more rational part kicks in and takes over. The great behavioural scientist and Nobel laureate Daniel Kahneman refers to these two cognitive responses as System 1 and System 2 thinking. System 1 operates intuitively, automatically and rapidly, relying on past information to make snap decisions about the current situation. Its ability to make decisions in microseconds saves countless lives in tight situations but also often leads to the wrong conclusions when there is nuance and complexity. System 2 is analytical and calculating but requires effort and time to get going. It can still make cognitive mistakes, but when investing, we should rely on the more deliberate System 2, rather than default to System 1 when the adrenaline starts pumping. In simple terms, System 1 will tell you to get out of the markets when you should be buying or vice versa. So, let’s give System 2 a chance to rationally assess the situation and conclude. This means looking at the macro-outlook, and then the valuations for each asset class.
Hawks in full flight
First of all, the big macro headwind is clearly inflation and central bank response. Inflation hit 8.6% in May in the US. Coming from an emerging market environment where inflation can be volatile, this might not sound so terrible (SA inflation briefly hit 7% in early 2016 and was above 8% in early 2009). But it is hard to overstate how much of a shock this is to people used to low and steady inflation. Inflation was last this high during the early 1980s in Europe and North America.
While US inflation was initially driven by rising prices of fuel and a handful of lockdown-impacted items, it has now broadened out considerably. Moreover, it is not as if energy prices have eased noticeably. No matter how it is sliced and diced, inflation seems to be becoming entrenched. Consumer surveys shows that ordinary folk now expect relatively high inflation to persist. This is not what any central banker wants to see.
In response, the US Federal Reserve hiked its policy interest rate by 75 basis points last week, the biggest rate increase since 1994. The previous meeting delivered a 50 basis point hike and the one before, 25 basis points. The increased increments point to a deeply worried central bank that believes the time for playing nice is over. It is time to fight back against inflation, even if it hurts markets and results in rising unemployment.
Every quarter, the forecasts of senior officials at the Federal Reserve and its regional banks are plotted anonymously. This “dot plot” gives a strong indication of what the collective mind of the central bank expects of the future. It shows how rapidly the Fed – and markets – have had to ratchet up interest rate expectations. In December, the dot plot pointed to short rates peaking at 2.1% by end 2023. In March, it rose to 3%. The latest estimate was boosted to almost 4%. Bearing in mind that the actual rate was 0% at the start of the year, this is a mighty quick dose of tightening.
But it must happen since the Fed now expects inflation to only return to the 2% target by 2024, even with all these rate hikes. Supply improvements will help, but ultimately the US economy has to cool substantially on the demand side to bring inflation back to acceptable levels. If it tips into recession, it appears the Fed will view it as unfortunate but necessary collateral damage. The Fed cannot bail out the markets and the economy until there is “clear and convincing” evidence (Fed Chair Jerome Powell’s phrase) that inflation is heading back to target.
In the same week, the Bank of England hiked its policy rate by 25 basis points, as expected, while warning that inflation could hit double digits soon. On the other hand, the Swiss National Bank surprised markets by increasing rates for the first time since 2007. In other words, the Fed is far from the only central bank in full hawkish flight.
A well-known Irish joke refers to a traveller asking for directions to Dublin. The local shakes his head, “If I were going to Dublin, I wouldn’t start from here.” Where you start matters. The better the starting point, the easier to get to your destination.
In investing, the best starting point is when an asset class is cheap relative to estimates of the cash flows it can be expected to deliver over time. When it is cheap, you don’t have to make heroic assumptions about those cash flows. When it is expensive, the cash flows will need to outperform to deliver any kind of return. In other words, you can buy a fantastic company with a strong brand and loyal customers. But if you pay too much for it – if there is too much good news priced in – returns are likely to disappoint. The technology shares come to mind here. Fantastic transformative companies they might be, but investors just expected too much from them and now their share prices have fallen a lot. Usually, assets are expensive after a period of strong growth. Often, it is precisely when growth starts to settle down towards more normal levels that people jump in to buy at elevated valuations – this is System 1 at work.
So, let’s look at the major asset classes at a high level.