Real Return Team Viewpoint

The beatings will continue until morale improves.

Unknown

Marked to Market

2022 was a brutal year for financial-market participants. Global stocks and bonds lost more than US$30 trillion in value – the largest losses in asset markets since the global financial crisis.¹ The market value of companies traded across all global stock exchanges tumbled by US$25 trillion, and the MSCI All Country World Index of developed and emerging-market equities finished the year down 19.8% in US-dollar terms.²

Those investors looking to their government bond holdings to offset the losses were sorely disappointed. Bloomberg’s Multiverse index, which tracks global government and corporate debt, was down almost 16% – US$9.6 trillion in market-value terms. The US 10-year Treasury closed the year yielding 3.87% – a level not seen since 2010 – with an annual increase of 2.36%, the largest rise since at least 1953. The US 2-year Treasury, meanwhile, was yielding 4.43% as the year ended, chalking up a 3.69% increase – the largest annual rise since regular issuance began in 1972.³ The record-setting moves in bond yields have coincided with one of the greatest monetary-policy tightening cycles in history, as consumer price index (CPI) measures of inflation accelerated to multi-decade highs in the US and across Europe.

The upside of 2022 is that the vertiginous rise in inflation and interest rates has seen what we believe to have been the hokum economic theories put forward to explain low nominal growth and interest rates vanish without a trace. Former US Treasury Secretary Larry Summers’ ‘new normal’ of secular stagnation is no more, while former Federal Reserve (Fed) Chair Ben Bernanke’s global savings glut vanished in a few short months. Once again, central bankers and economists have been marked to market and the returns are poor.

Blue Skies on the Horizon?

At the turn of the year, investors and traders are looking to pick themselves up and dust themselves down from the beating of 2022. Needless to say, a lot went wrong for asset prices last year, and there is a case to be made that some of the key headwinds are set to ameliorate as we enter 2023.

Central banks tightened far more aggressively in 2022 than markets expected. In December 2021, the market was pricing in around 0.70% of Fed interest-rate hikes during 2022, but as 2022 ended the Federal Open Market Committee had served up combined rises of 4.25% for investors’ delectation.

We have argued since early 2020 that several developments were feeding the forces of a structural acceleration of inflation, and that the inflationary impulse of 2021 would extend into 2022, confounding the transitory inflation consensus. But while we are of the view that we have entered a period of secular inflation, this does not mean that there will not be cyclical decelerations of inflation. Indeed, CPI measures of inflation began to cool during the fourth quarter of 2022, with a number of updates coming in below expectations in the US and Europe. In combination with the easing of hawkish rhetoric by some central banks, in particular the Fed, some investors are looking forward to a halt in monetary-policy hostilities. There remains substantial uncertainty as to the path of interest rates into 2023, but as long as inflation is generally trending lower, we think it is highly unlikely central banks will repeat the kind of aggression we saw in 2022.

The other major headwind of 2022 was the continued economic slowdown in China. Things have moved quickly since Xi Jinping tightened his grip on power in October, securing an unprecedented third term as president. The new term got off to an inauspicious start as November’s mass protests against continuing Covid restrictions meant that the ‘dynamic clearing’ strategy of centralized quarantine and locking down the populations of cities in order to prevent the transmission of the virus was no longer tenable. After three years of restrictions, Beijing has abandoned its zero-Covid strategy, and so rapid was the policy volte-face that investors were largely taken by surprise. Over the course of December, the easing of restrictions proved even more far-reaching and less cautious than outlined by Beijing at the turn of the month. Consequently, heading into 2023, the second-largest economy in the world is opening up after being in lockdown for three years.

Inevitably, investors are applying the reopening playbook from the US and Europe to China. Many are anticipating a surge in consumption thanks to three years of pent-up demand. Household savings in China have increased substantially, as they did in the US, with Chinese households having around 50% more cash in their bank accounts today than when the pandemic began.⁴ While there are reasons to believe that the recovery in consumption will fall short of that seen in the West, and particularly in the US, China looks set to see an improvement in 2023 once the current surge of infections has subsided. Additionally, Beijing has announced a raft of monetary and fiscal policy-easing measures to support the economy.

As we see it, the reopening will not solve the structural problems of the Chinese property sector, but a cyclical upswing is probable. A lack of sales thanks to absent buyers has no doubt been an issue, but Beijing’s efforts to deleverage the bloated property developer industry have been the main cause of the sector’s financial troubles. Cash-strapped firms have had to suspend work on many construction projects. In turn, buyers have been reluctant to put down money for pre-sales if they are unsure whether developers will complete the units, given their questionable finances.

Developer finances are still tight, but we believe this vicious cycle is likely to break soon. Policies rolled out in November will give developers the cash to resume building, and Beijing has pledged more support if required. With plenty of cash on hand, mortgage rates that declined by 1.3% over the first three quarters of 2022, and an increase in confidence that developers will finish projects, we believe buyers will return to the market. For all the talk from Beijing of moving China up the value chain, the property sector remains the fulcrum of the Chinese economy. Reduced construction activity has been a major headwind to economic activity over the last two years, and that activity is likely to see a significant improvement in 2023.

The outlook for China’s longer-term growth prospects remains concerning to us. Nevertheless, with China reopening rapidly, monetary and fiscal policy being eased, and support being provided to the property sector, we think China is likely to see a significant shorter-term cyclical recovery. After two years in which China has been a drag on global growth, we believe it is very likely that the country will, at least from a growth perspective, become a tailwind in 2023.

From a macro financial perspective, a lot went wrong in 2022. This has left many with a dim view of the outlook, and the consensus is for a recession at some point in the year ahead.

However, with scope for central banks to ease up on the brakes, China stimulating, and the energy-driven terms-of-trade shock easing, there is a case to be made that 2022 was the darkness before the dawn. After things went so wrong on multiple fronts, it would not be hard for things to be less bad; markets are made on the margin, and this would augur for a better 2023.

Graham vs. Soros

Benjamin Graham arguably did more for the investment management industry than any other individual. Thanks to the prolific success of his mentee, Warren Buffett, the lessons espoused in Graham’s book The Intelligent Investor have been written into investment lore. The CFA Institute went one better and institutionalized Graham’s ideas in the Chartered Financial Analyst program. The received wisdom within the investment management industry is that the intrinsic value of a security is the sum of the discounted future cash flows. Perhaps this is why, when people seek to explain the moves in a share price, there is a tendency to do so with recourse to some variable in a valuation model – the cost of capital has gone up, the earnings outlook has dimmed, or the dividend has increased.

But before the investment management industry, there was the money management industry, which had existed for centuries prior to the birth of investment management in the 1950s. In the money management industry, there was no intrinsic value, and custodians of capital sought to grow that capital through what the investment management industry refers to as ‘speculation’. No doubt many investors have had considerable success following the teachings of Graham and Buffett, but focusing on fundamental analysis to navigate markets has arguably diminished the hive’s understanding of the forces that drive market outcomes.

According to the rules of investment management this does not matter, and the shorter-term moves in markets are not important. What matters is that, over time, price will converge on intrinsic value; investors should therefore focus on determining the intrinsic value of a security, buy when the price is below, and sell when it is above. This is the essence of Buffett’s well-worn quote “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” But is this true?

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

Warren Buffett

In his book The Alchemy of Finance, George Soros critiqued the fundamental/intrinsic value school of investing. He noted that the connection between stock prices and the companies whose stocks are traded is assumed to be in one direction – a linear problem to be solved in which a company’s fundamentals determine the share price. The possibility that changes in a company’s share price may affect the fundamentals of the company is neglected. Soros wrote that “stock market valuations have a direct way of influencing underlying values: through the issue and repurchase of shares and options and through corporate transactions of all kinds – mergers, acquisitions, going public, going private, and so on. There are also more subtle ways in which stock prices may influence the standing of a company: credit rating, consumer acceptance, management credibility, etc. The influence of these factors on a stock’s worth is, of course, fully recognized; it is the influence of stock prices on these factors that is so strangely ignored by the fundamentalist approach.”

Soros was effectively arguing that there is a reflexive relationship between the price of a company’s stock (or debt) and the company’s fundamentals. When a company’s valuation is rising, it positively affects the variables referenced by fundamental analysts. Conversely, when a company’s valuation is declining, it has a negative impact on the variables referenced by fundamental analysts.

What relevance does this have to today’s markets?

Liquidity, Valuation and Fundamentals

After witnessing the effects of 15 years of not-so-‘extraordinary’ monetary-policy intervention, few would argue that central-bank liquidity does not affect asset prices. The steady flow of central bank-minted liquidity into the financial system inflated asset prices, pushing valuations to historic extremes across asset classes. As central banks have belatedly responded to multi-decade highs in inflation by aggressively tightening monetary policy, asset prices have declined. The cost of capital is rising across the financial system.

Clearly, this has consequence for valuations. But to Soros’ point, it is not only valuations that have been inflated over this period; fundamentals have been inflated too. Access to cheaper financial capital makes all manner of things possible. It lowers the required return on investment for capital expenditure to drive organic growth. Companies are able to use the low cost of capital that a rich valuation affords to fund growth through acquisitions, while those businesses that are unable to grow earnings per share by investing can do so by buying back their shares.

Not all companies benefited equally, and those companies that saw their valuations inflated the most are likely to have seen the greatest benefit to their fundamentals. In the low-growth, post financial-crisis world this was those companies that were seen to be able to grow earnings. Central-bank largesse disproportionally benefited not just the price but also the fundamentals of these companies.

In 2022 some of the US tech heavyweights saw their share prices tumble by 30-40% or more, with others losing almost two thirds of their value. The scale of the price declines has investors rightly looking at these companies to see if they offer value. But with central banks now constrained by inflation, it appears unlikely to us that these companies will see their valuations return to the levels of recent years. They have been subjected to a long-term increase in their cost of financial capital, and with it we believe their fundamentals are likely to have deteriorated, both in absolute terms and relative to the market. That is not to say that these companies are now bad businesses. However, it does mean that investors should be aware that price is not the only variable to assess when considering the investment case.

Liquidity and Volatility

Liquidity and volatility are two sides of the same coin. When liquidity is abundant, it suppresses volatility, incentivizes risk taking and, in doing so, leads to the misallocation of capital. When liquidity ebbs, volatility increases and risk-taking declines. If liquidity falls below some threshold, misallocations of capital are exposed and the bills fall due. In his 1867 article On Credit Cycles and the Origin of Commercial Panics, John Stuart Mill wrote that “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” As central banks continue to withdraw liquidity, we think investors should be prepared for continued market volatility. No doubt the misallocations of capital made possible by years of central-bank largesse will continue to be exposed. The implosion of Sam Bankman-Fried’s cryptocurrency ‘exchange’ in late 2022 is perhaps the most conspicuous example to date of this cycle.

Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.

John Stuart Mill

After the incineration of capital in the grinding bear market of 2022, one might think investors would be prepared for tail risks in 2023. A reasonable assumption, but we believe it would be wrong. The S&P 500 Skew index, which indicates the extent to which market participants are pricing in tail risks, has been trading near the bottom of its historical range.⁵ The higher the Skew index, the greater the premium the market is placing on out-of-the-money puts over out-of-the-money calls – in other words, the greater the demand for equity downside protection versus upside exposure in the options market.

Part of the reason the Skew index has been low is because exposure to risk assets has been steadily reduced over the course of 2022, meaning there is less need for downside protection. The other reason is that 2022’s relentless bear market meant that downside hedges did not work as intended and instead have proven to be a drag on performance. As is their wont, investors have abandoned what did not work. The Skew index being at close-to-historical lows suggests to us a degree of complacency among market participants, which stands in sharp contrast to the start of 2022 when the index was near the top of its historical range. Ironically, the lack of downside hedging makes left-tail events more probable, and we think investors should be wary of such risks given the apparent sense of security.

The New ‘New Normal’

As we consign last year to history, the principal concern among investors is now recession, while there has been a noticeable decline in anxiety regarding central-bank monetary-policy tightening. As outlined above, there is a reasonable case to be made that the global economy could improve in 2023. Conversely, we believe that the undertow of weaker liquidity is likely to remain a continuing challenge for financial markets. The reality is that global quantitative tightening is only just getting started. The Fed was still buying bonds through the first quarter of 2022, while the process to shrink its balance sheet did not really get into its stride until September. Furthermore, the European Central Bank has not even begun its quantitative-tightening program yet, with a launch date set for March 2023. Central bank balance-sheet reduction is set to take place in tandem with a broad tightening of US bank capital. So, while market participants speculate about the Fed’s ‘terminal rate’, we believe liquidity is set to continue weakening into 2023, pause or no pause. Consequently, we think economic and market volatility is set to continue. Welcome to the new normal.

¹ Stock and bond markets shed more than $30tn in ‘brutal’ 2022, Financial Times, December 30, 2022
² Source: FactSet, January 2023.
³ Source: FactSet, January 2023.
⁴ Source: FactSet, January 2023.
⁵ Source: FactSet, January 2023.