We are living through a time of falling asset prices. It started with the most liquid assets – equity and fixed income – and will begin to appear in less liquid assets, such as property and infrastructure, in the near future.
This fall in asset prices has its origin in rising inflation, and therefore interest rate expectations. Interest rates, alongside future profits, are a core input into the value of assets and the higher they go, the less assets are worth. Given all the value of an asset is based on the future profits created from it, discounted back at an appropriate (interest rate-influenced) rate, it begs the question, what is the future worth?
In recent decades, the future has been worth much more than in the past. If we go back to the early 1980s, it was a world of high inflation and double-digit interest rates. Over the next 40 years we saw a steady downtrend in inflation and therefore interest rates, as technology and globalisation, among other things, had a favourable influence. Equally there has been a sustained and material increase in the profitability of companies, as a combination of innovation and operational efficiency has allowed businesses to make much higher profits.
Falling interest rates and rising profits have been a potent and positive influence on asset prices, one feeding on the other to result in a material increase in value. We are in a time of concern about the path of both these variables, which in turn is leading to lower asset prices. So, is the best time to own assets behind us? Yes and no.
There is little doubt the tailwind from falling interest rates is behind us. In a mathematical sense, it had to end. Falling from the 15% level of the early 1980s, we had reached levels close to zero. At best, interest rates would have remained flat, instead they have ratcheted higher as central banks seek to rein in inflation. The speed at which interest rate expectations have increased has been astounding. At one point, shortly after the UK government announced its new fiscal plan, fixed income markets were discounting 6% interest rates in the UK by the end of 2023! We doubt this will occur due to the economic damage it would inflict, but it is symptomatic of how unanchored expectations have become.
Interestingly, interest rate expectations are now back to where they were in the 2000s, before the financial crisis and the first use of quantitative easing. Also, equity markets are strongly suggesting that interest rates in the range of 5-6% would be overtightening, as reflected by double digit falls in September. It is possible that we have seen the worst of the adjustment in interest rates, and therefore fixed income, markets. Whichever way we cut it though, we will have to get used to a higher level of interest rates, at least for the foreseeable future, than in recent years. This has already lowered asset prices.
More positive is the long-term outlook for the profit side of the equation. One of our favourite ways of thinking about the world is atoms, bytes, and genes. Everything around us is made from one of them, so following trends in these areas is a great proxy for innovation and future profitability. In recent years we have seen the evolution of artificial intelligence (bytes), mRNA (genes) and semiconductors (atoms) in ways not predicted even a decade ago.
Our sense from talking to the companies that we invest in is that we are only just getting started. It seems to us there is a high probability that innovation will continue apace, and sustainable investors who focus on innovations that make the world cleaner, safer, healthier, and more inclusive will the see the profitability of the companies they own increase in the coming years. In the short term this may be impacted by weaker economic conditions, but we suspect the trend towards decarbonisation, digitisation, and improved healthcare – three of many areas we invest in – will continue.
Putting this all together, future returns may be lower than the past as only one of the two variables, profits, will be a tailwind in the coming years. That said this does not mean, provided the adjustment in interest rate expectations is behind us, that future returns for investors cannot be attractive. Indeed, fixed income looks much more attractive now after its correction, and equities have removed any overvaluation that may have been present at the end of last year. Amid all the recent pessimism may be a more favourable entry point for investors. In conclusion, we still think the future is worth more than the past, and that will be to the long-term benefit of investors.
How do bear markets end? Gradually, then suddenly
As we have previously written, we are undoubtably in a bear market. We are believers in the 10/20/50 rule for equity investing. This states that each year, equities will fall by 10% (at some point) due to a non-systemic issue, such as trade wars. Every five years or so there will be a recession, leading to a fall of 20% in equity prices. And every 10 years, it predicts there will be an issue so systemic that equity prices will fall by 50%. It’s only a rough rule and not exactly scientific, but it prepares you for market falls.
Although the past is no guide to future performance, in the past equities recouped their losses and made new highs. The last two 50% declines in equity markets were 2000-2002, when an economic slowdown after the technology bubble, accentuated by the terrorist attacks of 2001, led investors to abandon equity investing. The other, during the financial crisis of 2008-9, was led by a near-collapse of the global banking sector.
No one knows, with the S&P 500 down 25% and Nasdaq down more than 35% from their highs, if current conditions will turn into a bear market of the 50% variety but we sense it could be coming to a head. Bear markets tend to end quickly. Hemmingway was asked how he went broke, to which he answered “gradually, then suddenly”! Bear markets are like that. They start gradually as many investors don’t see or acknowledge the change in circumstances. They accelerate as investors see the reality, then panic and sell for emotive rather than rational reasons. This tends to lead to the last leg of bear markets happening quickly, often with further sizeable falls. Once this has happened, the next bull market begins, born from despair and low valuations.
Sentiment in markets is very negative. Indicators of sentiment, often used as contrarian indicators, are near historic lows and we can attest to that based on discussions with other investors. Most investors are now aware of the inflationary and economic problems the world faces, in a way they were not only a few months ago. Counter intuitively this is a good thing, as it suggests expectations in key investment markets are starting to reflect reality. We certainly think equity markets, for example, could be more sensitive to unexpected, good news (inflation falling, a change in central bank policy or an end to the war in Ukraine) than further bad news. We agree that the economic outlook is darkening, and inflation looks far from being under control, but everyone we meet thinks that too, which is noteworthy.
Should there be one final leg down in this bear market, it may happen quickly as investors capitulate in the way they have in other major bear markets. That final leg down, were it to happen, should provide some very interesting opportunities. In the meantime, we invest in high-quality, established businesses that we expect to be much more profitable 10 years from now than they are today. As such we see the risks but also the opportunities and understand this is the nature of markets. This too shall pass, gradually then suddenly.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.