Recap on this decade’s extreme macro environment
The extreme economic and market conditions of the past few years have been surprising, reinforcing the view that forecasting is a difficult exercise.
This decade began on solid foundations until the devastating pandemic. The Covid crash started in early 2020 with entire economies shut down, the highest unemployment rate since the Great Depression and oil prices turning negative. This culminated in the fastest stock decline in history. Who would be bullish in such an environment? Surprisingly, bullish transpired to be the right position. Massive monetary and fiscal stimulus saved the world, benefiting consumers and facilitating the weathering of a severe recession with no relevant credit losses. The world completely changed virtually overnight having the highest GDP growth for the third quarter since the beginning of the historical series. Experts at that time discussed the possibility of another roaring 20s with high economic growth and strong markets.
Dramatic change happened again when inflation got out of control during the second half of 2021. At first it was dismissed as transitory by governmental leaders, but with time, the inflation scenario worsened during the year. CPI hit a level not seen in half a century and central banks were forced to aggressively increase interest rates to tame the inflation. Meanwhile, a market bubble popped in disruptive technological stocks, a normalising economy faced disruptions in the global supply chain and Russia invaded Ukraine, creating the most fraught geopolitical landscape in decades, and increasing the likelihood of a nuclear war.
Where we are now?
We have lived through the worst first half market performance in over 50 years. What happens from here? There are many questions but with limited clues to the answers. Has inflation reverted? Will we enter a recession? Have we entered a new scenario of geopolitical crisis and elevated energy costs? Can China sustain its economic recovery while pursing zero-Covid?
No one can answer these questions with certainty but. here’s what we do know. Economic growth has slowed dramatically, GDP real growth in the first quarter 2022 was negative, inflation and commodity prices remained historically high, monetary growth has plummeted, financial conditions have tightened dramatically, employment as well as consumer balance sheet and demand for services remain strong. Both equities and bonds sold off simultaneously, while credit spreads widened. The only clue is that there has never been a recession without employment deterioration, a lagging indicator.
Where do we go from here?
The level of uncertainty about the future is always wide, but it currently seems extreme. A return to the low growth, low interest rate environment of the past decade seems a reasonable scenario in which high growth stocks will lead, as does the emergence of a new, higher inflation regime similar to the 70s in which value stocks with pricing power will benefit. The market will likely remain volatile as it figures out the answer and this dichotomy presents a challenge for investors. Unfortunately, the current market stock price is all about the macro. A US bank recently reported that fundamental trading now represents c.10% of trading flows vs. the other 90% are a combination of passive, systematic and macro discretionary. This means, in the short term, that prices will get even more disconnected from fundamentals than they did historically.
While current market valuations overall seem reasonable, we are witnessing extreme disconnections between what the market thinks something is worth (price) and what we think it is worth (value). Prices can always get more extreme but in the long-term, fundamentals will prevail. Therefore, our view is to focus on buying compounders with good capital allocation, at a reasonable price taking advantage of this market downturn and be patient doing nothing during a long-term period and, as Monish Pabrai recently stated, if you are patient, amazing things will happen.
Sir John Templeton advised to invest at the point of maximum pessimism and Howard Marks, one of the best contrarian value investors, recently said he’s seeing good opportunities and buying aggressively. We may be getting close to the bottom and to a once-in-a-decade investment opportunity!