Taking the Long View on Market Volatility Copy
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George P. Maris, CFA
Co-Head of Equities – Americas | Portfolio Manager
George Maris, Co-Head of Equities – Americas, says structural shifts in the global economy and market dynamics are likely to continue driving volatility in equities, but investors focused on fundamentals could come out ahead over the long term.
KEY TAKEAWAYS
- Tightening monetary policy and elevated inflation are having a dramatic impact on equity valuations and the prospects for future earnings growth.
- Against this backdrop and amid other factors driving market volatility, corporate fundamentals will take on more importance: the era of easy money lifting all boats has come to an end.
- So far, the market sell-off has been broad-based, lowering valuations of some companies with strong balance sheets and favorable supply/demand dynamics. That could spell opportunity for fundamentally oriented, long-term investors.
KEY TAKEAWAYS
- Tightening monetary policy and elevated inflation are having a dramatic impact on equity valuations and the prospects for future earnings growth.
- Against this backdrop and amid other factors driving market volatility, corporate fundamentals will take on more importance: the era of easy money lifting all boats has come to an end.
- So far, the market sell-off has been broad-based, lowering valuations of some companies with strong balance sheets and favorable supply/demand dynamics. That could spell opportunity for fundamentally oriented, long-term investors.
George Maris: I think sentiment across markets has been really rough, frankly, since last November, November of 2021. And that really was when the US Federal Reserve identified inflation as its number one priority, and that is fighting inflation. What does that mean? It means a drastic reduction in the easy monetary policies coming out of the US, but also the rest of the developed world. And you saw that primarily in the form of hikes in rates, but also the end of quantitative easing – that is, basically priming the pump monetarily, supporting money supply. That really has been the operating scenario since the Great [Global] Financial Crisis. So, we’ve had an emergency monetary response across much of the developed world for almost 14 years, and that has come to an end. And that, that backdrop really did allow for very easy investing across all asset classes, i.e., with money coming in into a fixed number of securities, you just raise the price of everything.
Now that that game has been signaled as being at its end, you’re going to have a changed dynamic. And that dynamic is going to reflect itself, one, in terms of lower valuations across all security classes. Higher inflation means higher discount rates; that’ll impact not only equities, but fixed income, real estate – everything that’s out there gets impacted by this, as well. But also, that slowing of monetary policy will also impact economic growth. That economic growth will result in harder-to-come-by earnings growth for companies, and that will hurt the earnings-growth trajectories for a lot of companies that people had forecast.
And I think, also, a couple of other dynamics are in play that have really hurt. One is the fact that you’ve had the invasion of Russian troops into Ukraine; [that] has created the specter of geopolitical instability on a major scale that we haven’t seen in decades. In fact, we’re looking at the reignition of a cold war. And that backdrop certainly does add instability into the system. And then, moreover, just when we think we’re past COVID, China’s been very draconian in terms of its COVID response, with zero-COVID being outlined, shutting down cities like Shanghai and now Beijing. And that’s also continued to exacerbate some of the supply chain issues we’ve had out there. So, all of these dynamics happening at the same time has created a very negative backdrop to market sentiment.
In addition, one of the other areas that’s playing out that’s different than it was, let’s say, going back to the 2000 to 2001 unraveling of the TMT [technology-media-telecom] bubble is that you’ve got a different level of market participant. Back then, what you typically had were a bunch of fundamentally oriented investors: long-onlys, hedge funds. They were the overwhelming majority of trading activity on established exchanges. Today, that’s flipped; those players are a minority. In fact, the greatest proportion of trading activity happens to be systematic, and then retail players, folks who aren’t necessarily doing the bottom-up work to derive what securities are worth. It has created vastly more instability in markets, much more short termism. And I think we’ve seen that dynamic play out in terms of heightened intraday volatility and certainly volatility that we are experiencing in truncated periods. This creates a very combustible dynamic. It has certainly enhanced the instability and negativity surrounding markets over the last several months.
I think in this environment it’s especially important to pay attention to the resilience of the companies and the securities that you’re investing in. So, a strong balance sheet, I think, is a mandatory here. You don’t want to have a weak balance sheet going into an environment where liquidity is going to be more challenging to come by. Banks and market participants are less likely to lend money, and you don’t want to be somebody who has to grab money at a distressed level. So that will certainly be impactful.
Valuation is going to be especially challenging at this period. When you have a period of negative interest rates – which is what we’ve had for a long period of time, both negative real [inflation-adjusted] and negative nominal rates [non-inflation adjusted] – doing cash-flow analyses and discounted cash-flow scenarios almost has no value. In a negative interest-rate environment, cash that you’ll receive in 2030 is worth more than cash you will receive in 2022. That makes no sense. It turns traditional thinking on its head, and that allowed for a lot of the valuation dislocations that we’ve experienced over the last year or so to occur. That’s come to an end. Now, cash in hand today is worth more than it is in 2030, getting back to normal financial reality, and that’s created a greater degree of focus on valuation and what you’re paying for the securities you’re buying and, frankly, that cash-flow growth that you’re likely to achieve going forward.
But it also challenges the indices. Indices were essentially a free proxy to go ahead and get allocations into markets without having to think through about what you were buying, right? And with an easy monetary policy and rising tides lifting all boats, it didn’t matter what you bought; everything was essentially going to work. That’s changed, and that’s changed dramatically. Now, it actually matters what you’re buying and the price you pay and the quality of the asset that you’re paying for.
The one thing I’d want to note, though, is there’ll be a lot of mess. There’s a lot of market participants who’ve used this cheap financing to lever themselves in, many ways, what could be irresponsibly. And you’ll see that play out in dramatic fashion in fits and starts over the next several months.
US companies offer several advantages, even in this tumultuous period. One is, the US continues to be the center for lots of innovation and entrepreneurship. We’re seeing some great examples of dynamism in information technology; in health care, particularly biotech and [health care] equipment; also, even in financials and things of that nature. So, there’s tons of dynamism still happening here in the US.
Moreover, a lot of the pain that’s been inflicted in US markets over the last several months has really kind of been across the board – baby-out-with-bathwater stuff – so, there’s some great assets that, if you’re looking at over a reasonable period of time, offer tremendous return potential. And that’s been, I think, overlooked by a lot of folks who only look at headline market areas. So, again, the US continues to be a very strong place to invest. The consumers look good, with healthy balance sheets. US corporations tend to look very good with very strong balance sheets, good margins and good earnings power. And so, on a through-cycle basis, the US continues to have lots of things to call to its merit.
So, Europe presents both real opportunity and some risk. I think the risk we’ll lead off with pretty quickly, and that is what’s happening with respect to the Russian invasion of Ukraine and the potential instability that creates on the European continent, in particular. You know, we’re seeing true instability, we’re seeing true security concerns come in. This invasion has frankly turned a challenging macroeconomic environment, one where rates were rising, into an even more challenging one, where you now have what are clearly stagflationary trends on the continent and then somewhat even in the UK, as well; where stagflationary being, where you’re not only creating higher inflation, but you’re also hitting employment and GDP growth. That is a very challenging backdrop.
That said, most folks – and I put myself in this camp – think that that’s likely to be more temporal and not long term. Moreover, one of the great things about European companies, especially those doing business within Europe and not necessarily globally, is they’re accustomed to dealing with low levels of demand. And because of that, they run very leanly and are well positioned to survive and do well in periods where there’s not a lot of economic growth at their backs.
Moreover, one of the things that’s benefiting them now is, relative to the US dollar, European currencies – the euro and the pound – have weakened. The weakness of those currencies has created a substantial competitive advantage for exporting countries coming out of greater Europe, which will also fuel earnings growth. Moreover, those companies that deal in dollarized economies, as they’re able to import back dollars relative to their own home currency, will have a markup on their income statement as well from that. So, it’ll benefit their income statements relative to US income statements when they’re importing foreign currencies. The nexus is while there’s tough near-term news, there’s really good long-term news here, as well.
Moreover, Europe is home to a lot of very strong, cyclically oriented companies, whether they’re in the energy space or commodities and mining space. And those are areas of the market that are doing very well. They are in severe shortage of supply globally, and they are able to generate very strong returns as these shortages continue to persist. So, strong cyclical industries, good valuation support, benefit from a weaker dollar and these are markets that started off more cheaply than the US. All merit a focus on Europe, even in what is a challenging period of time.
China’s a difficult market. I think one of the things that has impacted it has been its very draconian response to COVID. Another has been being much more impacted from a focus on fair trade from the US, in particular, and a moving away of supply chain activities out of China. So, those two events – the draconian focus on COVID, as well as the moving away of supply chains out of China into other countries – has certainly impacted China negatively.
But China has several things going for it. One of them very well being that it is still the second-largest economy on the globe. And as such, unlike most other emerging market countries, really can control its own destiny, especially with respect to monetary policy, i.e., it doesn’t have to follow what’s happening with the US dollar and have to move in lockstep and become trapped by that. So, what we’re seeing is that China can actually – and is actually – beginning to embark upon an expansionist governmental response to weak economic activity. So, while the rest of the world seems to be tightening the screws and focusing on inflation, China’s actually moving out of lockstep into a more expansionary phase of its economic growth and investment cycle. And that certainly is a benefit to China.
Moreover, those draconian COVID lockdowns seem to be nearing its end. Shanghai looks to be lifting. It’s unclear that Beijing will go through anything as draconian as Shanghai. And as we start getting through that, the comparisons will look really easy. There’ll be a lot of growth that emanates, and China is still a massive consumer of stuff from around the world and will generate growth just by its importing of industrials and commodities and all sorts of other types of material and services from around the world.
In addition, China is fairly inexpensive – or actually very inexpensive – relative to the rest of the world. And so, you’re starting from a low base to begin with. There’s not a lot of folks clamoring to get into China right now; frequently, that ends up being a very opportune time to invest in China.
So, it’s interesting because there’s a lot of sectors that look very interesting, even in this period of economic dislocation and turmoil. I think, you know, the ones that are the most compelling to me right now are the mining, commodities and energy space. We have underinvested in, whether it’s petroleum or copper and zinc and nickel, for over a decade. We’re bearing the consequences of that now with stark increases in commodity prices across the gamut. Those cannot be easily solved. You cannot just turn on the spigot and roll out millions and millions more barrels of petroleum a day or tons of copper a day. These are long-term projects. They will take a long time to get through. And frankly, it doesn’t seem that regulatory policies are really geared towards increasing the supply of these essential commodities around the world. And so, they are right now very interesting places to be; places that will buck the trend of weak economic growth, as well as inflation. Frankly, they’re one of the causes of inflation, and it’s always good to be investing in the bottleneck in the system.
I think other areas that are really interesting, you know, health care right now looks very compelling. It’s trading at cheaper-than-market multiple levels in many cases. For a sector that will grow relatively strongly throughout the economic cycle, it should be relatively indifferent to what’s happening economically, depending on the companies you’re investing in. And, you know, when you’re buying these really strong, resilient companies at cheaper-than-market multiples, there’s a compelling aspect to allocating capital there.
Luxury goods stocks, I think, are also very interesting here. People tend to think of luxury items as the ultimate in discretionary, and when the economy turns down, that you sell those off. The history is that they actually are very resilient. Even in the Great [Global] Financial Crisis, luxury spend was substantially better than the rest of consumer spend. And there’s real opportunity to buy these strong companies at a discount because the market, again, is throwing the baby out with the bathwater. They sold off some of these great luxury names and luxury brands, yet demand for their goods continues to be at a very strong pace.
Lastly, right now, I think it’s also in technology. I think semiconductors and even a lot of the software names that really had enjoyed tremendous returns over the last several years, sold off awfully hard; in many cases, well over 50% from their peak, some even 70%, 80%, 90% from their peaks. Some of these are really good businesses that will generate strong growth for the next several years. And I think if you’ve got the ability to focus on business fundamentals, a lot of these SaaS [software-as-a-service] and semiconductor names present tremendous opportunity for a long-duration investor.