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Fourth Quarter 2021 Global Equity and International Strategies

2021 was an interesting year for investors to say the least. Stocks surged on the back of a global vaccine rollout, investors embraced cryptocurrency as Bitcoin soared to new heights, and the Metaverse became a mainstream concept with Facebook changing its name to Meta Platforms in a symbolic move.

Let’s Talk About Inflation

In our recent conversations, a frequent topic of discussion has been around inflation. For the last few quarters, companies around the world have experienced rising input costs and tightness across skilled labour markets. Businesses are reporting difficulty with transportation and this has been exacerbated by the rising cost of shipping containers. Power outages, a shortage of truck drivers, and a large spike in the price of oil have also contributed to the current environment in which we find ourselves.

Are investors’ concerns surrounding inflation justified? We would say yes. As seen in this chart, U.S. consumer prices jumped in October at the fastest pace in three decades as inflationary pressures spread further throughout the economy.

The U.S. consumer price index (CPI) rose to 6.2% during the month of October. This represents the highest level since 1990 and it also marks a sharp increase from September’s level of 5.4%. While almost every single subindex was higher, the key drivers behind the rapid increase were energy, shelter, food, and new & used vehicles.

Policy makers prefer to focus on the core consumer price index which excludes the impact of food and energy costs, both of which can be highly volatile. However, even if we use the core CPI index, it tells us that U.S. inflation rate hasn’t been this high in 30 years. The recent core consumer price index measure was 4.6%, which is the highest level since 1991.

The inflation measures in Canada are somewhat lower but still concerning. As seen in the chart below, Canada’s consumer price index increased to 4.7% during the month of October.

Inflation is nearing its fastest pace since the Bank of Canada began using the consumer price index to set interest rates in the early 1990’s. The last time Canada’s consumer price index reached 4.7% was in February of 2003.

Economists and policy makers hope that inflation will be transitory, but the longer inflation lingers, the more likely it is that central banks will have to start raising interest rates and likely sooner rather than later. And perhaps at a faster rate than the market currently expects.

The question of whether inflation is transitory is important given that stocks have performed very well in the low interest rate environment that has existed for the last decade plus. Investors have coined the acronym TINA (There is No Alternative) to describe this phenomenon of investors paying higher prices for stocks than they have historically with low interest rates as the primary justification. However, if the stubborn bout of inflation persists, it will force central banks to raise interest rates. If this happens sooner and at a faster rate than the market is expecting, then investors may start to believe that TINA isn’t true anymore and they may gravitate towards bonds, which have less volatility. If this happens, it will spell trouble for stocks.

At the end of the day, the key question for investors is whether the current wave of inflation is transitory in nature or whether it will be longer lasting. Figuring out the answer to this question is very complicated given that there are so many different factors involved. To get to the bottom of this hotly debated issue, we need to answer a series of questions. Is the housing market strength sustainable, and if so, how long will it take for supply to catch up to this new level of demand? When will the COVID-enhanced unemployment benefits expire, turning today’s labor shortage into a labor glut? Will productivity surge in the aftermath of the pandemic due to new efficiency gains, thereby reinforcing the persistent and decades-long disinflationary pressures that have existed around the world? Will tensions between China and the United States result in a long-term move away from globalization, which has kept inflation under control for decades? Will the ruptured global supply chains be repaired in the next 6-12 months? Will high oil prices lead to demand destruction and ultimately cause a crash in oil prices just as energy producers decided it was a good time to increase their oil production?

These are very difficult questions and there are too many unknown factors making it very difficult to model future inflation with any degree of accuracy. So, if we can’t predict the rate of inflation into the future what should we do? The approach we have taken is to prepare for a wide range of scenarios. We believe that our portfolios have been constructed in a way that can hold up well in different types of economic backdrops including both inflationary and disinflationary environments. We believe the best way to accomplish this objective is to invest in high quality companies or what we like to call quality compounders. High quality companies have strong market positions, sustained pricing power, and seasoned management teams that can adapt to changes in the economic environment. In a higher inflationary environment, we believe that our companies will be well positioned due to their strong pricing power which will allow them to raise prices at least as fast as their costs and probably even faster. High quality businesses tend to have strong value propositions that enable them to pass on higher inflation to their customers. The ability to pass on higher inflation means that our companies can maintain or increase their expected future free cash flows in real, inflation-adjusted terms. In a disinflationary environment, we believe our companies’ pricing power will enable them to prevent their prices from falling as fast as their costs. We also believe that the dominant market positions and conservative balance sheets of our companies would allow them to survive and take market share from distressed competitors in a tougher economic backdrop.

In summary, we do not have strong views on the future level of inflation given the complexities involved in predicting the future rate of inflation. At a very high level, we believe that inflation will remain elevated in the short term. However, we also believe that many of the inflationary problems affecting the economy will get resolved over the medium term. When it comes to managing our portfolios, our positioning is not determined by a view on whether inflation will be transitory or not. Instead, we prefer to construct our portfolios with high quality companies that can perform well across a wide range of different economic environments.

Have a good weekend,
Phil

A Case for Optimism

After a brief period of volatility in September, global stock markets have resumed their upward trajectory during the month of October. In recent days several stock market indices have set new all-time highs including the MSCI World, the S&P 500, and the Nasdaq Composite Index. This should be viewed as a bullish sign, but it certainly feels like we are still climbing a Wall of Worry rather than celebrating new all-time highs. This is understandable given that there is a fairly long list of reasons to worry.

Today’s worries include but are not limited to, elevated stock market valuations, labor shortages, inflationary pressures, concerns around Federal Reserve tapering, the disfunction in Washington and the ongoing issues around the U.S. debt ceiling, China’s regulatory debacle and the evolving saga at Evergrande, the delta variant and whatever variant might emerge next, tightening global monetary policy, a developing energy crisis, and an array of inflation threats from a damaged global supply chain. All of these issues have added another brick in the wall for the bull market to climb over.

When we consider each of the forementioned risks, we view inflation as one of the more serious risks. Economic data has been pointing to stickier than expected levels of inflation tied to supply chain disruptions and labor shortages. If inflation remains persistent for an extended period, it will become a problem because it has been labelled as a transitory phenomenon by Central Banks around the world. If inflation is not transitory and it turns out to be significantly above market expectations, then the U.S. Federal Reserve Bank will ultimately find itself behind the curve. Under this scenario, it would be reasonable to expect a series of interest rate hikes that happen sooner and perhaps more frequently than the market expects. Based on history, this would spell trouble for the stock market.

From our perspective, we believe that inflation will remain elevated in the short term. However, we ultimately believe that most of the world’s supply chain issues will get resolved at some point in 2022. On a longer- term basis, we believe that there are several secular forces in the economy that will keep inflation in check. These forces include advances in technology and aging demographics. In addition to these secular trends, we believe that productivity will also be a key factor that drives down inflation. While the global economy has recovered significantly from the COVID-induced recession of 2020, there is still a significant amount of slack remaining in the economy. We believe that the global economy will grow at a healthy rate over the next few years on the back of pent-up demand from consumers and as global supply chains are repaired. We are especially optimistic about the recovery potential for the Consumer Services sector which includes restaurants, hotels, and travel related industries.

We believe that the United States will be a key driver of the global economic recovery. As we all know, the U.S. economy has important implications for the global economy because of its size and interconnectedness. The U.S. is the world’s single largest economy and it is also the largest recipient of foreign direct investment in the world. The U.S. Consumer is a crucial component of the economy given that consumer spending accounts for approximately 70% of the U.S. economy. We have an optimistic view for U.S. Consumers given our belief that they have both the willingness and the ability to spend in the years ahead.

The willingness exists because of the restrictions that were in place during the pandemic. As we move beyond COVID and the economy re-opens, consumers will return to baseball and hockey games, they will eat out at restaurants, go see their favorite band in concert, and travel to their cherished vacation destination.

It’s a great thing for U.S. consumers to have the willingness to spend but it’s just as important for them to have the ability to do so. When it comes to their ability, U.S. Consumers appears to be in great shape. There are many reasons for this including higher savings in the years following the Global Financial Crisis, today’s low interest rate environment, and the significant savings that were accumulated during the last 18 months as people were restricted to their homes for extended periods of time.

There are several different metrics that are used to measure the health of the U.S. Consumer. Total Consumer Debt as a percent of Disposable Income is a popular metric. Consumer debt is defined as all liabilities of households that require payments of interest or principal to creditors at fixed dates in the future. Disposable income is the amount of money that individuals or households can spend or save after income taxes have been deducted. As seen in the chart below, this ratio is near its lowest level in 20 years.

The U.S. Household Debt Service Ratio is another popular measure and it also paints a healthy picture of the U.S. Consumer. This ratio measures the percentage of disposable income that goes to interest on mortgages and other forms of debt. As seen in the chart below, this ratio is at its lowest level in 40 years.

In summary, we continue to have a cautiously optimistic view. We believe there is significant pent-up demand that will help drive growth for the global economy. We are confident that this pent-up demand will be unleashed given the health of the U.S. Consumer and the multiplier effect this will have on the rest of the world. Although inflation will likely remain elevated in the near term, we believe that inflationary pressures will eventually subside. This will occur as global supply chains are repaired, as productivity drives down inflation, and through ongoing help from secular trends such as Technology. Although today’s headlines are often filled with pessimism, we do see reasons for optimism.

Have a good weekend,

Phil

Sources:
Charts: The Federal Reserve and Bloomberg
The Global Role of the U.S. Economy: https://documents1.worldbank.org/curated/en/649771486479478785/pdf/WPS7962.pdf
FOREIGN DIRECT INVESTMENT IN THE UNITED STATES: https://www.selectusa.gov/fdi-in-the-us

Global Equity and International Strategies Third Quarter Review

Despite a bout of volatility that emerged during the month of September, global equity markets finished the third quarter with positive gains. The S&P 500 Total Return Index was up 0.6% while the MCSI World Total Return Index was up 0.1%. Although third quarter gains were modest, global equities have generated attractive returns through the first nine months of the year. On a year-to-date basis to September 30th, the S&P 500 Total Return Index is up 16.8% while the MCSI World Total Return Index is up 13.6%. The advance in global equity markets has been driven by the ongoing global economic recovery and further progress with COVID-19 vaccinations, which has allowed many countries to re-open their economies.

Climbing The Wall of Worry

It’s that time of year when investors get a little bit more nervous than usual. September is historically known as a turbulent month for the stock market and a time when accidents can happen, so to speak. It’s not just a case of seasonality that has investors worried, there are a bunch of different factors that are weighing on their minds. Peak economic growth, peak earnings growth, inflation, the U.S. debt ceiling, Fed tapering, the Delta COVID variant, the efficacy of the vaccines, China’s economic slowdown, Evergrande, and supply chain disruptions around the world. These are some of the concerns, otherwise know as the Wall of Worry.

The Wall of Worry refers to a tendency in financial markets for stocks to rise in the face of seemingly insurmountable problems. However, it usually turns out that the problems are temporary and that they are eventually resolved. As seen in the chart below, history is filled with such instances whether it be the bursting of the Dot-com Bubble, the Global Financial Crisis, or the COVID-19 Pandemic.

However, as we all know, the stock market cannot climb the Wall of Worry 100% of the time. Market pullbacks and market corrections are normal, even during Bull Markets. According to Cornerstone Macro, there have been 230 corrections of 5% or more for the S&P 500 since 1928. The average duration of these corrections was 1.8 months and the average decline of these corrections was 11.9%.

The complicating factor about corrections is that nobody can predict when they will happen and nobody knows how long they will last. Having said that, we believe that investors should embrace the next correction, whenever it might happen. From our vantage point, the global economy has a lot of slack remaining from the COVID-induced recession of 2020. We believe that the global economy has more recovering to do and this is especially the case for Consumer Service sectors including restaurants, hotels, and travel related industries.

In addition to an ongoing global economic recovery, investors will soon have seasonality on their side given that the 4th quarter begins next week. According to Ned Davis Research, the median Q4 return for the MSCI World Index since 1970 has been +4.4%. This includes a return of +4.6% during secular bull markets and a return of +4.1% during secular bear markets. Over the last 50 years, the 4th quarter has been positive 83% of the time, which is a higher percentage than any other quarter of the year.

Finally, it’s worth considering some of the various Consumer Sentiment measures. Many of these measures are severely depressed and sometimes this can serve as a contrarian buying signal. For example, the American Association of Individual Investors (AAII) survey is currently at a historic low. According to Piper Sandler and as seen in the chart below, the current survey indicated a reading in the bottom 10% based on all observed values since 1987.

Another consumer sentiment measure is the University of Michigan Consumer Sentiment Index. This index has declined for several consecutive months as the Delta variant and higher inflation appear to have dented consumer confidence. According to Ned Davis Research and as seen in the chart below, the overall index is at its lowest level since December 2011 and in line with the level in March of 2020 during the onset of the COVID pandemic.

These Consumer Sentiment measures indicate that investors are currently very pessimistic. This implies that there is a lot of room for consumer sentiment to improve. At some point this should have positive implications for the stock market. This helps to explain why we believe that investors should embrace the next correction, whenever that might happen.

Have a good weekend,

Phil

The Allure of Emerging Markets

Our global research team has a positive view on emerging markets. Emerging markets make up more than 80% of the world’s population and they generate approximately 60% of the world’s Gross Domestic Product. Emerging markets are appealing to many investors because of their attributes, which include large populations, young demographics, and a rapidly expanding middle class.

Among the various emerging market regions, our team prefers Asia given the opportunities across several countries throughout the continent. China is especially interesting given its large population and the long-term factors that will fuel the growth of its economy. These factors include the rise of the urban middle class, increasing domestic consumption, and the growth of the services economy.

Investing in China has been popular for a long time and there are different ways for an investor to get exposure to China. Some investors prefer to get local exposure by investing in domestically listed companies in China and Hong Kong. This can be accomplished by investing directly in the region or by investing in an American Depositary Receipt (ADR), which are listed on various stock exchanges in the United States. The rationale for investing directly is to get pure play exposure. Other investors prefer to get their exposure by investing in developed market companies that happen to have strong footprints in China. We have consistently leaned towards the latter strategy given that we have a higher comfort level in the accounting and the rule of law for companies headquartered in the developed world.

It has been a difficult period for investors who prefer pure play exposure. Goldman Sachs recently identified a basket of China American Depositary Receipts that has declined by 55% since the middle of February. One of the key reasons for the large decline is related to Chinese regulators who have targeted certain industries, with technology at the forefront. Last November, Chinese regulators blocked the initial public offering of Ant Group. Ant is a sister company of Alibaba, the e-commerce colossus whose founders include billionaire Jack Ma. Since reaching an all-time high last November, shares of Alibaba have fallen by approximately 50%. Internet giant Tencent has seen its shares fall by approximately 40% over the same period on the back of this regulatory fallout. Another example of regulatory interference can be seen with a company called Didi, which is China’s answer to Uber and Lyft. On June 30th, Didi completed an initial public offering that valued the company at $67 billion, only to have Chinese regulators respond fiercely. Didi was ordered to remove its apps from mobile stores and the company is now being subjected to a cybersecurity review. Didi’s shares have fallen by approximately 50% since July.

The regulatory risks in China extend beyond the Technology industry as seen by recent developments in the education sector. In the month of July, China announced sweeping new rules for private tutoring. These new rules created a significant business impact for private education firms as Beijing stepped up regulatory oversight of the industry. Shares of New Oriental Education & Technology Group and TAL Education Group have each fallen by approximately 90% since the new rules were announced last month.

As previously mentioned, we prefer to get our exposure to China through developed market companies that happen to have strong footprints in China. Examples include Estée Lauder and Nike. A brief description of each company follows.

Estée Lauder has a market leading position in the global prestige beauty industry. Prestige beauty is a large and fast-growing industry in China and it includes skincare, make-up, fragrances, and hair care. According to the NPD Group (a leading global information company), China’s prestige beauty e-commerce sales reached $5.4 billion through the first half of 2021. This represents a 47% increase over the same period last year. Estée Lauder first established a presence in Hong Kong in 1961. Today the company employs more than 17,000 people in the Asia Pacific region and it operates more than 400 freestanding stores and thousands of points of sale. For fiscal year 2021, the Asia Pacific region accounted for approximately $5.5 billion in revenue for Estée Lauder or about 34% of the company’s total revenue. Although the company generates a substantial portion of its sales from Asia, it is headquartered in the United States.

Nike has a market leading position in the global athletic footwear and apparel industry. Nike has an exciting opportunity in China given that the government recently announced an ambitious plan to make sports into a $773 billion industry by 2025, a 70% increase from 2019. This announcement falls on the back of China’s success at the Tokyo Olympics where it won a total of 88 medals including 38 gold medals. Nike has operated in China for more than 35 years and the company employs more than 8,000 people directly in its Shanghai headquarters and Taicang Distribution Center. In fiscal year 2021, the Greater China business accounted for more than $8 billion of Nike’s revenue or approximately 19% of Nike’s total sales. Nike’s Greater China business grew by 24% during fiscal year 2021. Although the company generates a substantial portion of its sales from China, it is headquartered in the United States.

In addition to Estée Lauder and Nike, we own several other companies that generate a significant portion of their revenue from China and other emerging markets. These companies include Moët Hennessy Louis Vuitton (luxury), Diageo (alcoholic beverages), and Essilor-Luxottica (eyewear). Like Estée Lauder and Nike, these companies are headquartered in developed countries. In addition to these companies, we also have some investments in companies that are headquartered directly in emerging markets. We have intentionally stayed away from industries where we see substantial regulatory risk and we believe that our exposures are manageable in the context of our global portfolios. When taken it aggregate, the majority of our emerging markets exposure is held through companies headquartered in developed world countries. However, this doesn’t mean we are completely insulated from the risks that exist in emerging markets. Earlier this year Nike went through a period of volatility on the back of a boycott of international brands. The issue was related to Nike’s avoidance of the Xinjiang cotton region and the controversy around forced labour in the region. More recently, we have seen some volatility in Moët Hennessy Louis Vuitton on the back of the backlash against luxury companies and conspicuous consumption in China. While we don’t enjoy it when our companies go through periods of volatility, we believe that the volatility is manageable in the context of our overall portfolio. More importantly, we remain optimistic about the long-term prospects for the companies held across our portfolios.

In conclusion, we prefer to get the majority of our emerging markets exposure by investing in companies that are incorporated in the developed world that happen to have strong footprints in the emerging markets. By embracing this strategy, we believe that we can accomplish three things. We will have more certainty about the sustainability of our investment, we can lower the volatility of our portfolios, and ultimately generate smoother returns for our clients over the long term.

Have a good weekend,

Phil

Sources:
Future Returns: Finding Value in Asian Emerging Markets
https://www.barrons.com/articles/future-returns-finding-value-in-asian-emerging-markets-01629831214
Emerging Markets – Powerhouse of global growth
http://www.ashmoregroup.com/sites/default/files/article-docs/MC_10%20May18_2.pdf
China’s new private tutoring rules put billions of dollars at stake
https://www.reuters.com/world/china/chinas-tal-education-expects-hit-new-private-tutoring-rules-2021-07-25/
China Prestige Beauty E-commerce Sales Increased 47% to $5.4 Billion in the First Half of 2021, Reports The NPD Group
https://www.npd.com/news/press-releases/2021/china-prestige-beauty-e-commerce-sales-increased-47-to-5-4-billion-in-the-first-half-of-2021-reports-the-npd-group/
China Sees Sports as Growth Driver After Its Olympics Success – Bloomberg News
https://www.bloomberg.com/news/articles/2021-08-06/china-sees-sports-as-growth-driver-after-its-olympics-success
Hedge Fund Trend Monitor: Goldman Sachs

The Parallels Between Sports and Investing

Market commentators often like to make analogies between professional sports and the world of investing. Although sports and investing can be very similar in certain regards, they’re also very different. Almost every sport is referred to as a game, but investing is not a game, unless you are day trading meme stocks.

In baseball, the length of a game is determined by innings. But in the world of investing, stock market cycles are measured in years. However, market commentators sometimes like to borrow from baseball lingo when they talk about where we are in the stock market cycle. Given the robust market gains of the last 18 months, investors are probably wondering if we are in the middle innings or the late innings of the current bull market. The thing is, you never really know. It’s only with the benefit of hindsight and the onset of a recession that we know with certainty that a bull market is over.

In football they say defence wins championships. But in the world of investing, determining the winners really depends on where we are in the cycle. If it’s early cycle, then offensively positioned (i.e. cyclicals) portfolios typically generate the best returns. But if it’s late cycle and we’re about to enter a recession, then defensive positioning in one’s portfolio will likely generate better returns than an offensively tilted portfolio.

So why are we using sports analogies in a forum that is supposed to be focused on investing? The reason is that it offers some perspective and it allows us to think a little bit outside of the box given the unusual circumstances of the current environment. In my 20 plus years of investing, I have never seen a global macroeconomic setup like the current one.

On a positive note, we are seeing huge pent-up demand related to the reopening of the economy as vaccines are rolled out around the world. Corporate earnings have been extremely strong and have been surprising on the upside. Furthermore, GDP growth in the United States could hit 7%1 during 2021. I don’t recall a single year during my investing career when the U.S. economy grew by 7%.

On a more cautionary note, this market is running incredibly hot. It is very stimulus driven and it is also deficit driven. For example, the federal deficit in the United States will hit $3 trillion2 in 2021. This represents a slight decrease from last year, but it is triple the level of 2019. This amounts to one of the largest imbalances between federal spending and revenue in American history. Given above average valuations, the stock market is vulnerable to any number of shocks whether it be a new COVID variant or surging inflation that causes Treasury bond yields to rise too rapidly.
The conflicting signals that exist today reinforce our belief in taking a barbell approach when it comes to constructing our portfolios. Looking ahead we believe there is a wide range of outcomes for the global economy. Given the current backdrop, we want to own companies that have both offensive and defensive attributes.

And that brings me to soccer and yet another analogy. A midfielder in soccer is a player positioned in the centre of the field in between the defenders and the forwards. The role of a midfielder is to provide a link between the offensive attack and the defense. The role of a midfielder is not limited to just one job, there are many different dimensions as these players are expected to defend as well as attack. In the world of investing, we can make an analogy between the midfielder and an all-weather stock. An all-weather stock is basically a business that can play offense and defense in the portfolio. Midfielders are high quality companies that have business characteristics that allow them to prosper during economic expansions but also demonstrate resilience during an economic downturn. Many of our Technology and Healthcare holdings play the role that a midfielder plays on a soccer team. For example, the majority of our Technology and Healthcare stocks outperformed the market during the COVID downturn and yet they continued to generate attractive returns during the ensuing economic recovery.

Given the various uncertainties of the current economic landscape, we believe it is prudent as ever to maintain the barbell approach that we use in constructing our portfolios. We own a large number of all-weather businesses and we believe these ‘midfielders’ will protect our portfolios should we enter a more challenging stock market environment. On the other hand, if global equity markets continue to grind higher, we believe that our portfolios are well positioned to participate in the gains that lie ahead.

Have a good weekend,

Phil

Sources:

  1. https://www.reuters.com/world/us/fiscal-stimulus-vaccines-likely-fueled-us-economic-growth-second-quarter-2021-07-29/
  2. https://www.washingtonpost.com/us-policy/2021/07/01/cbo-deficit-biden-stimulus/

It is difficult to make predictions, especially about the future

A number of folks employed within the Financial Services industry make their living by making forecasts about the future. Economists, strategists, and portfolio managers spend a significant amount of time trying to make predictions about the economy, the rate of inflation, and how high the stock market will climb in the years ahead.

When it comes to our investment process, we spend most of our time analyzing companies and spend very little time making forecasts about the economy or the stock market. This doesn’t mean that we don’t read the news or that we don’t have personal views on these matters, but we don’t see much value in trying to make projections about macroeconomic variables such as interest rates or bond yields. We prefer to control our overall risk by focusing on the quality of the companies in which we are invested. Instead of making predictions about the macroeconomic environment, we tend to focus on the earnings power, the balance sheet strength, and the sustainable competitive advantages of the companies we own across our portfolios.
As we think about the second half of 2021, we expect uncertainty and volatility to become more pronounced as investors digest the strong gains made by equities during the first half of the year and the potential for new COVID variants. Looking back on the first half of 2021 there was a huge focus by the media on the growth versus value debate. During the first quarter, the yield on the 10-year U.S. Treasury note rose from 1.00% to 1.75% and this became top of mind for market commentators. The abrupt move in the U.S. 10-year yield during the first quarter led to a surge in value stocks across the energy, financial services, and industrial sectors of the stock market. Growth stocks on the other hand, underperformed significantly during the first quarter on the back of the value rally. However, during the second quarter the yield on the 10-year U.S. Treasury note fell from 1.75% to 1.45%. This led to a huge rebound in growth stocks while value stocks underperformed. In a short matter of time the stock market narrative shifted to whether the value trade had run its course. These changing narratives based on 30 to 75 basis point swings in government bond rates are somewhat puzzling to us given that interest rates are simply one factor used in calculating the intrinsic value of a stock.

In recent years there seems to be more emphasis placed on the short term. It appears to us that market strategists and economists are spending an increasing amount of time trying to make predictions about short-term movements in the 10-year U.S. Treasury yield, the US dollar, and the rate of inflation in the economy. These predictions are then used to determine the best trades for investors such as the decision to be invested in value stocks or growth stocks. We don’t try to make predictions about the economy, the 10-year U.S. Treasury yield, or the rate of inflation. The rationale behind this is that we don’t think it is easy to execute an investment strategy based on forecasting the twists and turns of the global economy and then re-adjusting our portfolios accordingly.

We don’t think it is easy to execute an investment strategy based on forecasting the twists & turns of the global economy and then re-adjusting our portfolios accordingly.

One of the problems with making forecasts is that you can be correct in making a prediction but the investment vehicle that is chosen to capitalize on that prediction might not work out. There is an old adage in the investment management industry that portfolio managers don’t have a crystal ball. But suppose they did have a well-functioning crystal ball that could accurately predict the future. Would it help them? Not always. Suppose that on January 31, 2006, you knew with certainty that the price of gold would more than triple over the next five years, from $570 per ounce to $1,900 per ounce. Given that foresight, one might be tempted to invest in Newmont Mining. Buying shares in one of the world’s largest gold producers would appear to be a no-brainer. Yet by 2011, Newmont’s share price ended up at nearly the same price at which it started in 2006. Let’s take another example. Suppose you could know ahead of time which publicly traded companies would make money and which would lose money. A rational investor might be tempted to invest in the former and bet against the latter. Yet in 1999, the stocks of profitable companies barely moved while profitless tech start-up companies soared by approximately 80%. The same phenomenon occurred again last year in the 12 months that followed the market bottom in March of 2020. The price of a basket of Non-Profitable Technology stocks generated a return of more than 400% in 12 months, which was more than 5x greater than the S&P 500 return of 75% during that incredible rebound. Taking it a step further, let’s suppose you could have known the outcome of the 2016 Presidential Election in advance. Knowing that Trump was going to win, many investors would have bet against the stock market by short-selling stocks given that a Trump victory was a very unlikely outcome based on the polls at the time. Investors who bet against the market at that time would have looked smart. For a few hours. On the night of the 2016 election, stock market futures sank rapidly as a Trump victory became increasingly likely. The S&P 500 fell by more than 5% in premarket trading, triggering a circuit breaker to halt trading. However, by the time the market closed the day after the election, the S&P 500 was up by more than 1%. Between 2017 and 2019, the average annual price return for the S&P 500 was over 14%. This happened despite numerous predictions that the stock market would tank in the event of a Trump victory.

We focus our efforts on individual business fundamentals and the factors that will impact the profitability of our companies as opposed to trying to predict the twists and turns of the economy.

At the end of the day, it is difficult to make accurate forecasts about the future. But even if our forecasts prove to be correct, it doesn’t guarantee that we can profit from them as illustrated in the forementioned examples. When it comes to our fundamental research, we focus our efforts on individual business fundamentals and the factors that will impact the profitability of our companies as opposed to trying to predict the twists and turns of the economy. When we analyze companies, our time horizon is measured in years, not in days or quarters. Our focus is on finding wonderful businesses that have a sustainable competitive advantage or a “protective moat” around their business as Warren Buffet likes to say. We want to own companies that operate in industries with high barriers to entry. These types of companies typically earn above average returns on invested capital for extended periods of time and it enables them to generate sustainable earnings growth. We believe that sustainable earnings growth is a key driver of stock price appreciation over the long term. In summary, our research efforts are focused on identifying high quality companies so that we can invest in them for the long term and let them compound in value for the benefit of our clients.

We hope that everyone is enjoying their summer.

Phil

Sources: Forbes and O’Higgins Asset Management.

Global Equity and International Strategies Second Quarter Review

Global stock markets continued to rise during the second quarter with the S&P 500 increasing by 8.2% and the MSCI World Index rising by 7.3%. On a year-to-date basis the S&P 500 is up 14.4% and the MSCI World Index is up 12.2%. The year-to-date return for the S&P 500 is the 2nd best first-half performance since 1998. The best first half return since 1998 was generated in 2019 when the S&P 500 increased by 17.4% in the first six months of the year. The robust stock market returns of the last six months have been driven by strong economic data as the global economy continues to reopen helped by COVID-19 vaccinations and trillions of dollars of fiscal stimulus. The handsome year-to-date gains are on top of the attractive gains that have been generated since the market bottomed in March of 2020 with the S&P 500 and the MSCI World Index both up more than 80% over the last 15 months.

Is the Recent Uptick in Inflation Transitory?

Based on our recent conversations, it is apparent that there is a major debate going on with regards to the rate of inflation and the sustainability of it. As seen in the chart below, inflation has soared in recent months and this has created some concern for investors.

During the month of May, the Consumer Price Index (CPI) rose by 5% compared to one year earlier. This was above the 4.7% rise that was forecasted by Economists and it marked the largest increase in the CPI since August of 2008. The Consumer Price Index is a closely watched measure and it represents a basket of goods including food, energy, housing costs, and sales across a spectrum of goods.

The key question as it pertains to this recent bout of inflation is whether it will be long lasting or whether it will be more transitory in nature. There are good arguments to be made for both cases and it is possible that both scenarios will prove to be correct over time. In the short term, there are good reasons to believe that inflation will remain stubbornly high. However, over the medium and long term these inflationary pressures should subside.

From our vantage point, the recent uptick in prices that is being felt by both businesses and consumers is largely driven by transitory disruptions that have occurred across various supply chains. These supply chains include food, semiconductors, oil, lumber, copper, shipping containers, and trucking. The supply shocks that are happening are an outcome of several factors that can be tied to the pandemic response. In the early stages of the pandemic there was a series of shutdowns that affected businesses across a wide range of industries. These shutdowns were made not only due to concerns about falling demand but also public safety measures that were implemented to contain the spread of the COVID virus. In hindsight, the magnitude of the shutdowns proved to be far too pessimistic. The shutdowns significantly underestimated the speed at which vaccines would get approved and the resulting rebound in demand. As a result of this, the demand side of the economy has rebounded faster than expected and the supply side of the economy has not been able to ramp up production fast enough to satisfy this demand. This helps to explain why we are now experiencing a spike in inflation.

It’s easy to see why there is an ongoing debate about inflation. The inflation bears can point to certain corners of the market that have already started to simmer down. Take lumber, one of the biggest gainers among commodities over the last year as Americans poured money into home remodeling. The price of lumber has collapsed by 40%1 since its peak in May. The booming U.S. housing market has also cooled as measured by building permits, which are a forward-looking indicator for home sales. For the month of May, building permits fell by 3.0%2 to just under 1.7 million units. This represented a seven-month low and the decline was widespread across regions and property types. Copper is another commodity that has eased from an all-time high. However, the inflation bulls can point to the numerous areas of the economy where supply constraints remain and torrid demand have left prices at multi-year highs. The answer to the inflation debate is that it can probably be found somewhere in the middle.

The hope that inflation will remain low forever and that interest rates will remain near zero forever seems unrealistic. This is especially the case given the communication that came out of the Federal Open Market Committee meeting this week. In a nutshell, The Federal Reserve raised its expectations for inflation this year and brought forward the time frame on when it will next raise interest rates.

On the other hand, we believe there is a low likelihood that the global economy will return to the high levels of inflation that occurred during the 1970’s and the 1980’s. The rationale behind this line of thinking is that there are several counter-inflationary secular trends that exist in the world today with Technology at the forefront of these trends. Technology acts as a counter-inflationary force in the global economy in several ways. Automation and robotics on the factory floor have improved productivity and lowered the cost of manufacturing. The rise of Ecommerce and the Internet has led to greater price transparency. This has resulted in greater price competition and has squeezed out high-cost producers across a number of global industries. Demographics is also a secular trend that provides a counter inflationary force for the global economy. The world is aging, people are living longer, and they are having fewer children. As people get into their 60’s and 70’s, they tend to spend less and become more frugal. An economy with aging demographic trends is likely to grow more slowly and generate less inflation.

So how should investors protect their portfolios given the prospects of rising inflation and higher interest rates? We believe that investing in high quality companies is the best way to insulate our portfolios given the expectation of higher inflation and rising interest rates. High quality companies typically operate in industries with high barriers to entry. This makes it difficult for new competitors to enter the market and typically enables the incumbents to earn above average returns on invested capital for extended periods of time. It also means strong pricing power and very stable cash flow generation. These attributes will protect them as the global economy transitions to a higher inflationary environment. In terms of higher interest rates, it means increased borrowing costs and reduced cash flows for highly indebted companies. High-quality businesses are somewhat insulated from this given that they are characterized by robust financial strength and consistent free cash flow generation. This reduces their dependence on debt capital and the negative impact to their earnings from higher borrowing costs.

In summary, we do believe that inflation will remain elevated in the near term but we do not believe that we are entering a period of substantially higher inflation like what was experienced in the 1970’s and 1980’s. Furthermore, we believe that our portfolios are very well positioned for the current environment given the high quality attributes of our investments.

Have a good weekend,

Phil

  1. Factset Data
  2. 2.CNBC