As we are coming out of the summer holiday season, it is worth pondering over what has been one of the most complex investment environments for a long time. Between the concern over economic growth, a resurgence of inflation and an extraordinarily tense geopolitical situation, there has been very little space to hide in financial markets.
Most asset classes have produced negative returns and there has been a very sharp increase in volatility over the past 8 months. Despite one of the strongest rallies since the Second World War in July, equity markets are down sharply for the year, and we have entered bear market territory. The same is now true for bonds, as rates have increased markedly and only some commodities show a gain since January, albeit with much volatility as well. In this very arduous context, investors remain extremely cautious, and risk has been massively curtailed in most portfolios.
Inflation normalises monetary policy
What seems to be very clear at this stage is that inflation is too high and that central bankers will try to fight the demon with their blunt and aggressive tools: rates will continue to rise, and Western economies will slowdown. It is too early to form a clear picture of when we will reach peak inflation and of what will be the effect of monetary tightening on economic activity (how deep will the recession be). However, we have been there before and notwithstanding the political environment, we seem to be experiencing a “normal” cycle. This is welcome news, as the post 2008 monetary environment was anything but normal and probably distorted so many aspects of financial markets. If we are proven right, sanity could be returning to macro-prudential policies and financial markets. Markets are still weighing the most likely scenario and the extent of the slowdown, but we do not find making exact predictions useful for long term investors.
Geopolitical uncertainty complicates forecasts
The task of making meaningful forecasts is also considerably harder in the current geopolitical environment. Much has been written about the war in Ukraine and Mr. Putin’s intentions. The truth remains that very few people know what is driving the Russian leadership and therefore most attempts at predicting the outcome of this crisis result in just making a wild guess. Our own view at Quaero Capital is that the situation will fester well into 2023, as there is little incentive for Russia to yield any concession before gauging the determination of the Europeans to maintain their sanctions in the face of a cold winter and much public discontent. We strongly believe that markets will therefore remain volatile and mostly driven by the news flow and the political world until a lasting diplomatic solution can be found.
The return of globalisation seems unlikely
The Ukraine crisis is merely the most acute part of a much larger geopolitical struggle between Western liberal democracies and the rest of the world. China seems determined to take a larger role on the world scene and its position on Taiwan are likely to agitate market commentators well into 2023. Together with Russia and other non-democratic states, it is trying to provide an alternative model to Western democratic values, and we have seen a loose coalition of authoritarian governments trying to resist the calls to unite against Russia. Until this unravels – which we believe it ultimately will – we are unlikely to see a restoration of globalisation of trade and we need to get accustomed to a more divided world.
The solution: take the long view by focusing on the fundamentals
In this very uncertain context, we continue to hold to our philosophy of investing with conviction and taking a longer time view. It is worth remembering that each period of history has produced its own specific challenges and problems that seemed overwhelming in their own time. However, these problems have been of little importance ultimately to financial health and are mostly long forgotten. We have been there before, and the truth is that investors who were prepared to look over the humps have been handsomely rewarded. Despite the immediate volatility, the news flow has little impact on long term investment returns. In fact, discerning investors have mostly generated their best results while investing their assets in periods of great uncertainty and we advise our clients and friends to adhere to this counterintuitive world view. We strongly believe that dedication to bottom-up research, high conviction portfolios and the ability to focus on the longer term are key ingredients to consistent returns. This is what we hope to offer to our clients.
Opportunities to seize
We continue to see great opportunities in various part of the markets that will lead to significant returns should one be ready to weather more volatility in the short term. First, there continue to be very strong support of the energy transition and the transformation of our economies to low carbon production. With the signature of the Inflation Reduction Act, the US has finally committed enormous resources to clean energies and our team believes that it does provide a secular opportunity. Likewise, the world of infrastructure is also the target of massive investments which makes this sector extremely attractive. This, coupled to its intrinsic low volatility characteristics, makes the infrastructure sector a great investment in this more turbulent period. Perhaps less visible is the profound change that Japan is experiencing, as it reforms its corporate culture and begins to unlock long inaccessible value in its equity market. That market has disappeared from most radar screens and it was always easy to be underweight. We believe that it will no longer be the case and as always, the early movers will make the best returns. A similar case can also be made for the whole of Asia, which is at a completely different stage of the economic cycle and where growth is relatively cheap. Despite having been early on this theme, we continue to believe it offers great value and less macro risk. This is a small preview of our thoughts as we come out of the summer doldrums and we hope you enjoy reading about these investment ideas.