The rise in interest rates and the rethinking of globalisation should mark a return to active management and fundamental research.
Many investors are currently struggling to decide on an investment policy for this year and beyond. There are indeed many reasons for concern: the resurgence of inflation and the end of ultra-accommodating monetary policies have pushed up interest rates, marking the end of more than 10 years of cheap, abundant money. Added to this are the supply chain problems caused by China’s zero-Covid policy and, above all, the war in Ukraine, which has disrupted the international order that emerged from the Second World War.
The end of easy money
As a result, markets have corrected significantly since the beginning of the year and the future looks very uncertain for most players. This concern is exacerbated by the complete paradigm shift we are currently witnessing: after years of falling interest rates and the resulting extended bond bull market, the cost of money seems to have gone up permanently and the end of the easy money era is announced. With the end of unconventional central bank policies, liquidity conditions will tighten, with important implications for portfolio management.
A direct effect on present value
Indeed, the level of interest rates mechanically and inversely influences the present value of future cash flows, which is one of the main criteria for evaluating a company. During the last decade, the continuous fall in interest rates has largely favoured the stocks of the fastest growing companies, which are more sensitive than mature companies to any change in interest rates. But in recent months, the opposite effect has occurred: the marked and probably lasting rebound in yields has caused the former “darlings” of the stock market to correct sharply and it is now the value stocks that are regaining their lustre. However, there is one notable difference: investing in these companies requires real analytical expertise to sort the wheat from the chaff.
The end of the one-track investment mindset
In this new context, it is worth remembering a few old recipes that have proven their worth over time. The first is undoubtedly international diversification. While US growth stocks have largely been the winners in recent decades – driven by the US’s great innovative strength and its very liberal economy – it was easy to ignore, or at least largely underweight, other regions of the world. The same was true of the variety of investment styles in a portfolio, a notion that has been largely side-lined in favour of the “100% Growth” thinking of recent years. But as we witness a broad geopolitical rebalancing that will certainly see the world divided into zones of influence once again, it will be harder to ignore countries or regions that are not experiencing the same difficulties as those in the Western world. Similarly, while some predicted the death of the value management style, the reality is that price discipline is gradually returning to investment decisions. The same is true for alternative strategies, as their absolute performance objective was no longer attractive to investors as long as markets were rising steadily.
The return of difference
In the more complex environment that we now envisage, more selectivity will be required. In this context, it will be necessary to rethink forgotten sectors or regions that are still very poorly represented in portfolios and offer a very significant potential for marginal change. In this respect, the example of Japanese equities is striking: the market is considerably underweighted by international investors, even though it has very attractive valuation characteristics, as well as excellent transformation prospects. Any change in perception could create a significant inflow of cash and thus a marked revaluation. Similarly, smaller European value stocks offer the same potential for revaluation for investors willing to defy the general consensus.
The « free lunch » is followed by a hefty bill
As we have seen, the last ten years have favoured highly pro-cyclical strategies and the rising tide has lifted all boats together. There was no longer any real reason to choose one stock over another, which prompted some to prematurely announce the death of active management and investment boutiques. Indeed, one just had to invest through an index product such as an ETF to see one’s capital grow on a regular basis. Making money seemed easy and no one saw the point of doing fundamental research of companies before investing. Today, these certainties appear to be an illusion. The world has changed in a profound and lasting way, which is reflected (at last) in a strong return to active management and a revaluation of stock picking.
An opportunity for active managers
This development appears to be positive for active managers. Indeed, active management suffered from ETFs’s competition during the long bull market phase, during which it was difficult to compete with indexed management.
In this regard, it is worth remembering the words of John Mainard Keynes who said that “worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally”. However, the best results are often achieved by moving away from the consensus and prevailing ideas. The obvious goal of any investor is to buy cheap and sell high. And to reach this Holy Grail, it is important to break away from the general consensus and focus on the price paid for an asset.