August 2022
US stocks have just seen a two-month-long, 20% rally off their lows, which are very average metrics for a bear market rally. Long-duration technology stocks and lots of the old meme and other rubbish (loss-making) stocks led the charge, partly driven by share buybacks, in a short-covering rally that almost no one with any fundamental research outlook fully participated in. Stocks are now at a critical point where they either roll over, potentially even testing new lows in months ahead in response to a market or geopolitical crisis, recession, stagflation, or they go on with a new bull market in response to central banks becoming more dovish and giving up the fight against inflation.
Which is it to be? Let’s continue the debate…
What will drive a new Bull Market?
If it is to be a new bull market, it will likely be due to central bank policy alone. Central banks will pivot more dovishly, aggressive interest rate rises will stop, and inflation will ease enough for central banks to claim their job is done and/or accept a higher inflation target due to growth concerns. Ultimately inflation needs to be moderately higher to wear away the debt bubble (in the absence of running the economy well, which we have seen no evidence of in recent years). Hence such a policy shift will likely have to come eventually – it is merely a matter of timing.
The challenge with expecting a new bull market today is its prematurity; contained inflation of 2% (or even <4%) isn’t coming any time soon to the US, and more time or more aggressive policy on the part of the FED is required for it to get there. While US inflation may continue to fall from here as the economy weakens, inflation is highly likely to remain well above its target rate on average and volatile for months (if not years) to come. If history is any guide, this will require further meaningful interest rate increases as inflation has not become contained historically without interest rates exceeding the inflation rate. As we are nowhere near this point, the case for a new bull market today appears fragile unless you strongly believe central banks are incredibly facile.
While in the short term, the case for such a quick and aggressive new bull market appears flimsy, ultimately, we believe it is eminently sensible to question whether today’s central banks have the backbone or credibility to adequately crush inflation by making policy truly restrictive over the medium term. Central banks will again err on the side of easy money and will almost certainly do so in response to a financial or economic catastrophe (which they may even require to pivot dovishly). The question is around the timing of this policy pivot, with recent market action suggesting the market expects this is imminent and will not require a recession or crisis to get us there first, yet further meaningful interest rate moves will be highly likely to cause a recession or market accident. Being a bull involves betting against all the tough FED talk, effectively claiming they’re all talk and not willing to stop inflation in its tracks today because this involves killing demand and poor growth outcomes. The bulls may be correct over the medium term but risk being very wealth destructive in the short term.
Of Course, it is a Bear Market Rally!
The fundamental outlook suggests the bear market has further to go, both in time and potentially in degree. A bubble in everything isn’t simply corrected with a mere 20-30% fall and constant high multiples, but will require a big bad bear market to truly wash away the excess. Many assets (e.g. Australian housing) remain hopelessly overvalued, profit margins remain excessive, and speculation has not yet been properly extinguished. Many investors foolishly remain believers in passive investing and the idea that property and stocks will always make 10% a year despite not making that themselves and the outlook being poor! The geopolitical world order has rarely appeared more problematic – peaceful prosperity is dead – and deglobalisation and supply chain resilience along with public policy directed by environmental and labour ideology rather than being market-friendly mean market participants will likely require higher prospective returns and hence lower multiples in the face of entrenched higher inflation.
By now, we all know the economy is a basket case and that stagflation is already with us – inflation is high, but there is low real growth and disastrous productivity outcomes. Markets cannot be removed from real-world wealth creation ad-infinitum and floated on a debt bonanza forever, hence they won’t be. Expect years of volatile but go nowhere markets where only good active management can extract a decent return, but passive investing is dead for a decade.
It is difficult not to disagree with the bear market view that the party is not over until we see the lights turned off. Put the case for a bull market and a bear market together, and it is reasonable to expect that we will see a half-hearted but still punitive response to fighting inflation, causing a prolonged bear market or a market crisis before central banks feel compelled to double down and entrench a higher inflation outcome. Nominal growth can then be reasonable even if real growth remains disastrous with equilibrium valuation levels being uncertain. In the short term, the market would flounder before a new volatile “Ponzi like fake wealth” bull market begins with economic, market and political outcomes eventually resembling those of an emerging (or submerging) market.
Given the Scenarios and Economic Outlook, what are the three things we are doing?
(1) The economic and market outlook suffers from a high degree of uncertainty given its vast potential variability, sensitivity to tail risks and dependence on policy and geopolitical outcomes. As such, it is essential to be humble and build greater diversification and resilience into portfolios, just as it is important for countries to do the same with economic policies – effectively preferencing resilience over maximum return or efficiency. We believe in reducing reliance or conviction on bullish market outcomes and having greater exposure to alternatives and active management, as these diversify the sources of returns. As such we carry meaningful weightings to alternatives such as long/short, event-driven, market-neutral and convertible bond strategies in our portfolio and are doing so ahead of simple passive stock and bond exposures (better suited to times past). Simply put, we carry lower passive equity and bond exposures to limit our risk to highly adverse outcomes.
(2) Given it is more likely than not that we are entering a period of higher and more volatile inflation, notwithstanding an oil-induced short-term flattening in the US, with inflation more likely to be structural in the 2020s, we are also preferencing higher weightings to assets that do better in an inflationary environment, particularly those which have been and continue to be capital starved or have structural tailwinds. These assets serve the dual purpose of also being favourable should further geopolitical, and military conflicts ensue, which is increasingly likely. As such we are investing in real assets, commodities such as energy, uranium and precious metals, and resource stocks instead of financial assets.
(3) In addition to the above, we also like specific themes which offer partial solutions to today’s low productivity growth and technology challenges, including some technology and healthcare stocks and assets which are structurally favoured by government spending in response to populist or political beliefs such as climate change e.g. carbon futures. We are cautious about exposure to Europe and China while geopolitical risks remain elevated.
By having a highly differentiated portfolio from the mainstream, we run the risk and benefit of performing very differently. In the short term, we believe this is prudent because the economic and geopolitical risk is extreme and the risk of a continuing stagflationary bear market is much higher than historical levels. If a crisis ensues, our approach will also allow us to become more risk on and increase equity exposures at much cheaper prices. If not, we expect a portfolio which is better aligned with stagflation should do relatively well regardless over the coming years – as real growth remains weak due to an ageing population and disastrous productivity growth – and inflation proves more volatile than simply transient in response to poor public policy and ongoing geopolitical frictions. There is every need to act, re-engineer and better align portfolios to the dominant economic paradigm and we expect this will prove a necessity with time.
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