In our December quarterly we suggested that there were seminal changes underway in investment markets after a decade or more of the same investment factors impacting markets. Thus, until recently interest rates had been in decline since the GFC, inflation in developed markets had remained remarkably stable through a period of extraordinary monetary creation and the US stock market had consistently outperformed other developed markets. During the first quarter of 2023 we have seen little to dissuade us that we are indeed living through a period of decisive change. A prominent strategist recently highlighted a similar point in a more comprehensive manner.
Things you had never seen (as at end 2021)
One of the problems created by long running trends is that investors begin to act as if things will never change. Thus, asset classes and investment strategies that benefitted from these extraordinary conditions became popular, often spiced up with leverage. We saw this play through in the previous two market bubbles and subsequent collapses, the Tech Bubble and the Global Financial Crisis (GFC). It appears as if we are beginning to see some of those early signs now, where strategies or asset classes that became popular on the back of exceptionally low interest rates are beginning to show signs of stress. Plenty has been written on the collapse of Silicon Valley Bank (SVB) which appears to have flourished in a “Tech Bubble 2” environment, a time when money was essentially free and tech assets changed hands at prices that bore little apparent reference to profitability. SVB benefitted from playing a significant role in that eco-system and ultimately has been mortally wounded by interest rates increasing. Hardly a week goes by when there is not a fresh announcement from a tech company of staff layoffs as ‘free’ cash is no longer flooding profitless or significantly over-valued tech assets.
The private equity industry is another that has boomed in this low-rate environment with easy and cheap credit for financing acquisitions and ready markets available for on-sale of assets. Large amounts of capital, together with significant leverage, have been invested into this glamour sector. Here too things have changed with cheap funding no longer available, lending standards tightened and stock price declines, especially in the previously highly rated sectors, making a successful exit more difficult. In Australia we have seen a number of proposed acquisitions fail to proceed with recent examples being Link Administration and Ramsay Healthcare while speculation around final completion overhangs others. Given the leverage that exists with many of these private equity businesses, an economic slowdown will only exacerbate the pain that is being inflicted by higher borrowing costs.
Commercial property is an asset class that is almost always in the firing line when credit conditions tighten. Valuations in this space have benefitted enormously from lower interest rates. Capitalisation rates for regional retail centres firmed from ~6.5% at December 2009 (the low post the GFC) to ~5.4% while prime office has strengthened even more from ~7.7% to ~5.4%. Thus far there has only been a small reversal as interest rates have increased but the General Property Trust December 2022 annual report highlights that a 1% softening in capitalisation rates will reduce property values by ~18%. Given the experience of the last cycle and the extent to which interest rates have already increased, a 1% move in capitalisation rates would seem a minimum expectation and such a move would begin to pressure some REIT balance sheets. We retain a cautious stance towards REITs.
While investors can be reasonably confident that the areas highlighted in this note are likely to face significant challenges, it is the “unknowns” that are of most concern. The tentacles of ultra-low interest rates are likely to be very pervasive, but in many instances will take time to become apparent given factors such as delayed reporting cycles, existing hedging arrangements and assets held outside the immediate glare of market pricing pressures. The pace at which regulators, monetary authorities and governments have acted to avoid a liquidity crisis over recent weeks is encouraging for market participants and indicative of a keen awareness not to repeat the mistakes (understandably) made during the GFC. Nevertheless, it seems likely that additional challenges to market liquidity (and almost certainly asset quality) lie ahead.
Where there is more clarity is the impact that recent developments will have on economies. Tighter lending standards have been evident for a while and should be expected to have even more impact going forward. Together with the substantial tightening we have seen in monetary policy globally, it is a much tougher environment for companies to operate in and this seems likely to pressure earnings, a risk which markets in general are not giving much weight to. Stock markets remain surprisingly resilient in the face of stubbornly high inflation, placing weight on the view that current financial market disruptions will result in early monetary easing. Absent monetary authorities giving up on the fight against inflation (which would not be a good outcome for equities over the longer run), monetary easing would in our view only happen if weak economic growth aided a softening in inflation. Such economic weakness would flow through to reduced earnings, again something which the market is not pricing in.
In the uncertain environment in which we thus find ourselves, it would be comforting to be able to invest in a range of well-priced, industrial stocks exposed to less economically sensitive sectors such as food retail and health care. Unfortunately, with a few exceptions the more defensive businesses have also been a beneficiary of low interest rates and with extended valuations are another asset class where a correction seems likely (there is often a world of difference between a defensive business and a stock that is likely to prove to be defensive). The chart highlights that the price earnings (PE) multiple of industrial stocks has already corrected somewhat, but only such that it is now inline with the peak multiple seen in the Tech Bubble (i.e. prior to the sharp correction), and remains well above the peak prior to the GFC correction. In both those instances the PE multiple ended up below 15 times forecast earnings after correction, a long way from where we sit today at ~23 times.
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