“Although there was a sense of expectation rates would start to go up, I think there was just such a high degree of complacency.”
Hershan is quick to point out that many investors are still sitting on big gains on a two-year view; even with the recent falls, the ASX 200 is up 25 per cent since its recent low in March 2020, while the S&P 500 is up 88 per cent over the period. Even GameStop shares are still up almost 400 per cent since the start of 2020.
Yarra Capital’s Dion Hershan says corrections are the norm. Jessica Hromas
But Hershan says the two-year period where it seemed stocks could only go up was always an outlier, while this month’s correction can be seen more as a return to the reality of volatility and uncertainty. Historical numbers say Wall Street (a good proxy for global shares) will correct (fall by 10 per cent or more) every two years, fall into a bear market (drop 20 per cent or more) every four years and crash (fall by more than 30 per cent) every seven years.
“I think the key point here is that corrections are the norm. They are not an anomaly,” Hershan says. “This is what capital markets actually do. And once a rotation like this starts, it’s probably got legs given the weight of money behind it.”
Diverse investors
That’s in part because of the rising influence of market participants who are not necessarily as focused on fundamentals as institutions typically are. These include passive investors, quant investors, momentum-style investors and even parts of the massive army of retail investors who have flooded the market in the past 18 months.
“Because of this you can have more movement in both directions. You can have far more rapid changes. And you should have more volatility as well,” Hershan says.
The ramifications of rising rates are clearly the biggest factor in the market rout, but they are hardly the only emerging risk investors need to consider.
There may be hopes that the omicron wave has crested around the world, but the renewed pressure it has placed on global supply chains looks likely to last well into 2022, with companies as diverse as guitar giant Fender and electric vehicle maker Tesla expecting little immediate respite.
Geopolitics also remains a clear and present danger, from the threat of Russia invading Ukraine to ever-present tensions between China and the West, which in recent weeks have even extended to how athletes will be treated at the Winter Olympics in Beijing starting on February 4.
Beyond that are a series of issues that, while big-picture, need to be considered by long-term investors. What will the urgent need to address climate change mean for energy prices? How will the ageing of global populations hit economic growth? What do the forces accelerated by the pandemic, such as automation and digitisation, mean for markets?
Markets will remain fixated on the Fed’s next moves in the coming weeks, particularly after chairman Jerome Powell this week made it clear the central bank is becoming worried about the prospect of inflation proving hard to tame, and provided little reassurance that the Fed knows how to do that .
Inflation debate
But for Ben Powell, chief investment strategist for Asia Pacific at the BlackRock Investment Institute, the big-picture questions above feed into a much longer, and broader, debate about where inflation is headed.
BlackRock believes the likely rate increases from the Fed over the next two years have largely been priced in, and the recent action in bond and equity markets may be somewhat overdone. But zooming out, the investment giant believes the Fed and other central banks will have no choice over the coming decade but to learn to live with a much higher level of inflation than what world has become accustomed to.
Strong energy prices are likely to persist. Patrick Cummins
There are two reasons for this.
First, inflation will be driven by supply-related factors rather than demand – supply chain disruptions in the short term, but that beyond higher energy and labour costs caused by climate change and ageing populations.
Secondly, elevated debt levels around the world after the pandemic mean central banks won’t be able to raise rates and crush inflation, lest they also crush economic growth.
“It would seem to us that the Fed can and indeed should live with somewhat higher inflation,” BlackRock’s Powell tells AFR Weekend. ”And that’s true whether you’re an investor, a central bank, a consumer and an employee.
“Clearly over the next decade, it seems to us it’s likely to be the case that a focus on relative winners and losers from a persistently high inflation backdrop is going to be an important part of portfolio construction.”
It’s a view shared by Hershan, who says Australian investors also need to be wary that 2021’s COVID-19 earnings boost is likely to fade.
“I think what we’re going to see is the earnings cycle start to roll over,” he says. “It’s starting to roll over because of supply chain and cost pressures. It’s starting to roll over because financial conditions are getting a bit tighter – the cost of equity, the cost of debt – and confidence is going to start to pull back. And I think what we’ve also learned is that there were just extraordinary winners during COVID.“
Like Powell, Hershan says investors need to hunt inflation-resilient companies that operate in sectors with favourable structures and have so-called “quality” attributes, such as strong balance sheets and a track record of profitability.
Yarra Capital hasn’t invested in the insurance sector for more than five years, but Hershan says it now ticks many of these boxes: two companies (IAG and Suncorp) control 70 per cent of the consumer market, insurers have shown they can pass through hefty premium rises, and it’s one of few sectors that actually benefits from an interest rate rise.
The fact the industry has been sold off in recent years following a string of natural disasters also means valuations are good.
Australia vs the world
UBS strategist Richard Schellbach makes a compelling argument that Australian investors are better placed than their overseas counterparts in 2022. “The reason why locally focused businesses should outperform this year is simple – the economy is set to boom,” he says.
UBS tips Australian GDP growth will hit 5 per cent in 2022, ahead of the broader global economy. As a result, Schellbach likes the financial services, the consumer discretionary sector and the energy sector, where three to five years of chronic underinvestment in new production has left supply and demand tightly balanced and commodity prices strong.
Hershan agrees. “People were too quick to dismiss the sector on ESG (environmental, social, corporate governance) considerations. They were way too quick to decide oil and gas weren’t necessary commodities.”
Schellbach says another clue for investors hunting inflation-proof stocks is to focus on companies that have continued to invest in their businesses in recent years; he argues they “will have advantages in being able to avoid many of the input-cost pressures which their competitors will face.”
Those firms that have digitised their businesses and moved online should have lower cost bases, while companies that have invested in robotics and automation should be better placed to deal with labour shortages and higher wages.
One quandary for investors is how much they need to tweak their portfolios in response to the drama of the last few weeks.
US investor and commentator Barry Ritholtz wrote this week that there are several mental traps that investors can fall into at times of stress, including confirmation bias (being drawn to evidence that confirms our preconceived beliefs) and narrative fallacy (finding comfort in story-telling to help explain the world).
One of the biggest challenges for investors is defeating action bias – the need to do something – anything! – to react to bad news. ”We have a tendency to prefer to do something in the face of uncertainty or confusion, even when the overwhelming evidence suggests our actions on average tend to cause harm, and inaction is a more effective course,” Ritholtz says.
But Hershan argues the situation is complicated in Australia, where the ASX 200 has always been hugely concentrated around miners and banks, but will become even more concentrated following a series of recent takeovers, including those of Sydney Airport and AusNet Services.
While he concedes he’s talking his own book, he argues this is likely to be a period when careful stock selection really matters. “We’ve said it repeatedly: this is a year to tread carefully.”
But it’s probably not a year to get out of stocks completely. As BlackRock’s Powell says, while interest rates and bond yields are going higher, negative real yields (taking into account inflation) are “going to persist for years to come”.
As such, equities are likely to remain a key part of an investor’s overall portfolio; BlackRock’s preference is currently for a barbell approach, with cyclical stocks and one end and high quality, proven tech companies that can profit from the increasingly digital post-pandemic world.
”In the round, most investors still have the same challenges they had three months ago and three years ago,” Powell says. “How do they retire with dignity? How do they put their kids through college? How do they deal with expected healthcare challenges and so forth.
“We think a resilient, well-diversified portfolio is a critical part of that. That’s as true today as it was two months ago, and three years ago and 30 years ago.”
