It Is Not All Chocolates and Roses

“Truths and roses have thorns about them” – Henry David Thoreau

It is a little while since I last wrote but that is not for the want of trying. Information with which we all juggle, has been constantly changing, and at a pace that had the potential to make a mockery of any view or worse render it utterly wrong. With that said, as a team we constantly question the status quo and specifically how we recommend the deployment of capital. As you will know, we invest in companies which we believe to be of the highest quality and whose activities rely less on the coming and going of the economic cycle and to this, we stick. We apply a similar policy to fixed income too, where we aim to position investment in the right maturities, governed in large part, by the interest rate cycle.

Of course, I am not afraid of being wrong, far from it, given it is a path of discovery that informs debate, knowledge, conclusion, and decision. In July last year, I published a note called ‘Up, down, sideways and a round trip’ which also included the quote ‘Ride the horse in the direction that it’s going’ – Werner Erhard and in the same I wrote “I sense a change in the wind is coming the question is, what is the trigger and when will it manifest itself. I would like to call the current environment a dichotomy conundrum where two variables seemingly at conflict are not but then are at the same time.” In the same note, regarding US Bond yields, I also noted that “the pace of the increase [in yields] is a hotly debated issue. My current view is that US 10 Year bond yields will rise toward 2% over the next year and that this could even be by the end of this or even early next year.” The 2% level was reached in March 2022 and currently stands at almost 3.5%. As for the dichotomy, this is the complex interplay between rising interest rates to quell inflation and a potential recession calling for lower interest rates.

This note is not a trumpet blowing event, I am sure I have posited wrong views aplenty, but the key message is to keep challenging one’s own view, not for conformation bias but to recognise where the conclusions may be wrong and if so, what to do about it. Investments do not wait, they are ‘impatient’ to move and no more aggressively so than in times of uncertainty. As I am always pointing out, there is no worse error than soundly concluding that something may occur, setting a strategy, being proven to be right and not having implemented the strategy to address the conclusion.

It is safe to say, the confluence of global events is presenting us all with a challenging environment comprising multiple mixed messages. Whilst this maybe commonplace in times of uncertainty, the soup of information currently has a greater power to shape investor decision than is usual given a ‘fear of missing out mentality which is married to a fear of being ‘in’ whilst being charmed by the sugar of central bank rhetoric’. In summary, investment sentiment is lurching between ‘buying’ or ‘selling’ at a rapid rate whilst being bewitched by the central banks’ view where their current credibility is questionable.

We addressed our growing fears and concerns with a greater move toward cash (not fixed income) at the start of 2022 with the sole aim of protecting capital and this positioning remains the same today given the growing and significant uncertainty. This is not a move away from being invested, far from it, more it was the removal of an overweight in risk assets that we had been correctly carrying for many years, as the good times rolled on. Whilst this current period of uncertainty is uncomfortable, it should be remembered that investors have enjoyed a significant and uninterrupted period of prosperity that began in earnest, in 2009 after the Global Financial Crisis or GFC ended.

But what of the road ahead?

A helpful quote from Donald Rumsfeld will shed some light on the matter – “There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns; the ones we don’t know we don’t know.”

Since the start of the year, the global economic outlook has become increasingly uncertain with estimates for growth consistently ratcheted down from last year’s lofty levels. The conflict in Ukraine and ongoing lockdowns in China have further dampened world trade at a time that global supply chains were in the process of repair and inflation began its inexorable march higher. The early signs of inflation were quite evident in New Zealand, with help wanted signs on café doors, reduced staff impacting opening hours and spiking job ads indicating a dearth of workers; exacerbated by a lack of worker mobility due to the pandemic response. Energy price rises, whether it be natural gas or oil, were felt around the world and most especially in Europe and the United Kingdom which further stoked the wage and food price inflation fire there.

Economists and central banks typically focus on inflation ex-food and energy prices, given their inherent volatility. The result, core inflation, is the preferred measure and used, amongst other things, in setting interest rate policy. Whilst this levels the comparison ‘playing field’ it masks the negative impact on consumer spending especially where elevated food and energy prices remain for a sustained period. Like all investors, we keenly monitor economic data but often this is lagged with the numbers reflecting things that have already occurred. Often the best real-time indicators come from understanding your own situation and being aware of your own interaction – for example whether or not to buy a cucumber at $8 each. Without a doubt, there are food shortages that have been exacerbated by the war in Ukraine with corn and wheat exports curtailed but also from the cost of food production spiking due to fertiliser costs lowering crop yields and heating costs for greenhouses impacting production of fresh produce. For now, seasonality is suddenly back in vogue after decades of expecting all produce to be available all year round and at consistently low prices.

With rising prices comes lower consumption especially in discretionary items and global retailers have been warning on ballooning inventory for months and their share prices have responded by falling or worse, going out of business. With everyday items of necessity becoming more expensive, unionised labour has mobilised and for the first time in years has teeth. Strikes over pay are now commonplace and awards have sometimes been significant. This rightly scares central banks given this inflation is most certainly not transitory. For years, wage inflation has ranged between non-existent to treading water whereas today, companies find employment costs are rising, and fast. With a lack of available workers, companies are increasingly poaching from competitors, luring them on lucrative packages, and this comes not only as a higher cost but can become a virtuous circle. Paying existing workers more is quite often cheaper than acquiring from elsewhere but although this is a little more benign, it too unnerves central banks.

So far this year, manufacturers have been successful in passing on increases in operating costs whether they be from input (raw materials), energy or wage costs. Obviously, this has further fuelled inflation, but this straight-line power has started to be challenged. The results of this so far are mixed. In the United Kingdom, a major food retailer refused to agree price increases on a range of products from a well-known food manufacturer who responded by refusing to supply the retailer in a Mexican standoff. And it is not only in food and where one can, substitution is taking place.

Of course, there are other paths companies may take. They can decide not to pass on their price increases which will result in deflating profits, pass them on with the potential to destroy demand which will deflate profits, or they can reduce costs elsewhere to protect profits and not pass all if any of the price increases on to the end customer. But where would those savings come from? Potentially from a reduction in the workforce. It really is a heady situation that does not necessarily have a pretty ending. In addition, countries as well as industry are looking at their critical needs, items that allow economies to tick to a drumbeat – think semiconductors etc. – and safeguarding supply. This may involve onshoring from cheaper centres of production, notably China, and moving some to the more expensive labour market domestically or with shorter shipping routes and times.

What has surprised me over the last three months was how robust company profits have continued to be, seemingly shaking off the deteriorating macro-economic environment with aplomb but how long this will last is a matter of conjecture. My view is that the wheels will wobble sooner rather than later and quickly too if other pressures do not abate.

As discussed previously, central banks have been flat footed in their efforts to wage war against inflation, which may require a continuation of the aggressive interest rate hikes we have seen so far this year. Whilst some still hold onto the notion of a ‘soft’ economic landing, the rhetoric is increasingly of a recession and the spectre of stagflation is more likely than at any point in my career. With inflation, at least in part, caused by supply side disruptions (Ukraine war and the ongoing pandemic hangover) the ‘tools’ brought to bear by the central banks are blunter than normal and consequently orchestrating some demand destruction maybe the goal. Worse, in some countries, the central bank is also being countered by fiscal stimulus from government spending. It is worth remembering that most central banks have a mandate for stable prices, maximum employment, and moderate long-term interest rates. This appears to be increasingly difficult to achieve but no action is not an option despite the inevitable pain that will come. Indeed, delay will likely exacerbate the already mounting pressures.

While official data continues to point to a healthy job market, a reversal of fortunes cannot be ruled out especially if demand wanes and economic growth goes into reverse as I currently expect. If this does occur, I suspect a change in this sentiment and economic pillar could be swift catching many offside and would present additional hurdles to the already deteriorating environment. This has the potential to make any looming recession more potent than many currently expect given debt servicing costs, including mortgages are rising whilst inflation simultaneously erodes real purchasing power of money today and in the tomorrows.

The corollary to this will be an attempt by governments to use targeted fiscal spending to soften the monetary policy blow albeit in a somewhat more tepid way than many would like. The hangover from the unprecedented fiscal support, the result of the pandemic, has left many countries with public finances in a relatively weak position given rising debt servicing costs and the need to pay higher interest rates to fund future spending. The natural but unpalatable casualties here are social spending, the provision of services and the elephant in the room, climate change. What is critical is for those most vulnerable to be prioritised, but this is not always as easy as one might wish.

This all feels rather doomsday, but pain is always present when bubbles burst, and we have endured this before and we will again in the future. To varying degrees and in a bid to discount the economic deterioration, asset prices have fallen this year, but it is too early to rule that we are past the worst at this time. Indeed, the clouds on the horizon are thickening and a shade or two darker too but investors look forward and discount economic expectations and we are trying to work out how far interest rates need to go to control inflation and as soon as possible.

Will we move into a recession, see unemployment rise, endure higher interest rates, experience stubborn inflation and stagnating or falling company profits? Quite possibly, but it is always at its worst before the dawn, and it is precisely when the thought of investing makes you feel a little nauseated that one should do so. Any sell off may feel a little disorganised, but it is then that the ‘rats’ will have left the sinking ship.

I recognise that times are tough and that they may well get a little tougher still but investing in quality businesses and protecting capital will benefit when the turbulent seas calm and the sun rises. Opportunities remain and the dawn gets nearer every day. Capital destruction only happens when bad decisions are made, or one is forced to sell at an inopportune time.

I will finish with two quotes

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett

and

“The sharp thorn often produces delicate roses” – Ovid

Our thorn is inflation, slowing growth, rising interest rates and geopolitical unrest including the Ukraine war. We may enter a recession and we may not get out in a while, but we will get out. Then we will have our roses.

Stay the course!

Tim Chesterfield
Chief Investment Officer

September 2022