Investors need to pay attention to the capital cycle
The writer is editor-in-chief of MoneyWeek
Nothing says Christmas to a money journalist more than the arrival of the first 2022 outlook reports from the financial institutions. I can therefore tell you with complete certainty that it is nearly Christmas — and that, according to most of those who make a living in the equity markets, you will have no need to spend it worrying about equity markets. There is, they say, more good news than bad.
The last few weeks have been pretty volatile, they say, but economies are still growing nicely. Household savings are high, unemployment is low and both those things bode well for consumption in 2022, as does the shift in favour of fiscal policy by governments (they are all big spenders now).
Supply chain bottlenecks are also likely to ease in 2022, something that will both allow a gross domestic product-boosting inventory rebuild and ease inflation — which markets aren’t much worried about anyway. We are also, as one note from Invesco puts it, “living in one of the most noteworthy periods of change in history”, with the digitalisation of everything creating extraordinary new industries and medical advances yielding astonishing new ways of treating human diseases.
And Covid? By next year it may be that the expanded use of high efficacy antiviral pills will have pushed it some way down everyone’s list of things to worry about. Add all this up and global growth is likely to be over 4 per cent next year — well above the norm for the past decade. That, we are also told, is just the kind of background that is pleasantly supportive of share prices.
The analysts at Barclays note that this year has been characterised by nonstop earnings upgrades — companies just keep doing better than we expect them to. That, they say, is likely to keep happening, partly because of the good growth but also because Covid has “crushed competition” — the way in which the pandemic has “disproportionately hurt small and medium-sized businesses” means that there may have been a shift in the share of income going to larger (listed) firms from smaller (unlisted) ones. So there it is: markets are tough enough to shrug most stuff off. You can go and get on with your Christmas shopping. Nothing to worry about here.
A lot of this makes total sense. But there are a few problems with it nevertheless. It ignores policy risk. It ignores price. And it ignores the capital cycle.
Take policy risk first. It might be that inflation slows next year. But the truth is that no one is entirely certain quite how inflation really works. It is entirely possible that central banks have had a hand in keeping inflation low over the past 20 years. But it is just as likely — even more likely — that low inflation has more been an effect of the wave of globalisation and cheap labour that followed China’s entry into the World Trade Organization in 2001 and the expansion of the EU.
If that is true, the idea that central banks can sort it out with the odd 0.25 percentage point interest rate rise is laughable. It may be that they must either accept the inflation or actually raise rates properly above inflation rates to control things. That isn’t in anyone’s forecasts.
On to price. Markets are fragile when they are expensive, as they mostly are now — largely because not all market participants really believe everything they write in their outlooks.
We all know that future returns are a function of today’s price. And that’s fine when we can kid ourselves that earnings will soon rise so much that valuations will lower themselves without us having to lose any money. But it isn’t fine when confidence takes even the slightest of knocks.
That’s something we saw very clearly on Friday with the market panic over reports of a new variant of the Sars-Cov-2 virus. If global markets were cheap and resilient, the fact that we don’t know if the new variant is a bad one (more infectious and more lethal) or a good one (more infectious but milder) would have had no effect on markets. That they are neither had the FTSE 100 down 3 per cent before lunch.
Finally, consider the capital cycle. There is a must-have book for every stage of market madness. Right now it should be Capital Returns: Investing through the Capital Cycle, a collection of essays edited by Edward Chancellor. The idea here is simple: you should look at how much capital is flooding into a sector rather than focusing on price alone. The more capital there is, the more likely it is that sector will see oversupply and price collapse.
Right now it is easy to see those sectors in which capital seems both free and unlimited (renewable energy being the obvious example), and easy to see where it has been neither for some time (for instance, old energy and mining). This is a combination that should make investing feel both harder (the risks are high) and easier (there are obvious opportunities).
So what should the 2022 outlooks really say? That markets are fragile and set to be very volatile. That there might well be good times ahead, but that many prices already discount 20 years of partying. And perhaps that investors should bias their holdings towards cheaper sectors and, in particular, towards the capital-starved ones that it turns out we need as much as we ever did.