Removing the Crutches
The global economy faces many challenges as the pandemic enters its third year. The rapid spread of Omicron is testing the resilience of the economic recovery. The potential of Russia to invade Ukraine is posing a threat to international peace and security. Supply chain blockages coupled with strong demand for goods, rising wages, and the upward tear in commodity prices are creating price pressures and pushing inflation above central bank targets.
“Inflation is when you pay $15 for the $10 haircut you used to get for $5 when you had hair” - Sam Ewing
Inflation has always dominated economic discussions because it has a direct impact on the purchasing power of cash in your wallet. After decades of disinflationary trends, inflation has made a great comeback, as we observe inflation numbers exceeding the central bank targets in some major economies. We have built some inflation protection in the portfolios, please see, “Easily Broken”. As previously noted, the expectations on inflation have turned from transitory to be more persistent and can be explained by the following:
Demand and Supply mismatch – Elevated inflation is not only a consequence of supply blockages but also the very strong demand outstripping those shortages.
Shift in spending toward goods over services – Due to mobility restrictions.
Wage pressures – Goldman Sachs recently reported an increase of 33% in pay expenses suggesting the emergence of wage inflation.
Reduced labour force participation – Generosity of income support programs and withdrawal of older workers due to health concerns and a substantial increase in housing and financial assets.
Rising inflation has become a key concern for investors as persistently elevated inflation could force central banks to raise interest rates sooner than expected instead of a gradual hiking cycle. However, central banks have indicated their tolerance of higher inflation because moderately rising inflation is consistent with a recovering global economy.
Governments injected unprecedented levels of liquidity into the economy to help businesses stay afloat, support households and preserve employment – now that economies have restarted, and GDP is close to pre-pandemic levels it is appropriate for the central banks to scale back the support by bringing forward the interest rate hikes and accelerate the taper of asset purchases.
As central banks begin to remove the crutches, markets are feeling nervous and shaky before they start to walk on their own feet without support. Since the start of this year, S&P500 has fallen by ~10% and NASDAQ by ~15%. In comparison, we have protected approximately 2/3rd of the downside by having a defence mechanism in place and maintaining a diversified composition of investment holdings.
Will the global economy be able to walk without the crutches of policy support?
We think so, if the crutches are removed with care and in incremental steps. Overall, tighter policies will likely be appropriate as global public debt has reached record levels to cover pandemic-related spending. However, the restart is more dependent on the easing of restrictions now, than government support. Households have built up excess savings that can support the next leg of recovery as the consumption of services reverts to mean. Omicron may have derailed the recovery, but it has not stopped it – it has proved to be a less severe strain with a significantly lower hospitalisation rate than previous strains. The continuation of solid corporate earnings, increased consumption, and the adaptation of the human population to live with COVID-19 provides us the confidence to stick to our investment discipline and find investment opportunities presented by recent market volatility.
“To be able to focus is a great virtue if you are a watch repairman, a brain surgeon, or a chess player. But the last thing you need to do when you deal with uncertainty is to ‘focus’ ”. – Nassim Taleb, Black Swan
While facing uncertainty, we tend to focus all our attention on a single event and its potential impacts i.e., withdrawal of policy support in the current scenario. Nassim Taleb is reminding us to not lose our big picture view of the larger order instead of looking at the world from the tunnel vision of the most recent news flow. We believe that a market correction does not change the fundamentals of great businesses, their competitive advantages and earning potential, but provides entry opportunities for a patient investor. With a long-term outlook, every selloff is a buying opportunity, and one doesn’t even have to pick the bottom of the market. It is impossible to pick the bottom of the market unless you are lucky or lying.
Rising or falling markets is not just an economic condition. It is a state of mind which always changes. Hence, the significance of long-term investing cannot be overstated, and investors need to be on the constant lookout for opportunities presented by the market selloffs.
