Playing Investment Offense in a Defensive World

Playing Investment Offense in a Defensive World

For the past 25 years, the investment world has lived life under a succession of Fed Chairman “puts”, commencing with the “Greenspan Put”, yet as each crisis since then has been bigger than the last, so too has the implicit strike price of the central bank “put”.

More than any other market dynamic, this has extended the bull market in bonds by decades.

But that is all changing. The amount of negative yielding bonds has shrunk from a peak of $19 trillion to less than $3 trillion in a very short span of time, and this is at the very beginning of an interest rate tightening cycle. It remains to be seen just how far central banks can raise the official cash rate given the unprecedented amount of leverage in the global financial system, but we will find out soon enough.

Throughout this era of policy tilt or bias, there have also been a number of other distinct forces that have also converged on each other, such as:

Ø  The disinflationary impact of globalisation

Ø  The disinflationary impact on input costs of offshoring global supply chains

Ø  Valuation expansions enabled by declining interest rates

Ø  The repealing of the Glass Steagall Act, enabling banks to rapidly expand their balance sheets

Ø  Technological advances increasing the sophistication of financial markets and products enabling greater effectiveness of arbitrage strategies, leading to fewer pricing anomalies

Ø  Capital exporters, with lower relative yields in their own economies, sought a risk premium from capital importers

Ø  Capital expenditure levels in the US reaching the lowest level since 1958

Ø  Deregulation in financial markets leading to banks dominating equity indices and debt issuance – instead of providing oil to the economic engine, they became the engine

Ø  Unprecedented inflows in passive investment funds meaning there was always a “bid” from that sector, as they had to be fully invested

Ø  The proliferation of “zombie companies” - those who cannot service their interest costs through earnings (28% of the Russell 3000 Index comprised zombie companies)

In such an abundance of favourable conditions for investors, this meant that the biggest winners were those who played “offence” in such an offensive world. Those businesses that could run the leanest balance sheets and achieve the highest return on equity commanded the steepest valuations. The downside of this meaning that it was not businesses that were being managed, but share prices and credit spreads. It is understandable that passive equity funds should increase exposure to those stocks that issued more equity, but it is an absurdity that a company that issues more debt requires passive debt funds to increase their exposure. Share buybacks and debt-funded dividends are more layers of the same short-term management strategies.

This comes at a cost. Businesses become less resistant to shocks, less resilient and require central banks to increase their amount of financial system support as these less resilient entities cannot endure inevitable financial system re-sets.

But what happens when 40 years of investment tailwinds become headwinds? Contrast the above points to today, where:

Ø  Supply chains are being reconfigured due to, inter alia, national interests

Ø  Lack of investment in fossil fuels is being compounded by sanctions against one of the biggest producers

Ø  Fertiliser shortages from similar sanctions impacting future crop yields the world over, as well as grain supply being severely damaged by the Ukraine/Russia war

Ø  Increasing defense spending across the Western world (one of the most inflationary forms of expenditure)

Ø  Unprecedented, Covid-motivated economic subsidies and stimulus are being removed

Ø  The London Metals Exchange cancelling nickel trades due to counterparty solvency concerns

Ø  Massive price differentials in natural gas prices between the US and Europe

All of the above conditions are symptomatic of a contraction in globalisation and the emergence of inflationary pressures. This will cause a great dilemma for central banks, and none of those dynamics will quickly disappear or be resolved. For example - as an importer of food and energy, how long will the Bank of Japan be able to support their bond market at the expense of their currency? At what point will a strengthening US dollar put pressure on various currency pegs?

Global economies have entered a phase of higher interest rates, deleveraging, stimulus withdrawal and commodity shortages at a time of minimal resilience or buffer. “Too big to fail”, or those surviving only due to zero interest rates will become “survival of the fittest”.

Which is how markets should work – as a clearing mechanism.

So, how differently will investors need to look at the world we appear to be entering, that of a “defensive” investment world?

There are a number of themes, or lenses that will help navigate such an environment, such as:

Ø  Capital intensity – those businesses that are protected by the amount of capital required to compete against them, ie. the opposite of those relying on return on equity

Ø  Scarcity – those that supply something of increasing scarcity, and therefore maintaining pricing power

Ø  The “haves” versus the “have nots” – rather than being a capital importer-versus-exporter world, those economies that have a stable supply of essential commodities (read food and energy) will thrive against those that do not

Ø  Interest rates – those who have been competing against zombie companies will get stronger as they acquire cheap assets from the weaker

Ø  Structural price anomalies – those that are not reliant on mean reversion or arbitrage to eliminate such anomalies

Ø  Government – those that rely less on government largesse

Ø  Capital expenditure – those that reinvest in their business as opposed to short-term capital refunds to shareholders

Economic resilience will be more important than it has been since the last time we experienced a secular increase in interest rates. Avoiding permanent impairment of capital in a world where “boring is good”, as opposed to those dedicated to short term shareholder appeasement, will serve investors well.

Above all else, investing in a defensive world requires investors having the freedom to do what they choose to do, and not do what they are forced to do.