DAVID CROSOER: Making sense of investment cycles

Equity markets have been under considerable selling pressure in 2022 as investors expect that stubbornly high inflation will cause central banks to raise short-term interest rates multiple times this year. At the same time, expectations for global economic growth have been revised downwards, after further disruptions to global supply chains on the back of Russia’s invasion of Ukraine and China’s strict Covid-19 lockdown measures.

When investing for the long term it’s helpful to remind oneself that while markets go through cycles, it is often more important to focus on the long-term trend than become preoccupied with short-term fluctuations. As a multi-manager, the critical questions for us are whether interest rates, inflation and economic growth are likely to be structurally higher or lower than we have assumed in the past. These questions are important because they will affect our long-term strategic asset allocation to the various asset classes as well as whether tactically we are receiving sufficient compensation for going overweight or underweight a particular asset class.

Now, financial markets are pricing in substantial short-term interest rate increases from central banks (the SA Reserve Bank is expected to hike by 0.5 of a percentage point a further six times in 2022 after May, and the US Federal Reserve four times), but these rate hikes are coming from multi-decade low starting points, and markets have not materially upwardly revised their long-term expectations for the neutral short-term interest rates of about 2.5% for the Fed and 7.5% for the SA Reserve Bank.   

Long-term inflation expectations today are still anchored on what they have averaged since 2000. The IMF forecasts that developed market inflation may fall back below 2% per annum by 2024 (it has averaged 1.9% since 2000) and is not expecting SA inflation to exceed 6% a year over its forecast period (it has averaged 5.5% since 2000).

Consequently, while the market is preoccupied with the latest (high) inflation number, the critical decision is not so much the speed that inflation reverts to its trend (though this is an immediate and pressing concern), but rather whether the trend for inflation over the next couple of decades will be similar or structurally higher than it was in the past.

Given that markets are not expecting long-term structurally higher inflation, our portfolios tend to have a strategic allocation to inflation-linked bonds, as they will offer protection should inflation be closer to the 5% it averaged for advanced economies (and more than 10% for SA) in the 20 years preceding 2000.

At the same time, we have started building up a higher cash position given that the market is not expecting that real interest rates could be materially higher than the recent past, with muted interest rate expectations more than 12 months out.

While the prospect of an economic recession will undoubtedly affect asset prices in the short term, the more important question for the next decade (or two) is whether the global economy will continue to grow at its historical trend growth of 3.5% a year through its transition to a greener economy, and whether the SA economy will remain structurally stuck in an underwhelming 1% annual growth rate for the foreseeable future.

Our portfolios are overweight in SA assets, as we believe we are receiving sufficient compensation for taking on the risk of mediocre economic growth given that the market is not expecting that SA will be able to implement the reforms to change its growth trajectory in a positive direction.

At the same time, and partly to diversify this SA-specific risk, we have a long-term preference for (global) asset managers that can include a growth focus, given our view that such managers are more likely to identify companies that will benefit from the global transition to a less carbon-intensive global economy, while also favouring strategies that are flexible enough to include value opportunities should it make sense.

In short, it is tempting to be swayed by the short-term noise about economic variables and try to expect their next direction. But it is incredibly difficult to time investment cycles, and we think it is often more useful to look a bit further out rather than try to time short-term moves.

Our portfolios try to look through short-term volatility to appropriately benefit from longer term trends, while remaining well-diversified to limit short-term volatility.

• Crosoer is chief investment officer at PPS Investments.