The Viewpoint: This too shall pass

‘This too shall pass’ is an adage believed to be of Persian origin, noting that neither the positive nor negative aspects of life ever last indefinitely.

It is a reminder to appreciate the better times, and not to become too downhearted in more troubled ones. Given Persia is the historical Western name for the region of modern-day Iran, it is particularly apt now.

The events in Iran are distressing to see. The reasons for the war commencing and its likely outcome are beyond the scope of this blog. As investors we have to contemplate how it changes the environment we are operating in.

Crises are something that investors must learn to deal with. In my fund management career, I’ve seen the aftermath of the September 11 terrorist attacks, the global financial crisis, the crisis in the eurozone, a pandemic and the Ukraine/Russia war. In their moment they all seemed impossible to see a way out of. In time, they have passed.

Crises are something that investors must learn to deal with.

As investors, it is almost impossible to react to the first order effects of crises. To do so requires rapidly becoming an expert in complex and technical subjects such as geopolitics, war, viruses and many other things. Even those who have studied the relationship between Iran and the US for many years did not foresee what has happened. Predicting what happens next will be equally difficult.

It’s more achievable to think through the second order effects of crises, however. From a purely market point of view, these can be much more important than the initial impact. Looking back at the 2001 terrorist attacks, these created a global economic slowdown. This caused interest rate cuts and arguably the housing boom in the US which led to the 2008 financial crisis. The financial crisis in turn led to further interest rate cuts and government debt yield control via quantitative easing. This, and the advent of cloud computing, sowed the seeds for the bull market in growth investing from 2010 through to 2021.

The investment environment we were in pre-Iran was largely shaped by the aftermath of Covid and the Russian invasion of Ukraine. Both these crises were ultimately inflationary, causing interest rates to be adjusted structurally higher. This heralded the start of a bull market in value investing, complemented by AI-orientated US growth stocks. Since then, the best parts of the market to invest in have included commodities, financials, technology and defence stocks: a big change from the pre-2021 markets.

The investment environment we were in pre-Iran was largely shaped by the aftermath of Covid and the Russian invasion of Ukraine. 

What will be the second order effects of this crisis? I strongly suspect it will harden the post-2021 inflationary investment environment we have been in, rather than fundamentally change it. We were already in a world of rising geopolitical tension, reshoring supply chains and deglobalisation. The events of the last month will accentuate these points.

The second order effect we are less confident on is the impact on the global economy. It is clearly not good news, but whether it leads to a recession is a critical and unknown outcome. The mistake investors made in 2022 after the Ukraine war started and energy prices spiked, was to conclude an economic downturn was inevitable. That was incorrect: the US economy grew 2.1%, and the global economy 3.4%.

In fact, one defining feature of the US economy this decade has been its resilience in the face of crises. What markets didn’t understand in 2022 is likely still true today: a combination of resilient consumption and high levels of technology related capital expenditure makes the US economy, and therefore the global economy, less cyclical.

One defining feature of the US economy this decade has been its resilience in the face of crises.

Resilient consumption is a consequence of what is known as the ‘K’ shaped economy. When energy prices rise, lower income consumers suffer most as their discretionary expenditure reduces. There is one segment of consumption which is however relatively economically non-cyclical: the baby boomers.

The baby boomers are the generation which is currently retired or retiring. They have seen the benefits of rising house and equity prices over many years, and many have more wealth than they can spend in the rest of their lifetimes. As such they do not decrease expenditure in response to economic downturns. They spend on travel, healthcare, experiences and other high value items.

As an example of this, after the Ukraine war, we saw companies such as Dollar General, a US-based national provider of dollar stores, struggle as their low-income customers did, yet at the same time airlines were selling every seat they had on planes from London to New York. This is the ‘K’ shaped economy in action. To further illustrate this point Moody’s Analytics estimated the top 10% of earners in the US accounted for nearly 50% of total expenditure.

The other under-appreciated aspect of the US economy is the capital expenditure of US technology companies related to building and roll-out of AI data centres. The St Louis Federal Reserve estimates around 40% of all US real GDP growth comes from AI-related investments. Total infrastructure spending by ‘hyperscalers’ such as Microsoft and Amazon is expected to be 2% of total US GDP in 2026. Provided it continues, this is a non-cyclical buffer for the US economy. 

Should recession concerns prove to be unwarranted, a similar shape of markets to 2022 is possible. In 2022, markets sold off initially following the Ukraine invasion, then recovered strongly as the underlying resilience of the global economy became apparent. However, should this crisis be more impactful, or AI expenditure fade, markets may have to work through an earnings downgrade cycle before recovering. The relative probabilities of these two scenarios are highly subjective, but in my view this is a reasonable roadmap from here.

Readers of this blog will know that I tend to have an optimistic bias when it comes to markets and investing. This is simply a function of experience and seeing how adaptable the economy is to unforeseen events. It is also acknowledging that recessions are quite rare. Since the 1930s, the US economy has only been in recession about 15% of the time and has seen many crises and shocks in that time. Of course, at some point we will have another recession. It is worth being aware of the underlying probabilities, however.

For now, the best to hope for is a speedy resolution of the war. This is better from a human standpoint and will also allow a degree of certainty to return and for companies and investors to adapt to whatever new reality they face. In the meantime, it is worth bearing in mind that like previous crises, this too shall pass.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. Reference to any security is for information purposes only and should not be considered a recommendation to buy or sell. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change. Forward looking statements are subject to certain risks and uncertainties. Actual outcomes may be materially different from those expressed or implied.