‘Pivot’ is perhaps the most common word in financial markets at the moment. It is used in the context of central banks shifting from raising to reducing interest rates i.e., changing direction.
At every sign of a pivot occurring, such as comments from central bankers or better-than-expected inflation numbers, equity markets tend to rise. As those hopes are dashed, as they have been recently, a new sell-off ensues. Are investors right to focus so acutely on a pivot? Yes and no.
Two variables that investors don’t know with any certainty when valuing an asset are the cost of debt and future profits. Both are critical in understanding the value of all asset classes, but equity, fixed income and property are particularly influenced by them. All assets are valued by taking future profits, and the cashflows which are derived from them, and discounting them back to the present at a rate that considers the cost of debt used to fund that asset, and the cost of equity where equity is used too. Without knowing the cost of debt and future profits of an asset, any valuation is guesswork.
The recent change in the cost of debt for corporates and individuals, both in what has already occurred and what is expected in the future, is astonishing. Markets have gone from expecting interest rates of below 1% to levels in excess of 5%. This may not sound a lot, but put that increase into the value of fixed income, equity and property markets and it will change them materially – and already has. Fixed income markets moved first and fastest, due to their direct correlation, with equity markets following. Due to its illiquid nature, the value of property, both commercial and residential, has not moved as much so far, but surely will in the coming months. So, it is correct that markets have become highly attentive to any signs of a pivot as it would give visibility over what is the terminal value of interest rates and allow investors to value assets better. It is, however, only one part of the equation.
The more nuanced and relevant question is ‘what is the economic cost of central banks pivoting?’. A pivot will only occur when central banks believe they have inflation under control, and the only way they can do this is to induce an economic slowdown or recession. Whether we are entering into a slowdown (a certainty now) or a deep recession (unknown in key regions such as the US but highly likely in the UK and Europe) is important for forecasting the future profits of a business, which is the other element alongside discount rates in valuing an asset.
Our sense is that markets are much closer to discounting the terminal value of interest rates, at least in the short term, than they are in discounting a recession. This assumes the level of around 5% forecasts for mid-next year in both the UK and US is about right. Even if this is too low, and the final level is 6%, it is much less of an increase than we have seen this year.
With respect to profits, the recent earnings season in the US has been weaker than recent ones, with a number of companies, across a range of industries, noting a deterioration of prospects linked to a weakening economy. That said, most forecasters still expect profits for overall stock indices to grow next year, which may prove to be optimistic as the economic impact of much higher interests begins to be seen in the economy.
In summary, what we need to know to understand the correct valuation of many key asset classes is not just the level of interest rates when central banks pivot, but the impact on the economy of those interest rates. Currently we don’t have visibility on either of these two variables, hence why investment markets are falling and are not able to rally in any meaningful way.
The price of certainty
A key thing to differentiate between is a feeling of certainty and actual certainty. The world felt very certain on 10 September 2001, and we all know what tragically happened the next day. In 2007, the US economy and housing market was booming, but within in a year the largest financial system in the world came within hours of collapsing. Things also felt reasonably certain on 31 December 2019, yet within three months a global pandemic had shut the world economy down. Feeling certain shouldn’t be confused with being certain.
Equally, on 23 March 2020, when equity markets fell to their pandemic-induced lows, the world could not have felt more uncertain, yet in hindsight that was the point when investment markets were incredibly cheap: the S&P 500 was at just 2237. The same was true on 15 September 2008, when Lehman Brothers, the US investment bank that became the poster child for the financial crisis, went bust. On that day, the S&P 500 fell to 1193. At its recent peak, on 3 Jan 2022, the S&P 500 was 4796.
There is a saying that ‘investors pay a high price for a cheery consensus, and a low price for a miserable one’! This cannot tell us when and how investment markets will find their lows in the coming months, or indeed if they already have, but it can remind us that uncertainty creates lower prices and opportunities that long-term investors can benefit from. Investments remain one of the few purchases that buyers typically want less of the cheaper they get.
Overall, that the future feels uncertain isn’t the point. It is always uncertain, just sometimes we don’t know it. Past periods of high uncertainty have provided useful opportunities for investors, and we doubt this will be any different. While we sense that this bear market has further to go to adequately reflect the economic impact of higher interest rates, it won’t stop us from taking advantage of opportunities when we see them.
Lessons from the past
We are aware this year has been one of the most difficult ones in recent times for most investors. We haven’t seen markets like this since 2000-02 and 2008-09 (the pandemic-related falls were over so fast they don’t really count). The fact these bear markets were measured in years shows that it is possible for this one to last longer than it currently has.
This year has also seen a strong correlation between all asset classes due to the impact of rising interest rates, something that hasn’t been seen for several decades. This has meant asset allocations, which have allowed a degree of protection in down markets in the past, have not worked in the same way.
I started working in markets in the late 1990s, so I remember the two bear markets noted above. They were quite different. The bear market of 2000-02, caused by the end of the dotcom boom of the late 1990s and exacerbated by the impact of the 2001 terrorist attacks, was a long and grinding affair. The global financial crisis was shorter, and markets collapsed towards the end of it. Each was unpleasant to go through, but both came to an end right at the point that many lost hope that they ever would.
Bear markets are the price of good investment returns. They allow assets to be bought at more attractive prices and they allow economies to reboot after periods of excess. Although there is no precision in forecasting them, one every 10 years is a reasonable rule of thumb when looking historically. This means most long-term investors will see several of them through their investment lifetime. Accepting that they are part of the rhythm of markets and learning to deal with them is crucial. This bear market will eventually end, as all the other ones have in the past. In the meantime, we continue to invest in high quality businesses, which will weather the storm and hopefully come out stronger than they went in.
This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice. Past performance is not a guide to future performance. 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.