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Is there light at the end of the tunnel?

More wealth has been destroyed in 2022 than during the financial crisis and dot com bubbles. Could things get even more painful for investors as some are predicting?

  • It's true that with stock markets losing 20-30% across the globe and bonds having one of their worst years on record that a traditional 60/40 portfolio is down by more than any time over the last century.
  • That said, the current drawdown feels much more like part of a normal cycle than the more damaging structural problems we had during the previous crises. For example, there is no lack of liquidity in equity markets – even among smaller and less popular stocks – which was a feature of the financial crisis when many investors became forced sellers to cover their portfolio losses.
  • Today's environment resembles the late contraction phase of the economic cycle that we have seen many times before and will see again in future. The global economy has overheated following our recovery from COVID and interest rates will rise until demand falls enough to curb inflation. Stock and bond markets have reacted negatively to the speed and rate of monetary policy tightening but this is the just the normal ebb and flow of investment cycles, however painful it feels at the moment.

When do you expect that we will move into the recovery phase?

  • It usually takes an increase in bankruptcies and unemployment to help cool the economy before we refresh and then recover. I don't think we're quite there yet but I expect we'll see tangible evidence of inflation falling over the next two quarters.
  • There are increasingly optimistic signs that inflation globally is peaking due to input prices cooling and more favourable base effects. The latest US data showed that inflation in October had cooled to its lowest level since January, which is clearly positive.
  • The good news is that stock markets tend to move ahead of the economic data – both downwards and upwards – and we could easily see something similar to the violent rebounds we saw in 2003 (+26%) and 2009 (+23%) following the previous crises[1]. 

Is now a good time to invest or could stock markets still fall further from here?

  • No-one can call the bottom of the market and investors should assess their own risk tolerances or take advice.
  • If you take a step back and look at markets purely through the risk-reward lens, many of the biggest threats such as political turmoil in the UK, elections in the US and Brazil, and the Ukraine grain export deal have largely been navigated successfully.
  • There is clearly still geopolitical uncertainty, particularly over Russia and China, but risk is always a feature of stock market investing and needed to create positive returns.

Where is SKAGEN seeing most value at the moment?

  • Emerging markets have struggled for the last couple of years and valuations have fallen to levels associated with a very negative outlook and little economic growth – P/Bs are similar to the lows of the financial crisis and P/Es below 25-year averages that include several other crises.
  • Many EM countries moved early to raise interest rates and there are signs that the tightening cycle is coming to an end. Longer-term, the EM economic growth story remains intact, particularly as income levels take-off. Around three quarters of Chinese and Indian populations will be middle class by the end of the decade – compared to 40% and 20%, respectively, in 2020. This explosion should particularly benefit consumer companies who will have a larger pool of wealthier customers.
  • European equities are also very cheap – the aggregate P/E is a third lower than 25-year averages – with very low earnings growth expected next year. If a solution can be found to the war in Ukraine then factories across Europe will be needed to help rebuild the country and areas like construction, materials, engineering, building materials and banking will see demand increase significantly.

At the end of the current cycle do you think we'll go back to an environment of low inflation and interest rates?

  • It's important to remember that the ten years or so since the financial crisis with very low inflation and almost zero interest rates have been the exception rather than the rule.
  • The US Federal Reserve is clearly determined to do whatever it takes to kill inflation which inevitably means more rate rises, but perhaps less aggressively than previously expected. It's a similar situation in Europe although rate rises will probably be slower and ultimately lower given the region's economic pressures.
  • I think it will be a long time before inflation comes back down to 2% levels but the market will be happy if we see a period of price stability. It also seems inevitable that we're going to have to get used to higher interest rates in future but that's not such a bad thing – money should have a cost. It helps improve capital allocation by diverting finance away from loss-making businesses towards those making genuine profits using tangible assets – that's positive for value investors like SKAGEN.

[1] S&P 500 return figures.

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