In last month’s newsletter my colleagues Michael Faherty and Quentin Macfarlane established that, despite the large correction we have seen in the market this year, there is nothing fundamentally broken with the businesses we are invested in (Staying the Course). Stocks have primarily sold off as a consequence of the extremely fast rise in interest rates that we have witnessed over the course of this year. Meanwhile, the bulk of the discussion in the market today continues to revolve around where interest rates and inflation will go from here. There are those who see the recent slowdown in inflation as a sign that the worst might be behind us, while others are fearful that the bullish sentiment we witnessed at the beginning of the month is little more than the siren song of a bear market rally.
As always, there are persuasive arguments on both sides of this divide but the Quality Growth investor with a long-term mindset can afford the luxury of ignoring this debate altogether. On the whole, a high interest rate environment is not bad for Quality Growth assets. What really affects the valuations of our companies is not where interest rates ultimately end up, but rather the speed and direction of travel. Rising interest rates compress the present value of long duration assets, falling interest rates flatter them. To understand this is to draw a distinction between when one has incurred a permanent loss of capital and when one is simply seeing share prices fall to reflect higher future returns.
The Macroeconomic Background and its Consequences
Interest rate expectations have gone on a wild roller coaster ride in the last two years, taking the markets with them. While the general impression throughout 2021 was that central banks were behind the curve, 2022 presented investors with a very different picture. The Federal Reserve went from emphatically arguing that inflation was going to be temporary, to invoking the spirit of Paul Volcker to boost its inflation fighting credentials just a year later. The reason for this pivot is that central bankers, especially those in the US, seem to be determined not to repeat the mistakes of the 1970s. For them, effectively dealing with inflation means three things. First, they need to get supply back in balance with demand. Second, and more importantly, they need to get a handle on wage pressure. Third, they need to hold this state of affairs long enough for inflation expectations to come down, thereby avoiding the mistake the Fed made in the 1970s under Arthur Burns. In that period the Fed did bring about two recessions (1969/70 and 1973/75) by raising rates, but they were not aggressive or persistent enough to quell inflation expectations. Unfortunately for them, inflationary expectations are critical and constitute something of a self-fulfilling prophecy. The longer inflation persists, the more anchored it becomes in general psychology and behaviour and the more costly it becomes for central banks to fight it.
When looking at today’s situation, central banks are beginning to see signs that inflation, originally driven by supply chain constraints, is moving into the prices of services and wages. These are the so-called second order effects which are far more worrying to them. The more this entrenches, the harder and costlier it will be for them to get inflation back in the bottle. To get it under control they need wages to stop rising as they are the real heart of the problem. This in turn requires the unemployment rate to rise, and rise a fair bit. They (central banks) need a recession, and they need that recession to hold long enough for inflationary expectations to subside. That is, it needs to be around long enough for companies to stop raising prices (something they do when they fear their customers won’t accept the price rises) and to stop increasing the wages for their employees (something that happens when there are more people looking for jobs than there are jobs available). While this all sounds rather ominous, the reason central banks are looking to do this is because they consider the alternative to be far worse. A prolonged period of inflation can be very disruptive for the economy and gnaws at the very fabric of society.
Bringing about a recession is not going to be that easy in the US. Having saved much of their Covid cheques, consumers are in pretty good shape and the US is, after all, a consumer-led economy. Furthermore, the only tool central banks have available is interest rates, and that is a cruder tool with a significant time lag. We could therefore continue to see quite a messy environment, with central banks continuing to raise rates in a determined attempt to slow down the economy and especially wage growth, and market participants continuing to bet on where interest rates might be heading. For the time being it seems like the market will continue to be at the mercy of the volatility surrounding interest rate expectations.
Implications for the Quality Growth Investor
While this may all make for grim reading, there are actually a number of positives. The first is that, as a whole, the companies that we are invested in are less cyclical. A strong recession will lead to earnings downgrades even for our companies, but in the past, these have tended to be smaller in magnitude than the market at large. Furthermore, Quality Growth companies should be far better positioned to withstand the pressures from higher interest rates. Drawing a distinction between the impact that interest rates have on a business from the impact it has on the present valuation of a business is key here.
Difference Between Higher Future Returns and a Permanent Loss of Capital
The valuation of a company is the function of two things. On the one hand there are the cashflows that the investor expects a company will generate over its lifetime. On the other there is the discount rate that should be applied to those cashflows. Changes in the interest rate will affect how much those cashflows are worth today; it should not however (all else being equal) affect the cashflows that you expect the company to generate into the future. Just like a bond, rising interest rates will compress the present value of the cashflows to reflect higher future returns, not a permanent loss of capital. All else is not equal in the real world though, as the interest rate environment can have a significant impact on both a company’s willingness and ability to invest. For example, companies that are not yet profitable will rely on external financing to fund their investments. If that financing dries up, their ability to generate future cash flows from those investments also vanishes. A similar dynamic can arise when debt servicing costs rise and eat into a company’s ability to invest in the future. For a number of companies, the viability of many of their planned projects will depend on the interplay between the returns on capital they expect from those projects and their ability to finance them. If the expected returns move below the cost of financing, then many projects will become unviable. Cashflows that an investor could reasonably expect in a lower interest rate environment will now no longer materialise. This would constitute a permanent loss of capital.
By contrast, Quality Growth companies are profitable, have high expected returns on their investments, little or no debt, and generally finance themselves with their own cashflows. These characteristics mean that businesses should be far more insulated from the interest rate environment. Their high returns on invested capital mean they will continue investing in their businesses even when the cost of capital rises. That is, their ability to generate future cashflows will be broadly unaffected by rising interest rates.
Quality Growth investors can find comfort in the fact that the companies in which they are invested benefit from a reduced risk of their businesses being permanently damaged by market cycles, changes in the interest rate environment or liquidity events. When stock prices fall in these situations, what investors are seeing is the future returns of their holdings increasing. The significant fall in the valuations of companies at a time when their earnings have held steady means that a long-term investor can purchase these same cashflows at a much cheaper price. Similar to a bond with a fixed coupon, when the nominal value of that bond falls, its yield rises – in this case significantly. If the volatility becomes too much to bear, investors would be best advised not to seek comfort by trying to time sitting on the side lines, thereby realising a permanent loss of capital, but to instead turn off their screens and trust in the underlying quality of the businesses they own.
30th November, 2022
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