Over the past couple of months, and particularly since the beginning of this year, equity markets have been particularly volatile, with significant drawdowns experienced in the technology space. Based on our investment process and experience, we remain comfortable with our portfolio positioning for the long term. We explain our rationale below
What is happening?
Inflation has been more persistent than the Fed, the US central bank, had been expecting, due to a combination of government stimulus (in the form of transfer payments) to deal with Covid and pandemic-related supply chain issues. Whether the former or the latter is the dominant cause of inflation remains a hotly debated issue, and beyond the scope of this research note. Regardless of the reason, the Fed has now decided to adopt a more hawkish policy in its fight against inflation by signaling a series of interest rate rises and the start of quantitative tightening (balance sheet contraction to reduce the amount of liquidity in the economy) in 2022. This recalibration of the Fed policy has led to a spike in the 10-year US treasury yield, which is the lynchpin for the valuation of most assets. Higher yields therefore raise the cost of capital for governments, households, and corporations, which in turn results in lower equity prices, at least initially.
The charts below show that over the past 6 months, the 10-year yield has gone up by 61bps. The speed of this spike in yields explains most of the steep decline experienced by global markets, as measured by the MSCI ACWI benchmark, down 7% since the peak on November 16th, 2021. Other risk assets have also heavily corrected, with Bitcoin and Ethereum down close to 40% over the past 3 months.
Figure 1: The problem: US inflation reached a 20 year record of 7.0% in December 2021
Figure 2: The solution: an aggressive Fed talks up the 10 year Treasury yield, leading to …
Figure 3: … a 7% decline in MSCI ACWI since November and …
Figure 4: … a 40% fall in Bitcoin and Ethereum over the past 3 months
Can the Fed tighten as aggressively as the market expects? Not so fast or so high
As the markets fret about 3, 4 or 5 interest rate hikes by the Fed in 2022, followed by 4 more hikes in 2023, alongside quantitative tightening, we believe that the Fed is likely to raise rates by less than expected, for several reasons:
- Part of the current inflation scare is due to supply chain tightness, which should ease as the pandemic abates. Monetary policy is an inadequate tool to address this problem.
- Another element of the current inflation scare seems to be stickier, driven by government stimulus checks during the pandemic, which resulted in explosive growth in the US money supply. Indeed, US M2 monetary aggregate was up 37% between February 2021 and October 2021: this represents a 21% annualized growth rate vs. 7.1% average annual growth since 1960. In this case, monetary policy is appropriate to cool things off, and that is what the Fed is targeting.
- Too much leverage in the system, which means that the US cannot tolerate very high interest rates. Over the past 5 years, the ratio of US Federal debt to GDP went from 104% to 122% currently, just below the all-time high of 136% in the 2nd quarter of 2020.
- Global GDP growth is already expected to decelerate, which means that monetary policy would not need to be too restrictive. According to its World Economic Outlook report published Tuesday, the IMF expects global GDP growth to weaken from 5.9% in 2021 to 4.4% in 2022. The US is expected to grow at 4.0% in 2022, down from 5.2% previously expected. As a comparison, US GDP growth was 5.6% in 2021.
- Lastly, global EPS growth expectations continue to be revised down. Consensus now expects MSCI ACWI EPS growth of 7.1% in 2022 vs. 11% back in December. As growth becomes scarcer, we believe that companies with sustainable quality growth characteristics should start to outperform the more cyclical part of the market.
What do we do now?
Our investment strategy is to build a concentrated portfolio of high-quality growth companies for the long term (5-7 years), backed by rigorous megatrend analysis and disciplined risk management. Our portfolio companies remain fundamentally very strong to withstand a higher interest rate environment thanks to their robust balance sheets. Indeed, on a weighted average basis, our portfolio has a net debt to EBITDA ratio of -0.44x (i.e., they have more cash than debt) relative to 1.66x for the MSCI ACWI (i.e., they have more debt than cash). This means that our companies should not be hurt as much by rising interest rates or a slowing economy. Instead, our portfolio holdings can use their solid balance sheets to invest despite rising rates, as recently shown by Microsoft acquiring Activision for $68.7Bil in an all-cash transaction.
In summary, our companies are more profitable than the benchmark (ROE of 24% vs. 13%), invest more in R&D (R&D to sales of 9.6% vs. 5.9% for ACWI) and have delivered double the EPS growth relative to the benchmark over the past 5 years (24% vs. 12% for ACWI). Furthermore, over the long term, our companies are expected to grow profits faster than the benchmark (EPS growth of 16.2% vs. 9.7%).
However, this quality does not come cheap: our portfolio is almost twice as expensive as the benchmark, trading at a 31x PER forward vs. 16x for ACWI. As Warren Buffet put it in his annual letter to Berkshire Hathaway shareholders in 1989: “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Having said that, we recognize that the risk is that these elevated multiples contract as interest rates rise. Let us use an example to illustrate this point: Adobe, one of our holdings, is down 27% (vs. -6.7% for the MSCI ACWI) since its most recent peak on November 19th, 2021. During this time, 2022 EPS expectations for Adobe have declined by less than 5% (i.e, from $11.18 to $10.69) while the 2022 PER declined by 24% (i.e., from 62x to 47x currently). In other words, close to 90% of the decline in Adobe’s stock price since November is explained by the contraction in its PER multiple, rather than a significant change in its earnings profile.
As we review our portfolio considering the recent developments in financial markets, we remain confident about the prospects of our holdings over the long term. After an initial period when valuation multiples should adjust downwards to reflect tighter monetary conditions, our portfolio should continue to outperform our benchmark.
As well, we continue to view cryptocurrencies as disruptive and innovative instruments with attractive long-term growth potential. We will therefore maintain our allocation to this asset class, despite the recent drawdown, as we expect institutional adoption to continue. We view Bitcoin as a speculative hedge against inflation and Ethereum as a disruptive instrument with an attractive utility value that could fundamentally improve the financial system by eliminating many middlemen and savings costs.
Disclaimer:
The material contained on this page is intended for informational purposes only. Past performance is displayed only for the sole and specific purpose of demonstrating the experience and expertise of Pillow Investment Partner Limited. Past performance is not indicative of future results. It does not predict or guarantee future performance. It is not intended to be used as a source of information on any particular company or as investment advice or investment guarantee.
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