AdviserVoiceRobert Almeida Archives - AdviserVoice

The wisdom of earnings: Why EAFE’s past holds lessons for its future

Sun, 31 Aug 2025 21:10:42 +0000

Robert Almeida

Knowledge is a process of piling up facts; wisdom is the ability to simplify those facts. Take the old adage about the tomato: Knowledge is knowing it’s a fruit; wisdom is knowing not to put it in a fruit salad. This distinction has never been more apt in a world where the constant and growing flow of information often obscures simple truths.

Consider the recent emphasis by market pundits that the last time the MSCI EAFE Index outperformed the US market was pre-global financial crisis (2008). This piece of knowledge, while accurate, often fuels unhelpful narratives; it’s not particularly relevant on its own.
Outperformance, whether by a region, asset class, industry or a stock, does not die of old age. Knowledge is knowing the extent of performance differentials; wisdom is understanding why and, more importantly, what can change.

The earnings-driven truth

The MSCI EAFE outperformed the S&P 500 from 2000 to 2008 because EAFE companies outearned their US counterparts (Exhibit 1).

Since a stock represents the residual value of a company’s assets and cash flows, EAFE’s superior earnings per share during this period was the source of outperformance versus the S&P 500.

Conversely, earnings are the same reason why EAFE stocks lagged over the past 15 years—weaker earnings (Exhibit 2).

After we exhaust ourselves analyzing index concentration, duration and magnitude versus past periods, the simple takeaway is it’s always about earnings. Index concentration and market cycles are merely symptoms of earnings, not causes.

While the specific conditions of these two vastly different periods in the past (almost) 25 years might seem irrelevant to the current moment, they offer valuable context:

2003–2008: The Global Growth Engine: This period saw the global economy in a robust growth phase, driven by the emergence of China and other developing markets, alongside a burgeoning US housing bubble. This fueled immense demand for capital, labor and commodities, which disproportionately benefited EAFE companies. Their businesses, relative to US companies, have a higher revenue multiplier to GDP, and when juxtaposed against a more fixed cost basis, generate greater profit torque to changes in economic growth. This works in reverse too when growth is slowing. This dynamic is much like how value companies often outearn growth companies during periods of rising growth — because they are more mature businesses that have greater revenue sensitivity to the economy versus those with secular growth characteristics seeking to take share from market incumbents. The economic environment enabled EAFE companies to outearn US companies, and stock prices followed suit.

Post–2008: The Era of Secular Stagnation: Following the 2008 recession, global banks curtailed lending, consumers tightened their belts, developed companies cut expenditures and shifted manufacturing to Asia, and China/emerging markets began a deceleration that combined for one of the weakest business cycles in over a century. This environment benefited companies, predominately US technology firms, less dependent on the overall economy or business cycle. These businesses were adept at taking market share from “melting icebergs and cubes” and evolved into massive oligopolies, monopolies and monopsonies, thriving and aggregating profits even amidst broader economic stagnation.

Outlook: The winds of change for earnings

Looking ahead, we believe that conditions are ripe for another shift.

GDP growth is fundamentally a function of spending and prices. Both are currently higher than during the 2009 to 2020 period and are likely to remain so as demand for tangible fixed investment should be higher versus the 2010s. For example, for years, global supply chains were increasingly prioritized for efficiency and return. However, COVID, a land war in Europe, fighting in the Middle East and, more recently, tariff policies have reprioritized resiliency over cost minimalization. Additional demands for capital stem from the buildout of artificial intelligence, increasing energy demands, national security, defense and more.

At the same time, an era of abundance has ended. Everything from capital, labor and goods needed for production costs more than it did in the post-2008 years.

While economic growth may decelerate due to other factors, the combination of new investment cycles across different sectors, higher input prices and new businesses emerging for market share combines for potential earnings headwinds for US businesses relative to EAFE companies. Together with the valuation discount, we believe this forms a compelling algorithmic case for EAFE outperformance.

Conclusion

The wisdom derived from the knowledge of past cycles points us squarely to earnings as the ultimate driver. As the global economic landscape shifts, so too will the fortunes of different market segments. In our view, investors focused on the underlying fundamentals — with a vast research infrastructure that can help differentiate between the growing avalanche of noise and financially relevant truths — will likely be best positioned to navigate the path ahead.

By Robert Almeida, Portfolio Manager and Global Investment Strategist

The post The wisdom of earnings: Why EAFE’s past holds lessons for its future appeared first on AdviserVoice.

Shifting liquidity dynamics a potential US equity headwind

Wed, 23 Apr 2025 21:25:10 +0000

Robert Almeida

In brief

Shrinking liquidity exacerbates volatility and may help identify which equities are the most vulnerable if liquidity continues to tighten.
Since the global financial crisis, liquidity largely flowed into financial assets rather than the real economy.
The post-global financial crisis tailwinds of ample liquidity, globalisation and abnormally low interest rates are becoming headwinds at a time when tariffs may drain liquidity.

When volatility hits financial markets like it has in recent weeks, it’s often accompanied by a spike in demand for cash and a drain in liquidity. For example, while US equity volumes surpassed all-time highs in April, liquidity shrank, exacerbating price dislocations.

While the excessive gap between volume and liquidity may have been anomalous, it may help investors discern which equities are the most vulnerable if liquidity tightens.

Exhibit 1 illustrates the well-known outperformance of US equities since the global financial crisis. While superior earnings are always the primary performance driver, were there other factors at play?

Back in the early-2010s, deflation concerns were front and centre. Policymakers, particularly in the US, were desperate to prevent a negative feedback loop of falling prices and money velocity. The solution was liquidity creation, but the problem was how. Liquidity can be created in one of two ways, economic growth or borrowing.

With banks and households in austerity-mode and companies outsourcing tangible fixed investment to Asia, growth wasn’t an option. Debt creation through quantitative easing was the path chosen by the United States. The hope was that borrowed funds would drive spending, lift inflation and reignite economic prosperity. Exhibit 2 shows the growth of M2, a broad measure of money supply, for the US and other countries. As you can see, the US wildly outpaced all others. But the growth in money supply failed to produce economic growth because the transfer mechanism of liquidity to the real economy was broken because banks weren’t lending, consumers weren’t spending and companies weren’t investing.

Exhibit 3 is the combination of the earlier graphs, showing market capitalization divided by money supply. Viewed through this lens, the outperformance of US assets is more pronounced, particularly in the wake of COVID-era stimulus. Why might that be?

US Equities are longer duration

Partially because of the dominance of technology companies, we believe US companies have superior growth rates than the rest of the world. This manifests itself in higher terminal value and lower return of cash flows to investors as cash is reinvested in the business rather than distributed to shareholders. In bond parlance, US equities, particularly US growth and technology companies, are longer in duration than mature, lower-growth enterprises.

This matters in the context of market liquidity. While most market participants think about market liquidity as the ability to trade a security around the price quoted, we can also think about it through the lens of the time value of money. An asset’s liquidity beta is a function of market capitalisation compared with its duration. Through this lens, the greater the duration, the less liquid or more sensitive the security is to changes in market liquidity. Exhibit 3 illustrates this, as does underperformance of US equities in the past several weeks.

Why might this matter, looking ahead?

Tariffs reduce liquidity

While the situation remains fluid, I think it’s fair to assume we’ll face more tariffs in the foreseeable future than we did before, regardless of the rate.

Given that the US consumes more than it produces, tariffs are a tax on net importers, meaning companies who import goods to builds things, but also households. This tax, no matter the ultimate level, will pull money out of the real economy and threatens what we believe are elevated but unsustainable profit margins.

Conclusion

Shakespeare wrote in The Tempest: “What’s past is prologue.” While perhaps not exactly, the past can help inform us about the future.

The US runs a historic budget deficit, and the massive amount of liquidity created by US policymakers over the past 15 years has had a direct impact on long duration assets.

It’s always profits and cash flows that drive stock prices. And for much of this century, US companies have benefited the most from the tailwinds of globalization and artificially low interest rates, which resulted in historic levels of profitability. As I have written about extensively, those tailwinds are becoming headwinds. I believe that if liquidity is drained by tariffs, either slowly or quickly, it may also serve as an additional tailwind for further outperformance for non-US equities and for public assets over private ones.

The post Shifting liquidity dynamics a potential US equity headwind appeared first on AdviserVoice.

To find the bust, you need to find the boom

Sun, 29 Sep 2024 21:35:32 +0000

Robert Almeida

The capital cycle drives booms and busts

Capitalistic economies allocate resources in accordance with utility. The private sector pulls capital from industries with falling societal value and return on capital and allocates it to industries with rising returns and greater utility.

While the capital cycle drives innovation, progress and change, cycles are imperfect as evidenced by the repetition of industry and economic booms and busts. History has shown a tendency to flood high-return projects with capital, creating a boom. At first, supply meets demand, but eventually supply exceeds demand. Upon the broad realization that the industry or project has indeed reached a state of excess, returns on capital collapse and the bust is underway. Market forces often overshoot in the opposite direction until, ultimately, water finds its right level, equilibrium is achieved and returns normalize.

Many forecasts for a US recession in the last year have come up short, giving investors a renewed appetite for risk assets. But whether we’re in for a hard or soft landing, investor emphasis may be misplaced. I would offer that overallocation to industries with excess supply is a far greater risk to investors. Conversely, investments in industries in which supply is structurally constrained and returns on capital are sustainable may offer better outcomes versus trying to time markets based on highly uncertain economic and interest rate predictions.

In that spirit, I focus this edition of Strategist Corner on where the boom was and where the bust may be.

Where was the boom and why?

The business cycle following the 2008 global financial crisis (GFC) was long but weak due to the unwillingness of banks to lend and unwillingness of consumers and businesses to spend. When western enterprises weren’t repurchasing their stock or shifting manufacturing to China, they were allocating resources to software. This manifested in the software industry doubling its share of the S&P 500 market capitalization.

The spend was particularly acute across larger companies where the efficiency gains were the highest. Today for example, companies with more than 10,000 employees have on average 650 software applications. Although it’s hard to observe in aggregate stock prices, software spend has been in decline for the last couple of years. Why?

While companies provide numerous reasons, from economic concerns to budget constraints, in general, they are in a software digestion phase from years of spending. The more acute and potentially chronic factor, however, is wallet share take by artificial intelligence.

Technology is deflationary over time because it removes frictions from society. Replacing an old technology with a new technology allows not only for cost savings but greater and more efficient output, driving its value to society. When most people think of AI, they think of the benefits and positive impact to productivity. That’s true. But what about the revenue streams tethered to the technology AI is replacing? Many of those companies are driving the exhibit above and are facing collapsing returns.

Look in the right places

Investors are following cues from economists and policy makers, whose rear-view oriented models seek to assess future economic activity and interest rate levels. I think they may be looking in the wrong places. Much like generals tend to fight the last war, the next bust won’t come from where the last bust was. It will come from where the boom was.

The boom wasn’t in GDP, the labor market, household spending, etc. The boom was in software. And while that boom was justified by attractive return on capital and efficiencies for enterprises, AI can potentially do more at a fraction of the costs. We expect to see IT budgets shift from software to AI and for the number of software applications to fall. The question isn’t the direction of travel, but only the speed.

While software is saturated with too much competition, AI may not be able to duplicate mission- critical applications. Software and AI will work together, but the excess of sub-scale providers in undifferentiated categories needs to “recess.” Avoiding terminally value challenged companies while owning mission-critical software providers may prove a powerful recipe for outsized performance. That’s why I believe active management will be important after years of dormancy.

By Robert Almeida, Portfolio Manager and Global Investment Strategist

The post To find the bust, you need to find the boom appeared first on AdviserVoice.

Investors are seeking the right answers to the wrong questions

Sun, 28 Jul 2024 21:45:59 +0000

Robert Almeida

Key points:

Are investors asking the right questions?
Rate cuts are not a panacea for broken businesses.
What really matters are fundamentals.

Are these the right questions?

Following the inflation ambush in 2022, elevated inflation prints have fallen, as has the volatility of inflation, which has whipsawed investors.

In late April, I wrote about how the then-recent inflation readings were higher than market expectations, which was not a surprise to those who buy groceries or pay utility bills.

A similar pattern has played out in the last few weeks, but this time in the other direction, with direct and indirect inflation figures surprising to the downside. As a result, talk of US Federal Reserve rate cuts has been revived.

I am not dismissing the growing probability the market is assigning to a rate cut in September or the months after. But as the title of this piece suggests, I think investors may be asking the wrong questions. Are “When will the first rate cut be” and “How many times will the Fed cut in 2024” the right questions? Do the answers really matter? In 2028, when you’re digesting a five-year attribution analysis of a portfolio, will the timing of that first rate cut be a factor?

Better questions to consider

Perhaps a more relevant question could be why might the central bank need to loosen monetary policy? More importantly, if prices of goods and services are falling, whose revenue is being negatively impacted? Are their costs falling too? What will this mean for corporate profits compared with what has been discounted in stock prices?

So, while the market is happily applying a higher multiple to risk assets because of a potentially lower discount rate, it’s ignoring what mounting weakness may tell us about company fundamentals, and that’s what matters most to asset values.

Let’s look at what happened during the interest rate cutting cycle that followed the end of the technology boom in the 1990s.

In early 2001, fed funds peaked at 6%. Caught by surprise by a sharp growth slowdown, the Fed cut rates aggressively over the next 18 months to 1%. While the equity market troughed before the Fed’s penultimate cut, as profits had already bottomed and were poised to improve on the back of massive cuts to costs, the S&P 500 index fell almost 40%.

A pushback to this is that valuations aren’t as elevated today as they were then. Which is correct, and why I’m not suggesting we’re facing a drawdown of that magnitude. I’m merely pointing out that central bank interest rate cuts are not a near-term panacea for disappointing operating results. So, while valuations are not at 1990s extremes — which were the highest in US history — analysts’ expectations are for high, single-digit profit growth. Anything that comes in below that will prove disappointing to investors who have alternatives beyond the equity market.

We can also look at what happened during the rate-cutting cycle following the mid-2000s expansion and housing bubble, since stock valuations were not expensive heading into that recession.

As the chart below shows, fed funds peaked at 4.25% in early 2008 and then collapsed to 0% before the year was finished. At the same time, the S&P 500 was nearly cut in half.

What matters

Ever since 2022, inflation and central bank policy has been fresh on everyone’s minds. Or, arguably, even longer, dating back to the days of zero interest rate policy and quantitative easing, which produced a 5,000-year low in borrowing costs.

Recency bias, along with other cognitive biases, can be dangerous. In our brains, the biases can sometimes usurp, or at the least dilute, what is material, which in the case of investing, are fundamentals and future cash flows.

The right answers to the right questions, I think, rhymes with terminal value. What does the company do? How are they managing rising labor costs against falling prices for their goods? While artificial intelligence may bring efficiencies and savings, does it open the door to competitors with fresh entrants coming to market faster with equal or better products? Does AI introduce obsolescence risk to their business? How much debt do they need to roll in the next few years, and at what cost? Is that in equity analysts’ models?

I believe we’re careening toward the point where fundamentals drive valuations rather than discount rates or manoeuvres by policymakers. Central banks cannot fix businesses that are broken.

By Robert Almeida, Portfolio Manager and Global Investment Strategist

The post Investors are seeking the right answers to the wrong questions appeared first on AdviserVoice.

A different paradigm

Tue, 23 Apr 2024 21:40:42 +0000

Robert Almeida

It’s returns (on capital) that matter

The market value of equities, whether public or private, represents a range of assumptions about future returns on capital. When profit forecasts change, market values adjust accordingly. The adjustment can be quick in public markets or slow in private ones, but they’re inevitable.

Looking back at the remarkable period of wealth accumulation enjoyed by investors since the end of the global financial crisis, the catalyst was significant net income growth by companies regardless of region or style. While some materially out earned others, such as US large-cap growth companies, return on capital and stock prices were relatively high and faced minimal interruption.

Leaving aside the COVID-lockdown-stimulus-driven quarters, a global savings glut and falling fixed investment helped drive years of economic stagnation that weighed on corporate revenues. Yet many businesses around the world were still able to generate remarkable return rates thanks in part to falling capital and operating costs.

While that’s how we got here, what matters now is where we’re going. Since 2022, both capital and operating costs have risen. Below we explain why we don’t expect them to revert to prior lows and what that could mean for risk assets.

Two important – and intertwined – factors

In a remarkable feat, the Bank of England has compiled a 5,000-year history of interest rates. In it, we’re told that the year 2021 marked the all-time low for rates. To put that into perspective, for those, like me, born before the early 1980s, our lifetimes comprise a period when interest rates hit both 5,000-year highs and lows.

Three years later, and despite a tight labor market and a quarter-million new jobs being added monthly, market participants continue to discount a loosening of global monetary policy. While that may prove true, and I’m not suggesting otherwise, the more important consideration is what happens to yield curves and long rates down the road.

While overnight and short rates will likely fall before long, too many investors seem to be counting on a collapse in long rates and a resurgence in cheap capital costs. In my view, any reduction in short rates is more likely to result in more positively sloped yield curves than in precipitous declines in long-end borrowing costs. More important, I think borrowing costs, whether for the consumer, enterprises or government entities, are unlikely to revisit all-time lows because aggregate demand is too high, labor too scarce and the need for capital investment too strong.

A question I’m often asked when I share this view is, “In the event of market stress, won’t policymakers want to manipulate yields curves?” Sure. However, wanting to do something and having the ability to do it are two different things, and it was a lot easier to manipulate yield curves when savings were high, spending was low, labor was plentiful (thus possessing little bargaining power), and growth and inflation were weak.

What’s changed?

Today, what’s changed is that household savings are now being spent on food, shelter and energy and companies are spending to shorten supply chains (more on this later) at a time when labor is expensive and in short supply. All this spending is growth- and inflation-accretive. Also, inflation today isn’t only higher but more volatile than in the slow growth, low inflation paradigm, while budget deficits are far larger than in the recent past. This has led to policy constraint being dictated by the bond market, as we saw in the United Kingdom during the LDI (Liability-Driven Investment) crisis 18 months ago. This matters for risk assets because the hurdle rate to generating positive net income has gotten a lot higher.

Another factor is globalisation. Globalisation and just-in-time inventorying were tremendous catalysts for profit growth because warehousing goods is costly. Less inventory on hand means more working capital and higher operating and profit efficiencies. Low-cost manufacturing, particularly in Asia, meant many western conglomerates could slash labor expenses. The outsourcing of manufacturing meant that multinationals could decrease tangible fixed investment. All else equal, when capital intensity declines, profits rise. But when globalization allowed developed market companies to become asset-light businesses, it also ushered in a decade of economic stagnation in the 2010s. Thus, globalization isn’t without risks, and more of those risks have been exposed during the pandemic and the ongoing Russia-Ukraine war and conflicts in the Middle East.

Changing face of globalisation

A prerequisite for just-in-time inventorying and globalization was global peace. Ships got bigger and could hold more containers because the oceans were made safe by post-World War II alliances. Corporations needed to be sure goods would arrive exactly on time, and they were. As that confidence grew, and the benefits of economies of scale accrued, the percentage of the world’s traded goods via the seas more than doubled. At the same time, shipping costs deflated and profits soared.

Shipping is still cheap, but its cost is rising. More concerning, a global pandemic, two hot wars and a cold one have reduced the certainty that a critical part will arrive just in time. Meanwhile, labor arbitrage with Asia has ended because manufacturing in Asia is no longer cheap and hiring people is difficult almost everywhere.

Globalisation isn’t over and neither is just-in-time inventorying. But I’m arguing supply chains will become less stretched, cost more or both.

It’s time to be selective

Societies, like economies and financial markets, are cyclical. Throughout history, tough times have produced tough people. Those tough people, through the adversities they face, create soft times. Soft times create soft people. Those soft people ultimately produce tough times, completing the cycle.

In my view, the policy response to the global financial crisis and the pandemic purposely created a soft- business operating environment that produced high returns for owners of capital. Life, business and investing aren’t easy. Yet investing was recently made easy by the overwhelming policy response.

Conclusion

We believe the primary driver of capital returns over the past several years has been falling costs, not growth.
Costs are no longer falling. They’re inflecting upward while growth isn’t keeping pace.
Risk premia, across stocks and corporate bonds, is relatively low and leaves little room for error.

Portfolio returns will likely become more leveraged to business fundamentals as the aforementioned dynamics play out. We believe securities of companies positioned to successfully navigate the new higher-cost paradigm should comfortably outperform those who aren’t ready.

As the societal, economic and market cycle works to completion, the current, soft business operating environment will change. Adversity will rise but the new paradigm is not likely to allow policymakers to soften the blow this time. And that’s why I think discretion regarding what portfolios you own is advised.

By Robert Almeida, Portfolio Manager and Global Investment Strategist

The post A different paradigm appeared first on AdviserVoice.

Bad policy and unintended consequences

Mon, 10 Apr 2023 21:40:17 +0000

Robert Almeida

A great deal has been written in recent years about the uniqueness of Modern Monetary Theory and quantitative easing. The reality is that they are neither unique nor modern. They are centuries old. As Ed Chancellor points out in The Price of Time, facing a banking crisis in AD 33, Julius Caesar lent out the government’s treasure without interest, creating liquidity which pushed interest rates lower. And history points to each episode of their use ending with unintended and unwelcome consequences.

Why?

For capitalism to function, investors must be compensated for putting their money to work. At a minimum, interest rates need to be above 0% since without compensation for foregoing immediate gratification there would be no savings or investment.

Further, history shows that when policymakers suppress the cost of capital to levels below the natural or market equilibrium rate resources are often misallocated. When private market signals become distorted, malinvestments accrue and inefficiencies build. In other words, in such an environment, people are more likely to make bad financial decisions. While it can take years, the consequences of those decisions usually result in financial or economic turmoil.

We’ve seen multiple episodes of financial stress over the past year in cryptocurrencies, special purpose acquisition companies (SPACs), the UK pension crisis and, most recently, the failure of several regional banks in the United States.

Not a repeat of 2008

For the sake of brevity, I won’t detail the many reasons why the current US banking crisis is dissimilar to the 2008 global financial crisis but in short, in 2008 banks were liquid but insolvent due to years of bad consumer loan making and excessive leverage. Today, they are solvent but illiquid due to deposit outflows.

Today’s crisis is a result of artificially suppressed interest rates, another of those unintended and unwelcome consequence for policymakers. Years of subdued savings rates and anaemic demand for consumer loans pushed banks into investing deposits into bonds, allowing them to earn a hefty spread. But as savers shifted out of deposits into materially higher yielding money market funds, T-bills and the like, asset liability mismatches occurred, resulting in the stresses seen in recent weeks.

In speaking with clients, I’m repeatedly asked “Is the crisis over, and which bank is next?”

But what may matter more than if another regional bank will fail — as there is likely to be more given how portable deposits are due to digital banking — is the feedback loop to the economy.

Small banks are significant providers of capital to individuals, small businesses and other borrowers that drive the bulk of economic activity. While some of that lending slack will be absorbed by larger banks (which don’t face the same risks to deposits), the current climate makes deposit-funded banks less willing to lend. This is a disinflationary force that accelerates the pathway to a recession. Recent and not-so-recent moves in the bond market point in that direction as well.

The bigger picture

For many years, particularly since 2008, much of the wealth that was created did not result from economic growth. Instead, it was a by-product of declining capital costs which fuelled the gearing of existing income streams. This is readily observed in the all-time high global corporate profit margins that were achieved in the late-2010s amid the weakest business cycle in over a century was.

While profit levels have been high, their quality has been poor. The graph below, for instance, charts the difference between what companies tell investors they’ve earned versus what they earned per standardised bookkeeping, also known as Generally Accepted Accounting Principles or GAAP.

There are many good reasons for small differences between the two profit measures, such as non-cash charges that are one-time events and not reflective of long-term or enterprise health. However, as business cycles age, what we find is that companies increasingly ask investors to “ignore” an increasing number of impairments due to bad investments. While levels are nowhere near those observed in the 2008 financial crisis, they are at cycle highs and well above any other period this century, suggesting to me that the quality of today’s profits is very poor and are consistent with the bad decisions spurred by capital cost suppression.

Opportunity amid the great unwind

The surge in inflation over the last 18 months has forced global central banks to unwind many years of policies that suppressed interest rates. While the normalisation of interest rates has exposed small pockets of stress, in our view there are more unintended and unwelcome consequences to come. We think this new environment should set the stage for a multi-year transition in leadership from non-discretionary portfolios to fundamentally oriented active strategies and create significant opportunities for alpha generation.

By Robert Almedida, Portfolio Manager and Global Investment Strategist

The post Bad policy and unintended consequences appeared first on AdviserVoice.

A bird in the hand is worth two in the bush

Sun, 15 May 2022 21:50:29 +0000

Robert Almeida

Risk assets have gotten off to a historically poor start in 2022, a year in which seemingly diversified portfolios have been generating undiversified returns. Stocks and government bonds are down by double digits, with equities posting their worst performance in decades while investment- grade corporate bonds have had their worst year-to-date performance ever. There have been few places for investors to hide.

In November, I wrote about the risks of positive stock-bond correlation in a rising interest rate environment^[1]. Now I want to address the topic again from a different angle.

The hawk and the nightingale

In a Greek fable dating to around 500 B.C., a hungry hawk captures its prey, a nightingale. In desperation, the nightingale tries to convince the hawk that there are more appetising birds in the bush behind it. The nightingale’s effort proves unsuccessful as the hawk replies that a meal already caught, even if small, is better than a larger meal yet to be obtained.

Over the centuries, the story got boiled down to the maxim “a bird in the hand is worth two in the bush.” Or, what you have is of greater value than what you hope to have (because you already have it). It’s an apt metaphor for valuing risky financial assets in a turbulent 2022 and beyond.

Applying the fable

The nightingale stands for the yield on cash, things like savings accounts and money market funds. During the worst of the COVID-19 crisis, as interest rates went to zero (and in many cases below) in both nominal and real terms, the value of the bird in the hand (cash) evaporated.

The hawk represents investors. As the yield on safe assets disappeared, the only selling point of riskless assets was that they were a store of value that would return your principal at a future date. That’s not a very compelling proposition.

The ‘two birds in the bush’ are proxies for risk assets, everything from corporate bonds to private and public equities to real estate to cryptocurrencies and the like. As investors were forced to hunt in the bush for their metaphorical dinner, demand overwhelmed supply. To illustrate, in 2021 net flows into global equities exceeded the combined flows of the prior 20 years.

A 2022 reversal

In late 2021, as investors realised inflation wasn’t transitory and had risen much more than expected, the riskiest segments of the equity market such as initial public offerings, special purpose acquisition companies and small caps began to underperform. With the anticipated yield on cash continuing to rise as the new year began, its effects became more far reaching as a supply of new, competing investments had to be digested. The bird in the hand offered something it hadn’t in a long time: yield. That resulted in the correlation between stocks and bonds going straight up as both asset classes underperformed.

Consistent with historical patterns, defensive equities outperformed noncommodity cyclicals and growth stocks during this time. Historically, investors have tended to shift from higher-reward but high-degree-of-difficulty assets (e.g., unprofitable enterprises with hard to understand business models) to lower-reward but lower-degree-of- difficulty ones (e.g., companies with demonstrable, sustainable profits). Keeping with the fable, the hard-to-catch — but awfully tasty — bird in the bush becomes less attractive. Investors opt for easier-to-catch birds, which are generally enterprises with greater long-term profit certainty. At MFS, we generally prefer these and call them lower- degree-of-difficulty stocks. Others call them quality, a label we use as well.

Developing a roadmap

A sharp rise in interest rates has seen the tide turn and now the bird in the hand has value and will compete for investor capital. Keeping it simple, let’s think this through and develop a roadmap.

Higher short-term interest rates may bring higher asset class correlations. Not only might stocks and bonds become more correlated, but styles such as growth and value may sync more closely than in the past. If so, the performance gap between asset classes should prove less pronounced than in recent years. We believe emphasis should be placed on the quality of assets owned within each category rather than on the category itself. Security selection will therefore be paramount. The visibility and surety of the cash flow of the individual growth or value stock or high-grade or high- yield bonds is what will matter, not the broad asset class it’s assigned to.

I think company fundamentals, whether we’re investing in stocks or bonds, will be the main drivers of investors’ returns. In my view, owning quality, cash-flow-generating assets, regardless of style or category, is the portfolio construction roadmap to follow. This is how I’ve positioned the strategies I manage for MFS clients.

By Robert Almeida, Portfolio Manager and Global Investment Strategist

———–

[1] https://www.mfs.com/en-us/investment-professional/insights/capital-markets/respecting-three-centuries-of-correlation.html

The post A bird in the hand is worth two in the bush appeared first on AdviserVoice.