Goldilocks and the bear market

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Last week we had a chance to speak at the first London Quality Growth conference, a timely gathering of investors given the sell-off in markets and the even bigger sell-off in some of the companies we own.  We highlighted our long-term approach to investing in quality and value, and our view that volatility is as much an opportunity for long-term investors as the kind of rotation from ‘growth’ to ‘value’ we have had this year.  

For us, quality is a long-term concept.  We look for companies that have competitive advantages and opportunities for innovation and growth of cash flows for 25 years or longer.  Value is a long-term concept too, but there can be short-term opportunities for even greater returns that arise in a matter of days, weeks or months when uncertainty and fear lead to indiscriminate selling and opportunities. 

Pressures on markets are increasing this year and, understandably, many investors are nervous given concerns about inflation and the ongoing effects of the Covid-19 pandemic, in particular China, and the Russia/Ukraine conflict.

We have to remember that the Covid-19 pandemic shut down much of the global economy for two years and that it only survived because of government support.  We are now moving into the next phase of the transition to a post-pandemic economy, in which recovery continues and the expectation of interest rate rises is replaced by actual hikes. 

As a result of strong demand hitting disrupted supply, supply constraints have deepened in most industries.  We have highlighted repeatedly that these supply constraints were always likely given the lack of investment in private and public infrastructure in recent decades.  The pandemic and the Ukraine crisis have simply exacerbated this already fragile situation and caused greater bottlenecks. 

These supply restraints will take time to resolve but the question investors face is whether we will have a technical recession (which looks all but inevitable given the difficult comparisons to the high growth we had last year) that can be resolved in the short term, or whether it will be so severe that it will cause not just a slowdown in consumer spending and corporate demand, but a more significant downturn in the economy and a prolonged recession. 

What is certain is that whatever the outcome we are entering a new economic cycle and we think it is about time we recalled some of the concepts from the last time we faced the burst of a technology bubble, major geopolitical conflict, strong recovery, inflation and interest rises in the early 2000s.  We remember constant concern about economic growth and inflation being too high or too low and the Fed being too aggressive or too hesitant on rates.  

We will have to remember the distinction between ‘headline’ and ‘core’ inflation. As benefits and savings run out and workers re-enter the workforce, oil and gas production increases (especially in the US), and global supply chains are realigned to face the new realities (as hopefully, the Russia/Ukraine conflict starts to abate and China reopens), there should be a significant supply-side response, which should result in headline inflation falling over time.  It could take through the second half of this year, again given the difficult comparisons, but the result should be persistent core inflation but at much lower levels than today.

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