Like astrologists, investment managers are expected to publish at least once a year their
financial forecasts. And similarly to astrologists, they usually oblige and publish a long list of
apparently well-supported predictions.
Like astrologists, investment managers are expected to publish at least once a year their financial forecasts. And similarly to astrologists, they usually oblige and publish a long list of apparently well-supported predictions.
The only issue with that approach is that real life usually has in store many surprises, some positive ones and some less positive. So that in the end things often turn out quite different from the predictions. Thankfully for their authors, predictions tend to be forgotten relatively quickly which limits the risks.
As investment managers we have to monitor and analyze a wide range of macroeconomic, geopolitical, societal, sanitary and other aspects. We need to develop a view on parameters such as interest rates, the main currencies, economic growth and a range of other important issues.
However, at the end of the day we need to be aware that reality will play out differently than anyone anticipated. Conventional wisdom is often wrong. The natural human tendency is to think that things will continue as they are, more or less. Events such as the Covid-19 drama are impossible to predict. The Great Financial Crisis of 2008 took most by surprise as a thunder in a blue sky. Similarly, at the end of 2008, few were optimistic for the long term and expected the sustained bull-market that has been prevailing since. Warren Buffett, the eternal optimist, was one of the few.
With this in mind, we will succinctly present our views on A) some key macroeconomic considerations and B) investment considerations.
A – Macroeconomic Considerations
Inflation is key
In our mid-year outlook for the second half of 2021 we presciently warned of the risk of a rise in inflation although its speed and magnitude still managed to surprise us. In November, prices in the U.S. were up 5.8% officially compared to the previous year, a four-decades high! And that figure underestimates the reality as many goods of first necessity have increased over 10%. Inflation has turned into a key issue. Several drivers explain it, some of a shorter-term nature, like some of the supply-chain shortages, some of middle-term nature, such as an imbalance between energy production and demand, and some of longer term nature, such as the huge spending programs by governments world-wide, particularly in the U.S. and in Europe.
It is hard to remember that until 2008 balanced budgets were considered a vital priority in all western economies. However, since the financial crisis central banks are effectively “printing” money like there is no tomorrow, allowing governments to cheaply finance their deficits.
Only time will tell how high and how long-lasting inflation will prove. We, as well as some of the world-leading financial people we collaborate with, strongly believe that there is a very significant risk of elevated global inflation for the longer term with the associated risk of continued loss of value in real terms for private wealth.
Inflation impacts assets in two ways. First, it increase the production costs as raw materials and labor become more expensive. Companies lacking the pricing power to pass on the cost increases have reduced profits. Secondly, and even more importantly, inflation pushes up interest rates so that investors will ask for higher returns on investments which pushes asset prices down.
Negative real interest rates are here to stay
Central banks will raise rate but considering the very high level of corporate and sovereign indebtness, they will be limited in their ability to do so. As a result, elevated inflation is likely to be with us for the long term. Real interest rates (nominal rates on the bank accounts minus inflation) are therefore likely to remain significantly negative for the long term meaning that cash investments are likely to lose their real value over time.
In terms of investments, cash and fixed income, which we have been avoiding for a long time, are the most vulnerable. Real assets such as property, commodities, precious metals, infrastructure and art are likely to be more resilient to inflation and in some cases to even benefit from it. The same goes for the stocks of companies which enjoy pricing power.
Market outlook remains positive but increasingly risky
There is no question that market risk is increasing. In addition to the risks of inflation and hikes in interest rates, markets are trading at all-time highs with valuations levels that are high by historic standards on most metrics. However, while “this time is different” is possibly the most dangerous sentence in finance, the low nominal and even lower real interest rates create a novel situation.
Traditionally, Treasuries and investment-grade debt provided a reasonable opportunity for investors. Today, they are outright unattractive and this is likely to continue to push investors to allocate funds to riskier assets such as equities and other real estate, as has been ongoing for over a decade. In addition, if the return to normal following the covid pandemic continues, this is likely to provide a further boost for the markets. Equities are therefore likely to continue their positive momentum. The adventurous investor willing to accept ups-and-downs in his portfolio can make a sizeable allocation to equities. The more cautious one should keep exposure to benefit from a likely continuation of the bull market while adapting the sizing to his/her ability to stomach temporary losses in capital.
Currencies
Major currencies
Absent signs of clear over- or undervaluation of any of the major currency (USD, EUR, GBP, CHF and JPY) we do not have any strong views here. Considering that in terms of economic recovery the US is likely to experience the more significant interest rate increases there is a possibility that it will appreciate against the other main currencies.
Shekel
The shekel is the currency that appreciated the most in 2021. As we mentioned earlier, we believe that this trend is likely to continue in the longer term. Despite its continued security issues as well as socioeconomic challenges, the state of Israel benefits from some solid fundamentals including a young and growing demographic, a vibrant high-tech scene that attracts investment from all the world, the newly developed oil & gas industry and a generally strong economy. Absent a significant security crisis, these factors are likely to continue to push-up the rate of the shekel against most other currencies for years to come.
B – Investment Considerations
Avoid fixed income
As mentioned, cash and fixed income are most exposed to inflation risk.
Allocate to real assets
As mentioned, real assets are likely to be among the rare beneficiaries of inflation. Property owners in particular should be able to increase rents. If they are financed by fixed-interest rate debt the additional revenues represent additional profits that should increase the value of the asset. Such investments can be done directly or through listed property companies (which can however prove very volatile in case of market downturn).
Gold and other precious metals as well as commodities are traditional beneficiary of inflationary environments. The first two can be bought effectively through ETFs while commodities’ ETFs are an investor’s trap and usually bad investments. However, exposure can be gained by buying the stocks of the miners and producers.
Crypto is increasingly considered as an alternative to gold. We see bitcoin as basically valueless but with high upside opportunity based on the “greater fool theory”. Classifying it under the real assets seems a stretch to us as this is the ultimate immaterial and unreal asset. Regardless of any objective valuation considerations, the more “bitcoin believers” there is, the higher its price will go. Within the space, bitcoin would be our preferred play as it is leading the category by far.
The stocks of companies with high pricing power as well as retailers of basic goods can withstand inflationary pressures better than average.
Healthcare stocks look interesting. Beside their traditional resilience to inflation, we generally like their solid long-term fundamentals and lower than average risk. Following the sector underperformance in 2021 and considering the current valuation we believe that there is catch-up potential in 2022.
Consider Private Equity investments despite the illiquidityPrivate Equity investments remain a key trend in the financial world and are experiencing a tremendous expansion. For investors willing to allocate some of their portfolio to illiquid investments they can provide a superior risk-reward as they still provide an illiquidity premium and are also facing less competition than more traditional investments. This
includes direct lending / alternative finance which can provide equity like returns with superior downside protection.
Within private equity, high-tech investments remain interesting. The unabashed rhythm of technological revolutions in every industry continue to provide opportunities, particularly in the start-up nation.
Geographies
Despite high valuation levels, the U.S. continues to be the locomotive of the global economy and benefits from some of the world’s most successful and powerful companies. It should continue to do well.
Europe is currently trading at a discount (even adjusting for sector exposures) and therefore has some catch-up potential. Exposure through an ETF can be considered.
China has been the big underperformer of 2021 due to dramatic political and economical changes. Following the major correction of last year it likely provides interesting opportunities today. While the market as a whole may remain flat for a longer period of time, the current environment should allow active managers, some of whom have very strong track records, to do well.
Hoping for a financially, politically and sanitarily better year, we send you our best New Year wishes.
Orit Raviv Swery Ilan Weil
Founder & CEO Chief Investment Officer