During the pandemic that started in early 2020, governments spent freely to protect their economies from the fallout of the lockdowns. Monetary authorities slashed interest rates again after raising them gradually as economies recovered from the global financial crisis. Vast quantities of money were also pumped into the monetary system through quantitative easing to support global economies.
Inflation, which had been benign for 30 years, began to rise as economies emerged from lockdown and demand surged must faster than supply. Russia’s invasion of Ukraine also caused a rapid increase in the price of many commodities—including food and fertilizers.
Central banks had to reverse easy fiscal policies. The US Federal Reserve (the “Fed”) led global central banks in an unprecedented interest-rate hike cycle to tame runaway inflation, from near 0% to over 5% within 12 months—a pace of monetary tightening not seen for 42 years. Similar trends followed around the world.
Investors need to shift gears
The sudden change in the monetary landscape has profound implications for the global economy and investors.
In a world of cheap, plentiful capital and near-zero interest rates virtually all business models thrive. Raising capital is easy. Special purpose acquisition companies (SPACs) with no business yet can get listed through an IPO (Initial Public Offering). Meme stocks are promoted on social media. Non-fungible tokens (NFTs) attract millions in investments. Loading balance sheets with cheap debt increases profitability. Valuations are astronomical.
But when interest rates rise 5% in a single year, everything changes. The borrowing costs of highly leveraged businesses erode their profit margins, so they must review their capital structures and how they operate to make returns.
SPACs that have yet to find a viable business model become highly questionable if a risk-free investment can get a return of 5%, let alone cryptocurrencies and NFTs that are valued based purely on sentiment.
The same applies to business models that rely on consumer spending. Governments are no longer writing checks to consumers. Government spending is now focused on strategically important sectors in infrastructure, such as clean energy, computing (semiconductors, artificial intelligence), supply-chain restoration and national industries against changing demographic patterns, productivity trends, and technological gaps.
How to exploit the new era of investing
Investors can no longer invest in an index and expect returns. They must focus on valuations to ensure they are compensated adequately. They must also look carefully at the sectors and individual companies that have solid capital structures as the risks are much greater when liquidity is scarce.
Volatility creates ample opportunities for investors who are flexible and agile enough to navigate the turbulence and can identify bargains as soon as they arise.
For example, the failure of specific US banks with idiosyncratic business models that rely on large uninsured deposits to fund rapid balance sheet growth resulted in a 40% drop in the valuation of US regional bank stock from their early 2022 peak. US bank earnings multiples sunk to a 30-year low in absolute terms and relative to the S&P 500, although they have the highest capital levels in 60 years and have built adequate reserves to absorb loan losses. Their problem loans and delinquencies are at the lowest level in over a decade and their return on assets stands to grow in a high-interest-rate environment. Investors who have enough liquidity can purchase US bank stocks at bargain prices.
The good news is that investors can stay liquid by investing in high-quality fixed-income assets that provide a good return.
Another opportunity lies in private credit which has a senior rank in the capital structure with a higher return and more protection. Traditional lenders have a lower appetite to refinance amid falling property prices, creating an opportunity in real estate debt at a higher yield with ample cushion.
Investing in infrastructure or real assets also provides diversification to mitigate inflation, as it can lock capital at attractive valuations in a growth segment that is crucial for the economy. Selective public equities add growth and inflation protection to the portfolio.
The combination of cash, alternative investments, credit, and equities provides a robust asset allocation that enhances risk-adjusted amid the volatility.
Like always, investors must diversify across high-quality assets while considering the developing trends supported by government spending. Navigating the volatility amid an uncertain economic outlook requires an active approach to investing.
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