An important parameter for assessing the market valuation is the risk premium, which represents the difference between the yield of corporate earnings and risk-free government bonds. As interest rates remain elevated, equity markets approach previous highs and have risen disproportionally to corporate earnings. As a result, the risk premium is low despite the difficult market environment.
At present, inflation poses a significant source of uncertainty. However, the growth in corporate earnings demonstrates that companies have successfully tackled this challenge and have managed to partially offset the impact of inflation. On the other hand, fixed rate government bonds lack this characteristic, which justifies a lower risk premium for equities. To truly understand the risk-premium of stocks, it is important to consider the corporate earnings yield in relation to the inflation-adjusted real yield of government bonds. This perspective provides a more balanced view of the real risk premium and offers a more concise assessment of the current valuation of the stock market.
However, there are significant variations in the risk premiums among different sectors and individual stocks, reflecting investors’ expectations regarding their ability to thrive in the current environment. Companies are continuously striving to enhance efficiency and achieve economies of scale through increased sales volumes.
This serves as a partial offset to the impact of low inflation rates. During periods of elevated short-term inflation, as we have recently experienced, companies are compelled to pass on higher costs (such as materials, labor, and energy) directly to end customers in order to protect their profitability. Companies that are well-positioned and have high-demand products are more successful in this endeavor compared to those offering easily substitutable products. However, even some companies with weaker positioning have managed to achieve growth in sales and profits, as price increases have more than compensated for declining sales volumes.
The latter impressively illustrates the distorted perception that can arise from high nominal growth rates. Short-term wage increases, although initially positive for consumer sentiment, also contribute to this phenomenon. The concept of money illusion highlights the tendency for people to concentrate on nominal figures while paying insufficient attention to inflation. As a result, the effective loss of purchasing power is often neglected or recognized with a delay. Consequently, nominal economic growth of 5% with 7% inflation feels better than 0% growth with 2% inflation.
Higher interest rates have undeniably made the current environment more challenging. Expensive valuations must be consistently justified with profit growth, as any disappointments are swiftly penalized by the market. This was evident in parts of the health sector, which had benefited greatly from the effects of the Covid-19 pandemic but has since struggled to sustain the previous growth and has underperformed the market as a consequence. Nonetheless, the first half of the year demonstrated that economic prospects were overly pessimistic, and the anticipated slowdown was premature.
It takes time for the effects of higher interest rates to fully unfold. It is important to note that higher interest rates do not necessarily indicate rates that are too high for sustainable economic growth. Currently, the various economic indicators present an inconsistent picture. Central banks are likely to maintain higher interest rates until inflation appears to be firmly under control. The trajectory of inflation plays a vital role in determining real interest rates. As interest rates stabilize, the risk premium benefits from reduced uncertainty, enabling a stronger emphasis on profit growth.
The economic and investment landscape remains challenging, demanding thorough and nimble analysis of assets to be well-prepared for various scenarios. By exclusively investing in direct investments, we closely monitor the progress of all companies held in our portfolio and can promptly respond when needed. Additionally, we prioritize a balanced distribution of company characteristics to ensure the resilience of our portfolio. The past year highlighted the importance of not solely relying on growth but also considering valuations for sustainable long-term performance. A relative valuation discount to the market and comparable companies provides a margin of safety to better withstand unpredictability. In the current environment, we do not compromise on quality and valuation.
Despite the presence of various risks, adhering to our long-term strategy, maintaining disciplined ownership of the best companies in our portfolio, and trusting in their ongoing pursuit of growth and efficiency, regardless of the market conditions, has once again proven successful. We capitalized on the divergent performance of individual positions by realizing profits from volatile cyclical stocks and reinvesting them in attractively valued, more defensive opportunities.
Zurich, end of June 2023.
Low inflation rates accompanied by low interest rates have favored high asset valuations. After some 40 years, this trend has reached its temporary peak with the Covid crisis. The structural drivers of low inflation rates are facing headwinds for the first time in many years. Globalization, in particular the full outsourcing of production, has been challenged by geopolitical tensions. Energy supply dependencies have revealed underestimated risks. Technological progress continues to be unstoppable but is currently being held back by supply bottlenecks and is not fast enough to counteract the abruptly changing circumstances. In addition, low unemployment offers employees a promising negotiating position for wage increases.
While the supply side is facing various challenges, the demand side has fully recovered, also thanks to government support, putting additional strain on already troubled supply chains. Various studies have addressed this issue and have concluded that both supply and demand contribute significantly to the current high inflation. Unlike demand, the supply side needs time and investments to overcome these challenges.
The U.S. Federal Reserve is currently trying to curb demand with exceptionally high interest rate hikes, and the other central banks are following suit to varying degrees. From corporate and consumer loans to mortgages, a more restrictive monetary policy is hitting consumers, investors and companies. Until recently, almost cost-free debt capital has enabled financing endeavors that are no longer profitable or sustainable at higher capital costs. Combined with higher prices, especially energy costs, this is expected to cool economic activity until supply chains return to normal and supply can keep pace with demand. Flattening demand is also intended to counteract the tight labor market. This is because broad-based wage increases on the scale of current inflation could set the undesired inflation spiral in motion.
The consequences of higher interest rates on asset prices are very apparent, as we have seen significant corrections. With interest rates and thus capital costs close to zero, there were hardly any opportunity costs in recent years. Accordingly, good marketing was sometimes sufficient to drive up a company’s valuation. Tangible near-term profits and sound financial valuation seemed to be less important.
The U.S. Federal Reserve is currently trying to curb demand with exceptionally high interest rate hikes, and the other central banks are following suit to varying degrees. From corporate and consumer loans to mortgages, a more restrictive monetary policy is hitting consumers, investors and companies. Until recently, almost cost-free debt capital has enabled financing endeavors that are no longer profitable or sustainable at higher capital costs. Combined with higher prices, especially energy costs, this is expected to cool economic activity until supply chains return to normal and supply can keep pace with demand. Flattening demand is also intended to counteract the tight labor market. This is because broad-based wage increases on the scale of current inflation could set the undesired inflation spiral in motion. The consequences of higher interest rates on asset prices are very apparent, as we have seen significant corrections. With interest rates and thus capital costs close to zero, there were hardly any opportunity costs in recent years. Accordingly, good marketing was sometimes sufficient to drive up a company’s valuation. Tangible near-term profits and sound financial valuation seemed to be less important.
This year has been a stark reminder to investors that it is not enough to simply buy good companies with attractive growth prospects. The price at which it is being bought is just as crucial to the success of an investment in the long term. With the end of the low interest rate environment, the valuation is once again taking center stage. Higher interest rates mean higher opportunity costs and lead to a lower present value of potential future profits. The higher the valuation, the more this base effect comes into play. The speed at which individual companies recover from this correction is thus directly related to how high the valuation was in the first place. Another complicating factor is that the current environment with higher input costs and cooling demand is making it more difficult for companies to increase profits in the short term.
Valuation plays a central role in the selection of our investments. We invest exclusively in above-average quality, but always put this in relation to the valuation. Only if this ratio is attractive, we consider making an investment. We are convinced that a disciplined focus on both factors produces the best results in the long term. This applies to both equities and bonds. As a result of higher interest rates, fixed-income investments are once again a more attractive complement to equities and allow to generate reliable and stabilizing returns in economically and geopolitically uncertain times.
Zurich, end of September 2022