A Different Paradigm

In brief

• The return on capital drives equity valuation.
• The two tailwinds to prior capital returns are now headwinds.
• Discretion is advised.

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 outearned 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 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 globalization. Globalization 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 globalization

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.

Globalization 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.

The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. No forecasts can be guaranteed.