Finding a new investment frame: the dangers of looking at the past

• Why energy, value and banking stocks could outperform tech

You have just lived through an exceptional part of history. I am not talking about the Covid-19 pandemic, though that does play an important role in what we think of as the “Great Unwind”. Rather, I am talking about the extraordinary period of low inflation over the past few decades.

An article by the Brookings Institution put it in perspective earlier this year in which it argued that due to structural factors such as globalisation, demographic changes, technological advances and better policy frameworks “for nearly half a century, global inflation rates were headed one way: down”.

Half a century is a long time. In fact, many investment professionals have only known an investment environment in which global inflation rates have been on a long-term downward trend. And while current high inflation rates may moderate as inflation recedes from shockinduced highs (the pandemic, supply shocks and war), future inflation rates may well stabilise at higher levels than those we have seen since the global financial crisis (GFC).

As the Brookings article pointed out, previous periods of low, stable inflation in the 1900s and 1971 were followed by periods of high inflation. They argue that “low inflation is by no means guaranteed”. Our view is that years of underinvestment in commodities and the need to invest in the green economy already created a structural underpin to higher long-term inflation rates, even before the Covid-19 pandemic highlighted the fragility of global supply chains and the need to onshore (or friendshore) suppliers.

Why does this matter? For many, much of their lived experience has been framed by the low-inflation world. More recently, this experience has been exemplified by the ultralow inflation and interest rates that followed on the GFC. If ever there was a time when inflation seemed irrelevant, this was it. Markets did what they do best: sought out those assets that were sure to be rewarded in a “no inflation” world. Growth and long-duration assets thrived, while value and real-world assets underperformed. For many years, the low inflation party rocked on.

Outside our own sample frame lives a range of historical experiences that look quite different to what we have taken for granted as being “normal”. Now that inflation has made a comeback, our investment frame also has to shift. Strategies that proved successful in the lowinflation world are often not as suited to the environment we see ahead.

The need to recalibrate our decision-making becomes especially acute when the period we typically use as our historical frame of reference provides a poor representation of the period we are actually in. Recently, PSG Asset Management’s head of research, Kevin Cousins, pointed out that: “The use of quantitative measures derived from historical price volatility as a proxy for risk is nearly universal in modern finance. These models typically have look-back periods of eight to 10 years, in essence calibrating risk on the long period of secular stagnation post the GFC.

“The huge exposure to expensive long-duration assets is often justified based on these models. We believe true risk for investors comes from a permanent loss of capital and, on the other end of the spectrum, the inability to deliver target returns over the long term.”

However, the adjustment to a new frame is not easy. Many investors are still wondering if now is the time to buy into the winners of the past, as exemplified by the megacap technology darlings of the past. As one example: if the price of Meta has retreated about 75%, surely it must be offering value now, the argument goes. But few realise the low-inflation dynamic kept the cost of capital low, favoured growth stocks, and generally created an environment that suited these kinds of counters.

CORRECT QUESTION

This was reflected in spectacular valuations and a high concentration of certain counters in indices — investors simply wanted to invest in these perceived winners at any cost. For many owning these shares still holds much appeal based on their perceived status as performance stocks. However, herein lies the trap. Focusing on whether the prices of these assets have fallen enough is the wrong question to be asking.

The correct question is not, should I buy tech stocks now, but what should I buy that is suited to the new environment and is likely to become the performance stock of the future? The answer is wildly different from what many would expect. In a higher-inflation environment it is often energy, value and banking stocks that are wellpositioned to outperform. And as the performance of these assets was typically hurt by the same factors that benefited growth and megacap tech stocks, their representation in indices have typically shrunk.

It is crazy to think that even after the recent run-up in energy prices, energy stocks still represent barely more than 5% of the S&P 500 index, even as we remain so reliant on energy as the driving force of the global economy. Moreover, our analysis shows that most of the widely held global funds available to SA investors are not positioned for the new reality either. Unless investors thus make a big effort to shift their investment frame, they will remain trapped in investing in what had worked in the past — and their long-term investments outcomes are likely to suffer as a result.

We may not realise it, but the past few decades have not been “normal”, but exceptional. Investors need to reframe their thinking to successfully navigate the environment we believe lies ahead. To do so, they need to have a differentiated perspective, based on thorough research and a proven investment process than has been shown to navigate a variety of investment environments successfully.