Easy trends are over: what to do?

Destination Value, our flagship fund, has reached the two-year milestone since its founding.

 

We would like to take this opportunity to look back and take stock of the positive results (the data are available in our quarterly report dedicated to customers). This is also an opportunity to reflect on the future that awaits us.

 

When we founded Plenisfer, we expected highly dynamic markets and an increasingly complex global scenario. But who could have foretold such dramatic events as a global pandemic or a war in the very heart of Europe?

 

These events accelerated certain trends that we had hypothesized (see CEO letter, May 2020), and that we said would lead to a new era for investors: the end of deflationary pressures, the attenuation of globalisation’s peak impacts, and the transition from so-called ‘unconventional’ monetary policies back to normality.

 

Even prior to the events of these past two years, we had questioned the traditional investment logic and its methods. Our rethinking concerned both investment sectors (which positions to take) and how to carry out the investment activity.

 

This reflection is even more crucial today, and not only in light of the unfolding events mentioned above. In the first quarter of this year, for the first time since the fund's kick-off, the global tide turned carrying investors into a new paradigm. Both stock and bond indices posted negative results at the same time. Should this phenomenon continue, it would undermine a historic pillar of portfolio construction: the negative correlation between these two main asset classes.

 

We feel validated in our conviction that proceeding with traditional asset allocation, followed by appropriate stock picking, is no longer the right way to achieve our risk and return objectives. We cannot expect much in the future from the main asset classes, in terms of prospective returns, and the diversification between them may no longer be the best approach for hitting our targets. We think it will be necessary to delve deeper into individual asset classes, with the freedom and flexibility not afforded to those who invest against an index, and therefore cannot ignore those stocks in a basket’s core. The approach we have adopted, building the portfolio by ‘strategies’ instead of asset classes, appears most suited to this emerging paradigm. Within this strategy there will certainly be individual stocks or bonds, but our goal will transition to ‘total return’, rather than relative performance.

 

We enter the third year of management with the strength of results already achieved, but we look at the world ahead of us with the awareness that a method that has worked till now will be subjected to even harsher tests.

 

While we prefer to avoid painting apocalyptic scenarios of change, looking back at history, we know that there have been periods similar to those on the horizon. We have witnessed both ‘cold’ and ‘hot’ wars, high inflation, and periods of globalisation followed by periods of relative closure to international trade. However, if we limit ourselves to a comparison with the recent past, say the last two decades, we would seem to be headed for a significant break in continuity.

 

We are facing the ‘mature’ phase in the long-term economic and geopolitical cycle, in which we are witnessing a growing scarcity of inputs (capital, labour, and energy), leading to challenges on both the economic and geopolitical fronts: lower growth with higher inflation, and instability in the world order.

 

Admittedly, the elements for a higher inflationary environment were already in place prior to the most recent events. The seeds of inflation can be found in the hyper expansive monetary balance sheet policies, in an energy crisis that has its roots in the under-investment in fossil fuels, and in the intensification of income and wealth disparities that will require greater income redistribution policies.

 

However, the factors underlying the attenuation of geopolitical integration must be sought in the tariff wars and in the technological competition between the great powers (China and the US), leading up to the sanctions recently imposed on Russia.

 

Furthermore, from a microeconomic perspective and following the pandemic’s outbreak, companies were already reconsidering their supply chains which had been extended geographically in the search for maximum efficiency. Multinationals were re-evaluating their direct capital investments abroad and focused on reshoring manufacturing, requiring local, often more expensive labour inputs. This could only have a negative impact on profitability and returns on invested capital, in addition to triggering higher inflation.

 

Finally, the growing risks of energy shortages had already appeared as a result of supply-chain bottlenecks in fossil energy production, and the intermittent nature of renewables. Scarcity in the supply of raw materials (e.g. metals, rare earths), which are fundamental to the digital and energy transitions, also emerged.

 

The outbreak of the war in Ukraine accentuated all of these inflationary and growth risks.

 

New questions about the global financial structure have also arisen. Sanctions on Russia's foreign exchange reserves raise questions about the strategic value of dollar or euro-denominated reserves in the presence of escalating geopolitical tensions. There is increasing pressure for the creation of alternative payment systems, for example based on the Chinese yuan, to regulate trade outside the Western sphere of influence.

 

In short, the world in undergoing a profound transformation, compared to the one we were used to just a few years ago. Nevertheless, the debate between financial operators and investors still seems to be very focused on the short-term cycle of monetary policies, on the likelihood of a recession in the coming months, and on the probable decline in stock market multiples that are still too high. These are all relevant problems, of course, but they are entirely focused on the short-term.

 

Instead, we should try to interpret the phenomena we are witnessing - deglobalization, structural inflation, structural scarcity of energy inputs and raw materials - and determine investment opportunities with an eye to the longer-term future.

 

In this perspective, we are reconsidering the value of an asset class such as fixed income, destined to deliver negative real returns for a long time to come, despite the likely rise in nominal yields. In fact, keeping real yields below zero is an effective way to trim the huge amount of public and private debt created over the past two decades.

 

Equity investments will help defend us from rising inflationary pressures, while addressing the risk of a short-term recession. Select shares must be counted among the real assets. First of all, for the obvious reason that only some business models will be able to transfer rising input costs to higher market prices, but also because the formidable growth of stock market indices in recent years was based on discounting future cash flows at very low interest rates. This will no longer be possible in a world of rising rates. In other words, stocks, particularly in certain sectors such as technology, can also be 'long duration’. Stock selection is taking on a new meaning: it is no longer selection aimed at beating an index, but rather to identify business models that work in an inflationary environment.

 

Looking at commodities, we think they are at the onset of a long-term bull market. Although prices could suffer the effects of a global recession in the near term, in the long run the green revolution and digital transition will continue to support the demand for energy, metals and other materials. However, it will not be easy to access the returns that commodities can generate. These can be found in countries that present strong political risks connected to the growing temptation of governments to ‘capture’ the value inherent in these resources through continuous changes in regulations, licensing agreements or even nationalisation policies.

 

Finally, from a currency perspective, it will be necessary to proceed with caution. Both the dollar and the euro are subject to a process of structural devaluation linked to inflation growth. In the long run, the Chinese currency may play a greater role in international trade, though China’s failure to liberalise the capital account of the balance of payments will still be discounted for some time.

Emerging market currencies must be analysed one by one: competitive advantages will be increasingly linked to the possession of raw materials than to the availability of foreign exchange reserves deriving from the current account surpluses. Gold and precious metals will continue to play a fundamental role in portfolios, especially in relation to the devaluation of the so-called fiat currencies.

 

We founded Plenisfer with the knowledge and awareness that the days of ‘easy trends’ were behind us. The events we are witnessing, in particular chronic higher inflation and the return to geopolitical scenarios reminiscent of the Cold War, would seem to validate this prediction. As we have already noted, for the first time in many years, an asset allocation based solely on equities and bonds may not be sufficient to deliver satisfactory returns.

 

If the era of easy trends is over, in order to generate performance, we will need a truly active management in which the macro perspective and bottom-up analysis are two sides of the same investment philosophy rather than distinct decision-making steps. It will take courage to have a ‘different’ portfolio: even if in the short term this could lead to ‘volatility’, or decorrelation with market trends. We are creating a different and truly active portfolio: this is the commitment we feel we can make to our subscribers.

 

 

Giordano Lombardo

CEO e Co-CIO Plenisfer Investments SGR

 

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