This coming Thursday, Americans celebrate Thanksgiving. Thanksgiving is a family gathering, thankfully without the obligation of gift-giving. It is a holiday to reflect on that for which we are grateful.
Turkey is the mainstay of the traditional Thanksgiving dinner. A turkey is an odd bird, some might even say an ugly one. ‘Turkey’ is also an expression of failure. If something ‘flops’, it is said to be a ‘turkey’.
Which brings us to 2022 financial markets. For many investors, 2022 has been a turkey. Stocks and bonds have produced negative returns. Commodities have recently pulled back. Emerging markets have failed to live up to their promise. Balanced portfolios have not diversified risk.
But the biggest ‘gobblers’ this year have been UK government bonds (‘Gilts’), which sold off in the wake of the oxymoronic ‘mini-budget’ proposed by history’s shortest-lived UK prime minister, and the FTX crypto currency exchange, which imploded earlier this month.
It might seem, therefore, that many investors have few reasons to be thankful this holiday season. That’s incorrect, for in hardship there is much to be learned. As we gather for the feast, here are three lessons for which we ought to be thankful.
First, we should be grateful to consign lazy thinking to the rubbish bin. At the top of the list is the notion that stocks are an inflation hedge. As 2022 so clearly showed, they are not. Nor is that just because rising interest rates undermine stock market valuations. With accelerating inflation and the need for central banks to tighten monetary policy, comes recession risk. Equities, in other words, don’t just de-rate because bond yields rise. They also suffer because investors demand cheaper valuations to hold equities with more precarious future cash flows.
That lesson ought to be at the forefront of investors’ minds as they look toward 2023. Some, after all, might be tempted to believe that receding inflation and falling bond yields automatically imply rising stock prices. They don’t, particularly not if an economic recession leads to corporate earnings disappointments.
Second, we need to consign dated thinking to the same rubbish bin. Once upon a time, about 20 years ago, BRICs was the acronym of choice, representing an era of super-normal returns in emerging markets that was coming – specifically in Brazil, Russia, India and China.
Not only did 2022 fail to validate the BRICs thesis, but emerging markets have languished over most of the past two decades. Since 2000, emerging equities have just kept pace with developed market returns and have significantly underperformed the broad US equity market. Since 2010, emerging markets have lagged developed markets by roughly 50%.
As it turned out, BRICs fans forgot some important lessons. Strong economic growth does not automatically equate to strong investment returns. Nor is economic development easy. Throughout history, including this century, far many more countries have failed than succeeded in significantly boosting real per capita income. Of the BRICs, only one is a genuine success (China), another is imploding (Russia), and the jury is out on the other two (India and Brazil).
Here’s another useful lesson. The original BRICs narrative was an exercise in extrapolation, particularly that globalization would continue unimpeded. It clearly has not.
For investors, BRICs also naively assumed that ‘country’ or ‘region’ mattered more than ‘sector’ or ‘factor’ when it comes to equity returns. Yet the demise of ‘value’ styles and the rise of ‘mega-cap’ growth ones has dominated global equity returns since 2000, in the process diminishing whatever ‘excess returns’ emerging markets might muster.
Third, we need to remember Hyman Minksy’s insightful adage that ‘stability creates instability’. The near implosion of the Gilt market and the actual implosion of FTX did not happen in a vacuum. Lazy assumptions by UK pension plans about forever low bond market volatility and skinny ‘tail risk’, which arose out of a decade of easy monetary policies, nearly caused a major pension crisis. Meanwhile, greed and inexperience combined with breathtakingly uninformed fantasies about the future of cryptocurrencies, made possible the fraud and hubris that became the house of cards known as FTX.
The third lesson is one of financial fragility, which is typically exposed when central banks tighten. While no one can identify with precision the source of the next financial crisis, its trail typically follows the path of financial flows. That is often the destination of the ‘stupidest’ money.
Today’s path points in the direction of private markets. Private equity and private credit have attracted significant inflows in recent decades. Since 2000, for example, private debt markets have grown at a 14% annual rate, twice as fast as public debt markets. Over $2 trillion now resides in private debt markets. For private equity, the corresponding assets under management now approach $10 trillion.
Private markets have mushroomed for various reasons, but mostly because of the allure of high returns. According to McKinsey, private equity has achieved an annual internal rate of return of 19.5% since 2008. As a wag once put it: ‘If it is too good to be true, it probably isn’t.’
Private markets share other risky characteristics. They are illiquid, opaque, and often leveraged. In other words, if something goes wrong, investors can easily be misled, likely won’t be able to sell, and may have to liquidate other assets to meet their obligations as happened to many ‘sophisticated’ endowments during the GFC in 2009. That’s a recipe for contagion.
As we gather this Thanksgiving, during challenging times, let’s raise a toast to the end of lazy thinking. Whether the topic is inflation, emerging markets, the merits of alternative asset classes, or any other ‘hot’ topic, we all need to think independently and maintain healthy skepticism about the conventional wisdom.