Investing for the present

Parents are good at this. Watching their kids playing from afar, they scan the area for dangers just like Jason Bourne. The spidey-senses often kick in just before the child falls off the climbing frame, leans too far over the water or slips on tiles. Mum or dad swoop in just in time.

In the wider world, this sense of inevitability is everywhere. As much as we love the unscripted drama of sport or elections (ok, only some love those), the results of most matches are fairly predictable – which is why bookmakers are profitable businesses!

Forecasting the now

While sometimes you might be able to convince yourself that you’re the next Derren Brown, usually the truth is a bit simpler. You observed the present. And through experience, you instinctively just know what comes next. I mean there really is only one outcome when my young son is running on tiles with his socks on… he can barely walk in a straight line on a good day!

Even in investing it’s normally the present that dictates the future. But the problem is complex.

There are too many parts of the present, all combining in unseen ways to form the future. It’s like having to try and keep a thousand sons from slipping over at the same time.

What will economic growth be next year? How high will inflation go? Have markets priced this in? Does X matter? Will Y happen? Should Z be taken seriously?

Even if we had the answers, there are too many questions!

So, how should you invest? If you accept that we don’t know exactly what the future holds, you’ll have a healthy respect for risk. The best investors deal with this by thinking of the future as a ‘probability distribution’. Billionaire investor Howard Marks explains: “while superior investors — like everyone else — don’t know exactly what the future holds, they do have an above-average understanding of future tendencies.”

So, as we look into 2022, we should ask ourselves what tends to happen? We’re not looking for a precise outcome, just trying to establish our baseline on some factors which tend to be important. Let’s look at some possibilities right now:

01. More savings tend to mean more spending

If you want to have an idea of where economic growth is going, look at the consumer. Consumer spending makes up around two-thirds of an economy. But how would you know what 7 billion consumers are going to do? You could look at yourself. When you have extra money you probably spend it because, why not? And when you don’t have extra money you don’t spend it because you can’t.
This is why we keep stressing the spare cash situation in the US – it’s at record highs. A confluence of factors has led to this: pent-up savings from lockdowns, high-income workers keeping their jobs during lockdowns and unprecedented fiscal stimulus. People have money. And it’s not just in the US but around most of the world. And like you, the 6,999,999,999 other people in the world will do the same when they have money. Spend!

2. Rising home prices tend to support more building

There are many economic losers from COVID. Face-to-face service workers for one. The high street, another. But there have been winners too. One was the technology sector. Another was the housing market. Strong demand has led to record high house prices in the US – close to pre-financial crisis levels.
The difference this time is that rather than being led by exorbitant borrowing, it’s been driven by the low housing stock. The demand/supply imbalance is eye-watering. Homebuilders know how to react to rising prices and falling supply... build!

3. Low inventories tend to be followed by high inventories

In a recession, the first thing that tends to go is spending on big-ticket items. If you're worried about your job, you don’t buy a new car. But during the COVID recession, the opposite happened. Not only did discretionary spending hold up, it actually surged.
People replaced visits to restaurants, hairdressers and hotels with spending on cars, furniture and (in the US) firearms.
The companies that make these goods were taken by surprise. They were readying themselves for leaner times, but instead had to draw down on inventories to meet demand. The result has been record low inventories, and concerns that there won't be enough goods to go around soon. But manufacturers know how to meet high demand and low supply – produce more.

4. Low debt tends to be followed by high debt

The financial crisis of 2008 set in motion a fairly predictable set of events. Those that had borrowed too much over the preceding cycle were forced to pay it back, resulting in less spending. Less spending meant lower growth, lower inflation and lower interest rates.

But the flipside also holds. Household debt levels are back to much more reasonable levels while rates have fallen so far that interest payments as a portion of income are at record lows.

When people feel sure that an economic recovery is taking place and find that their debt costs are low, they tend to conclude they can borrow more.

5. High inflation tends to lead to lower inflation

When people hear the word inflation they tend to think of the spiralling kind. The 1970s, Zimbabwe, the Weimar Republic. But those are the exceptions and not the norm. Instead, inflation is what economists call ‘mean-reverting’. It’s self-correcting.
When you see the price of something shoot up, what is your immediate response? To buy more? No. You wait it out or you find an alternative. That self-correction is built into all of us.

We’re already seeing this in the markets. The sectors where prices surged earliest in the cycle – lumber, used cars, furniture – are seeing less demand. While the sectors where prices were hit most – hotels, restaurants, leisure – are seeing a resurgence. This is how the free-market system works. When prices rise, habits adapt and alternatives appear, and those prices correct. The higher inflation we’ve seen recently will eventually ease.

Investing for tendencies

One of the easiest mistakes to make as an investor is to base decisions on just one factor. Instead, the right approach is to look at an array of them. So we aggregate these tendencies and many others that are not listed: the end of austerity, the productivity boost from technology adoption, receding globalisation and so on, to produce our view.

Together, these factors suggest growth in the next few years is going to be stronger than in the last decade or so. And the rising inflation we’ve seen recently shouldn’t be a great concern, even though we think the era of deflation is over.

More growth and less deflation should benefit our Growth+ basket – a combination of cyclical holdings like Warren Buffet’s Berkshire Hathaway, nimble global mid-caps, beaten up world value stocks and emerging markets. But we balance this exposure with more stable positions like US healthcare and defensive alternatives – because we acknowledge that our view is only one possible world; in investing, tendencies are not certainties.