Investors should pay attention to the capital cycle

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The writer is editor-in-chief of MoneyWeek

Nothing says Christmas to a financial journalist more than the arrival of the first reports on the 2022 outlook for financial institutions. So I can tell you with confidence that it’s almost Christmas – and according to most of those who make a living in the stock markets, you won’t have to worry about the stock markets. There is, they say, more good news than bad.

The past few weeks have been quite volatile, they say, but the economies continue to grow well. Household savings are high, unemployment is low, and both of these bodes well for consumption in 2022, as does governments’ shift in fiscal policy (they’re all big spenders now).

Supply chain bottlenecks are also expected to ease in 2022, which will both replenish inventory and ease inflation, which markets aren’t much concerned about anyway. . We are also living, as an Invesco memo puts it, “living in one of the most remarkable periods of change in history”, with the digitization of everything creating extraordinary new industries and medical advancements producing new ways. amazing ways to treat human diseases.

And Covid? By next year, the increased use of high-potency antiviral pills may have pushed it down somewhat on everyone’s list of concerns. Add it all up and global growth is expected to surpass 4% next year, well above the norm of the last decade. This, we are also told, is exactly the kind of context that pleasantly supports stock prices.

Barclays analysts note that this year has been characterized by uninterrupted increases in earnings – companies continue to do better than expected. This, they say, is likely to continue to happen, in part because of the good growth but also because Covid has’ crushed the competition ‘- how the pandemic has’ disproportionately affected small and medium businesses Means that there may have been a shift in the share of revenue accruing to large (listed) versus smaller (unlisted) firms. So there you have it: the markets are strong enough to ignore most things. You can continue your Christmas shopping. No worries here.

Much of this makes perfect sense. But there are still some problems with that. He ignores the political risk. He ignores the price. And it ignores the cycle of capital.

Take the political risk first. Inflation may slow down next year. But the truth is, no one really knows how inflation works. It is quite possible that central banks have helped keep inflation low over the past 20 years. But it’s just as likely – even more likely – that low inflation was more a result of the wave of globalization and cheap labor that followed China’s entry into the World Trade Organization. in 2001 and the enlargement of the EU.

If this is true, the idea that central banks can fix the problem with the bizarre 0.25 percentage point interest rate hike is laughable. They may either have to accept inflation or raise rates properly above inflation rates to get things under control. It’s not in anyone’s forecast.

Let’s move on to the price. Markets are fragile when they are expensive, as most are now, in large part because not all market participants truly believe everything they write in their outlook.

We all know that future returns are a function of today’s price. And it’s good when we can kid ourselves that earnings will soon rise so much that valuations will go down on their own without us having to lose any money. But it’s not good when confidence takes the slightest hit.

This is something we saw very clearly on Friday with market panic over reports of a new variant of the Sars-Cov-2 virus. If global markets were cheap and resilient, the fact that we didn’t know whether the new variant is a bad (more infectious and deadly) or a good (more infectious but milder) would have had no effect on the markets. . Let them not either, the FTSE 100 went down 3% before lunch.

Finally, consider the cycle of capital. There is a must-have book for every stage of market madness. Right now it should be Return on capital: investing throughout the capital cycle, a collection of essays edited by Edward Chancellor. The idea here is simple: you should look at how much capital is flowing into a sector rather than just focusing on price. The more capital there is, the more likely it is that the industry will experience oversupply and collapse in prices.

Right now, it is easy to see the sectors in which capital seems both free and unlimited (renewable energy being the obvious example), and easy to see where neither has been one. neither has been for quite some time (eg, ancient energy and mining). This is a combination that should make investing both harder (the risks are high) and easier (there are obvious opportunities).

So what should the 2022 outlook really say? That the markets are fragile and look very volatile. That there might be some good times to come, but that many awards are already canceling 20 years of celebration. And maybe investors should shift their holdings to the cheaper sectors and, in particular, those lacking in capital which it turns out we need as much as ever.

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