Focus on fundamentals as ‘free money’ era ends

The end of the false equilibrium

For the past decade and a half, markets have operated within a false equilibrium, where near zero or negative interest rates and quantitative easing distorted the cost of capital, which in turn encouraged excessive risk-taking. When economies and markets tanked during the pandemic, policy makers provided massive stimulus measures to help alleviate tough financial conditions. But persistent inflation has brought an end to this, as central banks across the world have been forced to hike interest rates aggressively to restore price stability. Some businesses are ill-prepared for higher rates, as we saw in the banking sector in the first quarter. 

Despite these developments, the Federal Reserve (Fed) is committed to raising rates to lower inflation. It has been able to stick to its guns by making additional funding available to financial institutions to prevent banking liquidity or solvency issues. Rising interest rates have been a major headwind for markets. Investors continue to focus on any possible signs that interest rates may have peaked, and while global inflation has justifiably been a real worry, the health of corporate earnings deserves closer scrutiny.
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A gloomy economic outlook

Manufacturing activity has been contracting sharply in the US, reflecting the gloomy economic outlook. The bond market is also signalling that it is expecting a significant downturn in economic activity this year, as evidenced by long-term rates being much lower than short-term rates. The difference between 10-year rates and 3-month rates is the steepest it’s been since 1981. Cyclical businesses are feeling the pressure. As companies start losing volumes, their pricing power will suffer, impacting their earnings growth. 

For new entrants to the investment profession, he has some advice. “Don’t be afraid to involve yourself in as much as you can across different areas of your business. I also think patience is very important. When we’re young we think we know everything and should be given more experience, but it took at least five years for me to feel confident to be able to provide investors with a clear understanding of the market. Young people can be hasty, looking for career progression every year or two years, but you have to give it time.”

The chart above shows that during challenging economic conditions the energy, materials and financials sectors typically experience a far greater hit to profits compared to other – higher quality – parts of the market. It’s not to say definitively the energy sector will experience such violent moves, but we avoid these types of sectors and focus on areas with greater resilience, such as high-quality healthcare and consumer staples companies. 

Furthermore, although it is still not clear when the rate cycle will ease, it is notable that quality has historically outperformed as a style in the years after a hiking cycle has ended. As the economic outlook comes under increasing pressure – which may ultimately lead to rates being lowered – quality companies’ earnings and cash flows should prove to be more robust.


Yet it is fair to state that sectors such as staples and healthcare generally have lower levels of growth, so investing in other high-quality opportunities that offer long-term growth is important to balance a portfolio. Semiconductors, for example, have attractive structural growth trends – with some predicting the industry will top US$1 trillion by 2030. But because of inherent cyclical risks, it is important to seek out companies with sound business fundamentals and compelling long-term growth prospects.