There are decades where nothing happens, and there are weeks where decades happen

A brief comment on the last few weeks.

  • What is happening quickly with the style rotation in equities, and the rise in bond yields, is both inevitable and desirable. Excesses produced by years of mistaken monetary incontinence need purging.
  • There is still time to get a better portfolio since the next 5 years won't be like the last 5.
  • Wages now need to rise RELATIVE to profits. While equity investors may hope for continued rates of profit growth and margins, for both to rise merely produces inflation/stagflation/dragflation.
  • Companies have never had it so good. They can't take all of the value added in GDP since wages would be zero, thus they have to share with their workforce, or governments will intervene. To some extent in a mixed economy of course, they do. This shift in profit share has become too favourable to companies in the last 20 years, aided by the asset price put option policies.
  • Better for management to keep governments out of wages vs profits by behaving sensibly and ethically? Although it may be too late since there are signs that governments are getting ready with a raft of new "good" ideas. - eg windfall taxes on the companies which have been disincentivised to invest in producing more supply! The stupidity of this policy merely emphasises the point about government intervention being undesirable.
  • This trend to higher RELATIVE wages will prompt the necessary private sector capital expenditures to raise productivity. In the USA share buy backs thus have to fall in their size and frequency to fund this capex. This increase in capital expenditure will drive job growth and real GDP. Investors should thus logically desire lower profit margins in the short term to produce higher quality profits in the long term.
  • Thus profit margins on average will fall in the near term especially as non-wage input prices are rising - some were predictable events (the Green transition) and some weren't (Ukraine).
  • This will mean volatility in risk assets persists as reality bites. The decades of preventing normal rebalancing recessions and the incentives to not invest have produced an enormous bubble. The removal of complacency is happening in weeks. Hence the title.
  • Portfolios can capture this shift but variance drain from badly constructed multi asset portfolios which produce volatility, hurts your end wealth.
  • Many investors choose illiquid funds. While illiquid funds have the appearance of low risk this is confusing investment risk with price volatility. The lock-up or surrendering of liquidity can also hurt returns since it is expensive in lost re-allocation optionality if the returns from the illiquid asset are anything less than stellar.
  • For background to these principles and 'lessons learned from experience' check out recent Delft articles

Delft Partners May 2022

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