Terry Smith on Credit Cycles

The Fund therefore underperformed this comparator in 2022 but is still the best performer since its inception in November 2010 in the Investment Association Global sector with a return 299 percentage points above the sector average which has delivered just 179.1% over the same timeframe. Whilst a period of underperformance against the index is never welcome it is nonetheless inevitable. We have consistently warned that no investment strategy will outperform in every reporting period and every type of market condition. So, as much as we may not like it, we can expect some periods of underperformance. Underperforming the MSCI World Index is one issue, registering a fall in value is another. In 2022 unless you restricted your equity investments to the energy sector you were almost certain to have experienced a drop in value: Performance of S&P 500 Sectors in 2022 Energy +59% Utilities -1% Consumer Staples -3% Health Care -4% Industrials -7% Materials -14% Banks -22% Software & Services -27% Real Estate -28% Consumer Discretionary -38% Communication Services -40% Source: Bloomberg Why has this happened? We have exited a long period of ‘easy money’: a period of large fiscal deficits, where government spending significantly exceeds revenues, and low interest rates.

Quantitative Easing (‘QE’), so-called ‘printing money’ in which central banks created money to purchase assets, starting with government debt but eventually ranging into corporate debt and equities. As an aside, quite how it aided the economy of either Japan or Switzerland for their central banks to buy international equities is beyond my grasp. This was combined with low, no (Zero Interest Rate Policy — ZIRP) or even negative interest rates (NIRP). These measures I have collectively christened with the generic term ‘easy money’. Attempts to suppress volatility will only exacerbate it in the long term. If you count the current events, we have now had three economic and financial crises this century and it is still in its first quarter. This would seem to illustrate that attempts to expunge volatility from the financial system are actually producing the opposite of the desired effect. They breach the rule for what you should do if you find yourself in a hole. This is hardly surprising given that the central banks were aiming at the wrong targets. Central banks were attempting to maintain a benign level of consumer price inflation but ignored asset price inflation caused by their actions. Some also adopted employment targets that were not or should not be part of their remit. One of the problems of easy money is that it leads to bad capital allocation or investment decisions which are exposed as the tide goes out.

triple A credits when they were really triple Z. You can’t improve the quality or liquidity of an asset by putting it into a structure. The other problem with the policy of easy money was that it had to end eventually, but not before it had one last hurrah. There were half-hearted attempts to reverse QE in particular by lowering central banks’ bond purchases but when the stock market unsurprisingly reacted badly in the so-called ‘taper tantrum’ in 2013, these were abandoned. Then in 2020 came the pandemic and central banks reacted to this by enacting that good old saying ‘To a man with a hammer, everything looks like a nail’. They decided that they should double down with their new toy, QE, which seemed to work so well in the Credit Crisis without any nasty side effects, well none that had yet become apparent, and apply an almighty stimulus. This was applied when there was no problem with demand or the banking system. It was just that people were locked up in their homes and unable to spend on bricks & mortar shopping, travel and entertainment and the global supply chain was malfunctioning, leaving consumers with pent-up savings waiting to be spent. What happened next may be an example of Sod’s Corollary to Murphy’s Law: • Murphy’s Law: What can go wrong will go wrong. • Sod’s Corollary: Murphy was an optimist.

Sod’s Corollary gave us the February 2022 Russian invasion of Ukraine which affected the prices of oil, gas and other minerals, such as nickel, and cereals following the central banks’ stimulus. The net result of the further stimulus and this invasion has been an upsurge in inflation and as a consequence a rapid and painful end to easy money. This final round of easy money post the pandemic led to all the usual poor investments which people make when they are led to assume that money is endlessly available and costs zero to borrow or raise. We can see the unwinding of these unwise investments, for example, in the collapse of FTX, the cryptocurrency ‘exchange’ (sic) and the meltdown in the share prices of those tech companies with no profits, cash flows or even revenues.suffering

We have no idea when the current period of inflation and central bank interest rate rises which caused this prediction to come true will end. It is sometimes said that central bank policy is always either too lax or too tight, it is never exactly right. We need not discuss whether it has been too lax in the past. Presumably at some point it will become too tight and quite probably tip the major economies into recession. This holds few fears for us. Our companies should demonstrate a relatively resilient fundamental performance in such circumstances, and the only type of market which ends in a recession is a bear market. What we are clear about is that we continue to own a portfolio of good companies. Where the end of the easy money era has exposed any doubts, and there are always doubts, we have acted upon them and/or aired them in this letter. Our companies are more lowly rated than they were a year ago, now being rated roughly in line with the market. This does not make them cheap and there is no guarantee that they will not become more lowly rated, but our focus is on their fundamental performance, as it should be, because in the long term that will determine the outcome for us as investors.