'Refuge' to believe it !

Article by Valérie Lemaigre, published in Le Temps - July 2022

The virtues of diversification are widely advocated in both the economy and finance. "Avoiding putting all your eggs in one basket" is a strategy adopted by entrepreneurs and investors alike. Entrepreneurs balance their investment sources between capital and debt. Investors allocate their assets between equities and bonds, taking into account their sensitivity to risk, knowing that a company repays its debt before paying a dividend. In the same way that diversity between individuals creates value and limits the risk of mispricing, diversification of companies according to their sector and region of activity or their size limits significant fluctuations.

 

Yet, there was no refuge for investors in the turmoil of the first half of the year. Virtually all corporate equity and bond securities suffered similar corrections, averaging close to 15%. We would have had to have all our eggs in the same fossil fuel basket to avoid the devastating effects of volatility on the prices of securities listed on the equity, bond and even real estate financial markets. Has concentration become the only refuge? I 'refuge' to believe so.

 

How can we explain these movements without considering for a moment the central banks and their interest rate adjustments? Whether these come as a surprise or not, whether it was a major move or a more moderate one, is ultimately irrelevant. More than a concerted effort, the main focus in mid-June was on synchronising interventions to get interest rates back on track as the main instrument of monetary policy. Monetary policy normalisation is well under way in some regions. It has triggered the discounting of future income across asset classes. Does this mean that the capital or debt values of companies should be devalued overnight because inflation is destroying their value and preventing them from continuing to operate and generate profits? We should therefore not automatically equate inflation with recession because of the stagflation that prevailed in the 1970s, as the industry and index structures then are very different from those today. Similarly, we should not push central banks to raise interest rates more than necessary (monetary policy error) to combat inflation that cannot be tamed by interest rates alone.

 

We should focus on the main effects of inflation: assess the impact according to the type of activity and/or sector, the burden of commodity costs and the possibilities of absorbing cost increases or passing on price increases. Let us go back to the fundamentals of companies to re-establish the virtues of diversification between assets, between sectors of activity, between company sizes, between capital and corporate debt. The world is moving towards a new equilibrium with slightly higher inflation and normalised interest rates. There is no doubt that high-quality companies will adapt to this new environment and investors, young and not so young, need to be convinced of this.