Almeida: What’s on the minds of institutional investors today?
Hyland: It’s an interesting time to be investing. I believe our clients recognize that the next few decades ahead of us are going to be fundamentally different from the past few. We are in a paradigm shift that may require a different mindset. Last year was a market environment that we haven’t experienced in decades—more than 40 years since the last time both equities and bonds were down in the same year. Given that backdrop, there are a few key trends facing institutional investors.
First, with the markets down across the board in 2022, addressing liquidity needs with lower total values was a challenge. The second trend is the role of fixed income. Bonds are back. Riskless assets, such as Treasurys, are now a competitive asset class. Institutional investors may need to rethink the role of public fixed income in their portfolios and examine their current allocation and its composition. The third trend is managing overallocations to private markets, given the current market environment. Staying disciplined and keeping your exposure aligned with your long-term policy is a focus for clients.
Finally, there’s the role of active management. Given the changing economic backdrop, the return environment may be more muted going forward. Alpha may become a critical component of your overall total return. In the 13 years leading up to 2022, declining rates created a strong beta environment where a rising tide lifted all boats. Higher rates will likely lead to more volatility and dispersion in markets. Selectivity will be key. Clients have many alpha levers: Regional allocation, sector selection, style selection, security selection and manager selection are different ways to generate alpha in their portfolios. This is an environment where the role of active management matters.
Hyland: It’s a tough investing environment: a hot war with Russia, a cold war with China, a climate transition and upward pressures on costs. What should we expect in 2023 and beyond?
Almeida: I’m less worried about GDP growth than about the years of interest rate manipulation, pushing rates below their natural equilibrium, because that’s when malinvestment accrues in the economy. People make financial decisions based on distorted signals, and those suboptimal decisions—starting a new product line, moving into a new geography or investing in a SPAC or crypto—get exposed. Over the next two, three, five or even 10 years, I think investors should be concerned about the things that we can’t see. What bad investments did a company make? What impairment do they have on the balance sheet? How much debt did they accrue to make that bad investment? When I think about where we are now, valuations are above average at the very least, companies are overearning and cash flows are too high. I think investors should ask, ‘Is this asset good? How much cash flow will the enterprise generate? Am I overpaying or underpaying?’ That’s where I think the focus should be.
I have less conviction on soft or hard landing. I don’t think it will matter as much as a company that refinances at 8% but has an ROI of 6%. They’re no longer earning their cost of capital. Recession or not, that company won’t survive.
Hyland: Over the past 15 years, a backdrop of declining rates, fiscal stimulus and quantitative easing put the world awash in easy money. How do companies adapt to an environment with a higher cost of capital and a tighter credit environment? Many companies will need to roll over their debt. When you look across our platform, how does this impact individual companies? Where are we seeing the risks and opportunities?
Almeida: Over the past 10 years, you had a ton of corporate debt issuance because interest rates were so low and central banks hoped that that capital would be funded into projects, plants, property and equipment to create economic growth, jobs and money velocity. That didn’t happen. Instead, you had the greatest profit cycle in U.S. history, with the weakest economic growth cycle in 150 years. Instead of capital being put into production, it went into financial gearing. Companies levered up existing income streams. That’s why profits are so high and why the equity market responded so well. That’s over now. Interest rates are at 4%; we went from quantitative easing to quantitative tapering/tightening, which changes the dynamic. While I don’t know how fast or slow, I think companies that are unable to earn their cost of capital will get exposed.
Now, we’ve outgrown our physical world; we don’t have enough green energy assets. Companies are worried about their supply chains. How much Mother Nature or geopolitical risk do they have? I think that spells a massive shift from increasing dividends and buybacks to reducing greenhouse gases and shoring up supply chains, which requires a tremendous amount of capital, and that comes at the expense of profit margins. We’re thinking about who can earn their cost of capital in this kind of environment and who can’t. To your point, where security selection matters, that becomes a big delta. We should see a lot of dispersion in the markets, both within and across sectors.
The market will price it in before it becomes tangible. I don’t know whether that happens next quarter or in three years. But as we’ve seen time and time again, markets discount things before they become tangible. You have to be ready beforehand, which goes back to your opening comments about what your clients are telling you: They’re worried about liquidity.
Hyland: From a bottom-up perspective, what are the opportunities you see in deglobalization and onshoring?
Almeida: Making sure supply chains are resilient and having our own semiconductor and electric vehicle-making capabilities requires people, parts and goods—a tremendous amount of capex and opex. Capital goods and industrial companies are at the epicenter of that. There seems to be the potential for a new paradigm or market leader, but many of these companies were good businesses to begin with, and we’ve owned them for a long time. While this may unfold slowly or quickly, it’s likely additive to earnings.
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