It appears, on the face of it, bizarre that weakness in equity markets in the second half of February was driven by expectations of strength in the economy as vaccine rollouts and ongoing fiscal stimulus spurred optimism.
In June 2020, we described the interaction between stock market levels and interest rates and said that, ‘the value of any asset could be determined by the cash inflows and outflows that can be expected to occur during its remaining life, discounted at an appropriate interest rate.’
We were explaining that, in the midst of the initial lockdown and as earnings expectations were falling, markets could still rise if expectations of interest rates fell by a sufficient amount. Today, the inverse is true; expectations of earnings are rising but so too are expectations of interest rates.
We see the antidote to portfolios in an environment of rising rates to be two things. First, exposure to businesses whose earnings benefit from higher rates (mostly financial services businesses). Second, a margin of safety in the price at the time of investment, such that discounting expected cash flows, even at higher rates, justifies today’s valuation.
Over the last 18 months, we have tried to increase our exposure to the former (whilst doing so only when we think we can find high quality long-term investments) and we will forever argue it sensible to maintain discipline in the latter. It is no surprise to us therefore that some of the best performing investments in the fund over February were financials such as Close Brothers and out-of-favour retailers such as Burberry.
We will continue to spend little time trying to predict changing interest rate expectations and will focus our efforts on finding businesses that we think satisfy one or both of the above criteria.