All that matters to investors in a world of crises

The full effects of these shortages are likely to show for some time, likely years. But this week the lesson has become clear that scarcity leads to higher costs, higher inflation and higher interest rates.

The trends that have defined global markets since the GFC — low inflation, ultra-low interest rates, globalization — will completely reverse, in ways markets still lack traction, Almeida argues.

“The market is doing a great job discounting what’s ahead – the next two quarters or three-quarters. I think this is a multi-year dynamic, or a paradigm shift.”

But as Almeida likes to say, he is not an economist or politician, but a modest stock picker. His focus is on a simpler question: what should investors focus on in a new world of crises?

Fortunately, his answer is equally simple: profit margins.

Almeida says in a market flooded with data points and commentary on every minute of movement in macroeconomic conditions, it is foolish to waste time and energy “counting how many times [Federal Reserve chairman] Jay Powell blinks”.

“Let’s get back to what matters. You finance a company. What does the profit and loss account look like and what will it look like? And how much do you pay for that?”

In this way, Almeida condenses the regime change in the markets.

Profit is a function of revenue and costs. On the revenue side, it is clear that economic growth is slowing, which will weigh on revenues. Obviously, rising inflation means costs are also rising. Earnings will fall, which means company valuations and stock prices must fall.

That’s the simple version, but it doesn’t tell the whole story. While the direction of the margins is important, Almeida is really focused on the magnitude of the fall we could see. And this comes back to what central banks and governments have been doing since the GFC.

A very different world

It may be hard to remember now, but profit margins around the world were even at record highs just before the COVID-19 outbreak in 2020. They fell briefly as the pandemic hit and the world went into lockdown, but as waves of fiscal and monetary stimulus were unleashed across the globe, margins rose again, overshadowing those pre-GFC highs on their way to new all-time highs.

It is important to consider why margins were so high both before and during the pandemic.

Prior to the pandemic, economic growth around the world was lukewarm at best, so strong margins were a cost story. Companies outsourced labour, used just-in-time supply chain management to reduce working capital, and took advantage of cheap capital to lower borrowing costs and, in Almeida’s words, “finance” other areas of their business, such as debt and receivables – the factoring products offered by collapsed lender Greensill is a good example of this

When the pandemic hit, margins got a double boost — revenues grew as closed households overspend on goods, and businesses “cut all costs that weren’t fixed,” including travel and marketing.

Almeida argues that a completely different world has now arrived.

Economic growth slows, so revenues fall. But what is more important is what happens to the costs.

Business expenses are back

First, the legacy costs cut during the pandemic are coming back – as a simple example, Almeida points to the fact that he’s back in Australia talking to customers and not doing it on Zoom.

But on top of that, a new set of costs is now emerging.

Companies are finding it much more difficult to cut labor costs by outsourcing labor, and union action is increasing around the world as rising inequality causes workers to demand a greater share of profits.

Rising environmental standards and expectations are forcing companies to spend more on their business. Regulations are increasing as ESG issues become more focused. Whether that’s modern slavery rules for recycling, Almeida says compliance costs — and non-compliance — are no longer an option.

The energy cost crisis in Australia could be placed in the same basket.

Before COVID-19, the energy security challenge was mostly theoretical, but it is now clear that it will drive costs at levels unheard of just a few years ago.

And then there’s the rising cost of capital. Almeida says that with inflation across the world between 6 and 9 percent, central banks have no choice but to continue raising rates to the point where they destroy demand.

The central bank doesn’t care about share prices. They care about inflation. They have to create pain.

He says the market’s obsession with the idea of ​​a Fed put – the level at which the Fed will ease monetary conditions to support stock prices is misleading, because society simply cannot live with inflation at this level for long periods of time. periods.

“The central bank doesn’t care about stock prices. They care about inflation. They have to create pain.”

Does that mean a recession? Almeida doesn’t know and says his best bet is a 50 percent chance of a recession in the US.

But again, he comes back to profit margins. What higher rates will do is that the techniques of financialization – borrowing to fund shareholder returns, factoring debt and receivables, operating without making a profit – headwinds rather than headwinds.

Almeida’s conclusion is relatively simple: too many companies have earned too much for too long and profit margins must fall between 40 and 55 percent.

The last time profit margins fell 50 percent was in the GFC – when stocks fell 50 percent too.

Clearly, Almeida believes the current stock market correction is far from complete and investors should brace themselves for more pain and certainly more volatility.

But on the other hand, these conditions do give stock pickers a chance to prove their mettle. The risks to margins are not complicated or hidden. The companies that run sustainable businesses, that pay their people well and that haven’t earned too much in ten years have to stand out in a time of scarcity – of energy, labor and returns.

“The market will be able to price risk,” says Almeida. “Companies that should never have been given capital will disappear. That will create an opportunity for that better or higher quality company that gets through this to take a bigger market share on the other side.”

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