World stock markets are facing much consternation over key issues including high inflation and the path of interest rates, the Ukraine war, and the Covid pandemic in China, all acting to disrupt supply and global trade.

Against this background, traditional stock market value measures such as price-earnings ratios are still near the high end of historical valuations in many countries, earnings margins are beginning to come under pressure and consumer confidence is decreasing as costs increase.  This does not bode well.

Australian inflation is 5.1% per annum, and US inflation was last measured at a rather impressive 8.5%. The US experienced negative real economic growth in the last quarter, suggesting a stagflationary economic environment.  It was only last year that you would be laughed at for suggesting stagflation (we did so we know), and the RBA governor was telling the market how foolish they were for even suggesting a rate increase as a possibility in 2022. How times change!

Supply disruptions combined with ridiculously easy fiscal and monetary policy are the reasons for the significant recent lift in inflation globally. Central banks currently have interest rates set near record lows. They believe they have to lift interest rates to try to stop inflation from becoming overly entrenched, despite the supply-side issue. Interest rates tend to move in waves; they historically do not go up and down consecutively, instead tending towards trending. Thus, changes in direction are important and closely followed by markets.  This time could be the same, but not necessarily so.

For most markets and their participants, the extent central banks will move rates is currently the most relevant and important factor for investment decision making.  The bond market is pricing aggressive rate increases, which to many market participants - us included - appear unrealistic.

US Government Debt to GDP averaged 64.54% from 1940 until 2021, reaching an all-time high of 137.20% of GDP in 2022. US household debt to income is above 77%, while Australian debt to household income is just under 200%; historically, approximately 65% is normal. Many other countries have high debt levels, following further government spending to support economies during Covid or at the consumer end due to higher house prices or credit expansion during a period of record-low interest rates.

How will central banks and markets react to this economic background?
Firstly, economies should prove very sensitive to lifts in interest rates due to high debt levels. We don't think it will take that many before something meaningful breaks either in markets or the economy or both simultaneously.  A recession is a real probability, imminently in Europe but also in other economies in 2022 or failing that in 2023.

Secondly, it will be very tempting for central banks to try and ultimately "under-respond" to high inflation as they need to act to inflate the debt away and will become scared again about deflation and a financial crisis should they overdo rate increases and see markets and economies collapse.  This could occur much earlier than most believe.

The unfortunate reality is central banks don't control everything that goes on in an economy, albeit are loathe to admit it.  Monetary policy only has a limited effect on supply-side inflation and ultimately to be effective at addressing this must kill demand i.e., induce a recession.  A recession is hence a realistic expectation if central banks are to be taken seriously.

Ultimately, it will be very important how far central banks go. A policy mistake lies beyond every decision they make from here.

The Reserve Bank of Australia recently lifted interest rates slightly, announcing that the cash rate would increase by 0.25% to 0.35%. Incredibly, this was the first interest rate rise in over 10 years. This appears to be a small opening shot against inflation but it is not until rates are closer to "neutral" that we will know how far they are prepared to push it, and neutral cash rates may be lower than ever before.

We would suggest that central banks will continue to lift interest rates, however, to a more limited extent and less than what is priced in.  This is because we think something meaningful will break long before they manage to meet the expectations of the bond market, or alternatively, they'll aim to tolerate higher inflation and raise rates cautiously over a more extended period while talking a tough game and hoping inflation will have some dips.

Investors, many of which have only had limited experience of inflation and how it can have dramatic effects on the purchasing power of cash over a number of years, will need to pay close attention to central bank actions.  Macroeconomics matters now like never before.

Market falls could be dramatic because the risks are high and because of the influence of passive investors who don't know what they own, only that they expect it to go up.  Passive investors might wake up one day and decide they're over-allocated to risky assets due to their backwards-looking models that simply don't match the times, providing constant selling pressure.

A geopolitical and technological disruptive period
Importantly, it is not only interest rates and inflation that investors need to consider.   

Geopolitical risk should be front of mind as the era of (relatively) peaceful prosperity appears over.  Power games are occurring on a grand scale and the stakes are big.  One wrong step and it is literally kaboom.  When people with a history of following through on their threats start threatening the use of nukes, nuclear strikes must be considered a realistic possibility (like it or not).

Investors also need to be aware that we are headed into one of the most technologically disruptive periods in history. The integration of technology into many businesses will see certain companies thrive and many others prove uncompetitive.  For example, artificial intelligence, robotics, and the move to the electrification of transportation will have positive benefits for technologically innovative companies over time, while having negative effects on companies unable to implement or use these new technologies productively.

Will the commodity and mining boom continue?
If inflation is permitted to continue to run and demand isn't destroyed in a recession, commodities and thus mining companies should continue to benefit (albeit not in a straight line).  We see electrification, automation and robotics as likely to increase mining company margins, while mine production may continue to lag product demand due to green groups and government slowing mine starts in many countries. Lithium and copper are likely to continue to see market support while nickel could be negatively impacted by a move toward lithium, iron, and phosphate batteries in the electric vehicle space.

The move towards reduced carbon is an ongoing important secular thematic and we are hence allocating towards an active strategy investing in carbon futures to benefit from needed and likely carbon price increases over time.

While technology stocks and disruptors are understandably lagging today as rate increases decrease the value of long duration stocks and some of these stocks are absolutely detested, should the central banks not follow through with the priced rate increases and/or reverse their policy, these stocks may see some respite from their entrenched bear markets later in 2022.  Real productivity growth is an important secular need that some technology stocks will provide and benefit from overtime, while many others will fail to reach profitability and hence continue to disappoint or disappear. 

Precious metals will also benefit if positive real rates fail to be sustained, which we think is likely in most Western economies in the absence of good policy choices, due to large debts, worsening demographics and mediocre leadership.

Asset allocation and stock selection will hence become a bigger driver of investment returns in this new unstable and dangerous period in world economies and markets. The days of the index approach are hence numbered as broad real returns will likely continue to prove disappointing, and certainly so to anyone with reasonable or high expectations. 

Being overly concentrated or convicted may also be highly dangerous in such an uncertain and risky world (many funds are already down 40 or 50% from highs using such an approach!).  A humbler and more diversified yet still highly active and selective approach is, in our view, more able to manage the risk and uncertainty, smooth the return path and keep losses to more tolerable levels.

The primary dangers for investment markets are (1) an overly aggressive interest rate stance by central banks, which we would see as an explicit policy error, or (2) an escalation of the war or a new war.  Covid policy in China is an x-factor but one would think likely to resolve over time.

If there is one thing we would leave you with, expect to be surprised. We're in a new dangerous investment era where surprises will prove commonplace, and arrogance and an inability to be flexible may prove deadly.  Being humble, cautious and backing good research and prudent risk management might not (yet) be very popular but it will be soon enough. It provides a greater chance of being effective and avoiding the disastrous downdrafts which we expect will afflict many investors in 2022.

The question everyone is asking,

Is this a mid-cycle slowdown or have we moved into a new bear market for shares? 

We are firmly in the latter camp.​

The balance sheet recession that followed the financial crisis was a powerful deflationary force. Households and businesses de-levered while governments exercised fiscal restraint allowing Central banks to reflate without creating inflation. Low growth with deflation was a 'goldilocks' era for risk assets, not too hot and not too cold.

In Fig 1 below, you can see four very clear and discrete mini business cycles of four years each starting in March of 2009, as Central Banks' eased and then tightened policy. Together they make up the 14-year secular bull market in shares.

The cycle has turned, the bear is here

In each reflation episode, real interest rates moved lower and lower and 'financial assets' such as shares and bonds, moved higher and higher. At the same time as real interest rates turned negative, capital was re-allocated away from short-duration 'hard' assets such as commodities.

The share market has followed each of these business cycles peaking on each occasion at the blue advance line in Fig 1 as it has once again in December of last year. As policy support is once again withdrawn we have moved into the next 'cyclical' bear.

Market bulls will have you believe policymakers can engineer yet another soft landing, pivot, and reflate one more time. It's highly unlikely this time however as we no longer have these deflationary tailwinds, instead, we have inflation at the highest level in 40 years in many western economies.

In the last tightening cycle in 2018 (Fig 2), the US Federal Reserve started raising interest rates much earlier while the economy was still expanding rapidly (PMI was rising). They didn't even reach the neutral interest rate however where policy pivots from accommodative to restrictive (the dotted line) before economic activity fell sharply and they were forced to reverse course and ease rates again. Back then, inflation was barely at 2%, and the Fed was still trying to push inflation higher!

US Federal Reserve Target Interest Rate

This time will be very different, they are late and are tightening as growth slows. Furthermore, to bring inflation back under control, theoretically, policy must 'overshoot'. They need to move beyond the neutral rate (dotted line) to slow demand enough to stimy inflation. Goldman Sachs have suggested this overshoot may require interest rates as high as 4% or above to curb inflation.

Interest Rate markets are clearly well below this level today and with an inverted yield curve, bond investors are already signalling a recession is ahead.

Given central banks are late and tightening into a slowing economy and the need for a policy overshoot to curb inflation, the prospect of a recession in advanced economies next year is high. A soft landing and another round of asset reflation is equally unlikely.

Not just any bear. A new secular bear.

This will not just be a 'cyclical' bear market like the four prior episodes but the beginning of a new secular bear where shares move sideways for many years to come. As with secular bulls (the last one lasted 14 years), secular bears typically last 10-15 years​

A secular bear market

Strategists often refer to the 1970's secular bear as a precedent for what lies ahead. You can see in Fig 3 above this was not a unique period. Inflation eventually kills most secular bull markets and that should be our base case this time also. It is dangerous to expect this time will be different. ​

Within this secular bear we will still have the four-year business cycle playing out as shares rise and fall, but within a broadly sideways trend.​

A new secular bear for bonds also

With the return of inflation, it looks like the 31-year secular bull in bonds is also now complete. It is clear from the momentum signal in the bottom panel below the low for bond yields (the high for bond prices) is in.

Most risk assets are priced off the long bond - the very low yield on these securities has led to a re-rate of other long-duration risk assets like shares. The P/E re-rate of shares and for growth shares in particular is an extension of the depths bond yields have fallen too.

As commodities are an inflation hedge, secular trends in commodities have historically been negatively correlated with financial assets. You can see this indicated in red below. A new secular bull market in commodities has probably begun.

Secular bear in bonds/a secular bull in commodities

US Treasury Yield % (10 year)

Further confirmation of a reversal in bond prices is near to hand. In Fig 5 below you can see bond yields across multiple durations are pushing up against the 30-year downtrend as we speak. If yields break through here, we will be at a seminal moment for risk assets. The 30-year tailwind for share market valuations will have reversed.

How it plays out for shares this year

Following the strong bear market rally in March, shares are likely to track sideways in the months ahead but will fall short of prior highs. It is still too early for a major draw, shares still offer decent profit growth this year and analysts are still upgrading profit estimates. Furthermore, with money pouring out of the bond market, investors have few alternatives other than to invest in shares.

The next major drawdown in the share market is likely to occur later in the year as economies slow and the street starts cutting profit estimates. ​As shares start to move lower and investors come to realise there will be no Central Bank bailout this time around, share markets will fall hard led by mega-cap technology - the last and largest bubble still to burst.​

Closer to home, we may well see a replay of the Teck Wreck and the GFC where the lucky country once again misses the recession bullet given our exposure to a resurgent resources sector. Given our markets' heavy weighting to resources, the ASX may still make a new high in the months ahead.

From here, I would advise thinking of the Australian share market as two discrete markets - the All Industrials share market which today is still 7% below the August 2021 high and a resources market which is making new highs as I write this piece. Don't chase it though, the initial advance in commodities is nearly complete. As late cyclicals, resource shares will also fall in the second half of the year as global growth slows. 

Vrimp, the vegan alternative to shrimp, is made from peas, seaweed and konjac root, a vegetable found in Asia. The vEGGie, a vegan egg, is a mixture of soy protein and omega-3 fatty acids. Wunda is a pea-based alternative milk. Offered too are the Vuna, a vegan tuna alternative, and vegan burgers, while an experiment is underway to make vegan chicken that comes with fake skin and bones. These products add to the plant-based dairy alternatives for chocolate, coffee, creamers, ice cream and malt beverages. Such are newest offerings of the Swiss-based Nestlé, the world's biggest food and drinks maker, as it responds to the latest twist in consumer demand.

The innovation drive extends to the staples that bring in so much of Nestlé's revenue, which reached 87.1 billion Swiss francs in fiscal 2021, a jump of 7.5% on an organic basis from 2020 and the fastest pace in 13 years.

Coffee (26% of fiscal 2021 sales) has benefited from the launch of Starbucks at Home, a tie-up with Starbucks and Nespresso, and a revamped approach to producing Nescafe instant coffee. Bean selection is now approached in much the same way as wine makers grade grapes and there's an organic option. Of note is that in 2021 Nestlé scientists discovered two novel plant varietals of the coffee tree that produces Robusta beans. The result is a jump in yields by up to 50%, lower carbon emissions and people can now enjoy a super-premium barista blend in their soluble coffee. And every second of every day, the world enjoys another 5,500 cups of Nescafé, including the premium Nescafé Gold.

The pet care staple (18% of sales) has become personalised (animalised?) and much science has gone into producing healthy high-end labels. In many parts of the world at production volumes that achieve economies of scale, Fido can receive a unique blend of dog food and supplements delivered to the home with his name stamped on the front. For house pets so inclined, there's a pet food line where insects and plant protein from fava beans and millet are mixed with meat. Pet carers are considered too. Improved online ordering means people don't have to lug home heavy packets.

The KitKat staple, which was revitalised by a marketing campaign in Japan in 2014 that exploited how the Japanese pronunciation of KitKat (kitto katto) resembles the phrase 'you will win' (kitto katsu), now has stand-alone stores. These 'KitKat bars' offer almost countless flavours including a vegan option (KitKat V) and let people devise their own recipes - 'create your break'.

Such is the revamp of a company with a history stretching to 1866 since Mark Schneider became CEO in 2017. Key drivers of success under Schneider include a switch into healthier products such as plant-based foods and vitamins and supplements, and a focus on novel products and faster times to market with the latest offerings. Schneider has reinvigorated the company's portfolio of assets by conducting at least 85 divestments and acquisitions over the past five years.

Nestlé shares are trading around the record high set in November last year because investors recognise that an overhauled company with great brands is enjoying a virtuous cycle kicked off by digitalisation. The enhanced consumer insights improve innovation, which leads to the creation and successful launch of better products produced at economies of scale that bestow an unassailable competitive advantage on the company.

What brands the company has. Nestlé has 31 'mega-brands' including Coffee mate, Haagen-Dazs ice cream, Maggi noodles, Milo, Nescafé, Nesquik, Nespresso, Purina pet care and San Pellegrino mineral water. Each has loyal consumers, which means these products command a premium price and superior access to supermarket shelves. Each generates global sales of more than one billion Swiss francs every year.

Nestlé, in all, boasts 2,000-plus brands that are sold in 186 countries and many hold the No. 1 or No. 2 positions in their categories. The brands are split across seven segments. These are in order of fiscal 2021 sales: powdered & liquid beverages (28%), pet care (18%), nutrition & healthcare (15%), prepared dishes & cooking aids (14%), milk products & ice cream (12%), confectionery (9%) and water (5%).

Nestlé's great brands mean the company has steady cash flow and earnings streams no matter the state of the economy. As such, the stock has a 'defensive' appeal, which is why it's held up better than most during the share slide so far in 2022. Since Nestlé is well positioned to achieve its sales growth target of 4% to 6% in coming years, the stock is likely to generate superior returns for investors for a long while yet.

To be sure, Nestlé products face ferocious competition. Some products (chocolate) are struggling to boost sales. But the success of coffee and pet foods make up for these laggards. The health push exposes the food processor to charges of hypocrisy because many of its goods are unhealthy and cannot easily be made wholesome. But the company is out to reduce that percentage and sales show junk food is popular enough. For all its global reach, Nestlé is overexposed to a downturn in the US, where it sources about 33% of its sales and profits. The company has warned that higher costs for its agricultural ingredients, packaging, energy and shipping threaten margins. Russia's invasion of Ukraine has intensified that challenge, especially that wheat and energy prices are rising. But as a third of sales come from premium products, Nestlé is better placed than most of its peers.

A business that has changed so much since two Americans established the Anglo-Swiss Condensed Milk Company 156 years ago (that eventually merged with a company Henri Nestlé founded to sell milk-based baby food one year later) is used to overcoming challenges. If Nestlé can make such a successful start to going vegan and vegetarian (sales of 800 billion Swiss francs in fiscal 2021), what can't it do?

Sources: Company filings and website, Bloomberg News and Dunn & Bradstreet.