Innovation and Growth – The Antidote to Inflationary and Recessionary Forces?
“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.”
Ronald Reagan, US President (1981-89)
The current economic environment is reminiscent of the late 1970s stagflation era when inflation rocketed (from a much higher base level) to 12% in the US. Economic growth remained anemic throughout this period, and the economy entered a brief recession in the first half of 1980. While the investment environment is likely to remain challenging in the near future, investors can certainly draw some crumbs of comfort from recent history and the conclusions we can draw from it.
For example, we know that equities are ‘lead indicators’ and anticipate future conditions. We saw a great illustration of this in 2022 when equity markets suffered significant losses before the economic environment became anywhere near as difficult as it is now. By the same token, equities should start to rally in anticipation of economic recovery several months before it actually materializes. We saw a perfect example of this in the period beginning March 2009.
The other reassurance comes from an analysis of the performance of equity markets during periods of rising and falling inflation. This reveals that stocks benefit from falling inflation. It is important to bear in mind that, although inflation remains stubbornly high to the chagrin of central banks, the overall level is falling in each of the G7 economies, with the exception of the UK.
A further consideration in the prevailing environment is that innovative growth companies possess the key attributes to counter the unusual combination of inflationary and recessionary forces. Innovation drives efficiencies which facilitate pricing power. While pricing power affords inflation protection and drives growth. Companies that can continue growing in a harsh trading climate will invariably attract investors.
This concept is perfectly illustrated in the 1970s stagflation era when the Nasdaq significantly outperformed the S&P500 index. The Nasdaq is the traditional gauge of the fortunes of innovative growth companies by dint of its majority weighting in tech. Currently, four of the FAANGs feature in the top ten constituents of this capitalization-weighted index.
Since the price of private market assets peaked in to 2021, we have witnessed what commentators refer to as a ‘great reset’ (where prices retrench to a foundation level supportive of strong future growth). And now we are seeing plenty of evidence that this process is at or near completion. According to Forge, the 75 most liquid names in its Private Market Index, traded up during Q2 - the first quarterly gain for two years.
In the secondary market for growth equity, prices are clearly bottoming out, as we can see from our constant monitoring of the Morningstar® PitchBook® Unicorn Select 20 IndexTM. As such, we feel that this an attractive entry point with assets trading at a significant to fundamental vale. In addition, the discount rate applied to future growth potential is likely to fall rapidly and drive asset prices higher.
It is also worth considering that private equity firms are sitting on vast cash reserves. According to estimates from Bain & Company, there could be as much as USD 3.7 trillion in ‘dry powder’ waiting to be deployed. With global merger and acquisition (M&A) activity falling to its lowest level for a decade in the first quarter of 2023, attention is shifting to investments with long-term potential from either operational improvements and organic growth, or scaling platforms through acquisitive growth. There are a number of companies with these attributes in the unicorn index.
Get ahead of the crowd…
Market timing is far from an exact science, but history suggests that it is more beneficial for investors to arrive early than late when prices are rising strongly and the bandwagon is overloaded by increasing numbers jumping onto it.
So far this year, the performance of public equity markets has defied even the most optimistic forecasts, and this rally has largely been driven by big tech companies. Consequently, the performance differential and the valuation gap between public and private market companies with high growth potential is very substantial.
Perhaps the share prices of publicly listed companies will drift lower to close this gap. Or will private market assets appreciate quickly to catch up? It could be a combination of the two. In any eventuality, it is clearly a very important time for growth-oriented investors to consider the private markets route, with secondaries appearing particularly attractive.
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