This was the year where interest rates were supposed to bite into asset prices with a vengeance, especially after a difficult 2022.
Instead, we have seen the resumption of the ‘dash for trash where companies with the weakest balance-sheets appear to have performed the best. Valuations of some of the most speculative companies in the Western capital markets have risen significantly, all predicated on the fact that interest rates will not stay high for long.
And slowing economic growth will eventually reduce the cost of money to manageable levels. It is striking to note here that most of the commentary that surrounds this thesis is based on the directionality of interest rates – and not on either profitability or growth.
This has resulted in an outcome where companies with stronger and more stable cash flow levels have underperformed their more speculative counterparts. Investors, having taken a hit in 2022, have bounced back to extol the superior price performance of the ‘new thing’.
Stocks like GameStop have risen by nearly 40 per cent, even as the company continues to lose money, and is a microcosm for what is happening in the technology sector. While housing prices in America are falling (in some areas by more than 20 per cent), the pain has not yet been felt in the capital markets.
Closer to home, capital markets have enjoyed a re-rating, demonstrating that for the median investor, it has been as much if not more profitable to seek exposure through real estate by investing through the capital markets. This narrative has been drowned by the supposed superiority of returns in the Western capital markets.
Despite the strong performance of newly listed IPOs - Salik, Dewa, Empower, ADNOC Gas, Al Ansari, etc. - as well as the restructuring plays like Union Properties and Gulf Navigation, investor interest still seems to be more focused on day trading in meme stocks.
A ‘casino mentality’
For the most part, history attests that this cannot be sustained. As financial literacy levels rise, there has to be a realization that the ‘casino mentality’ approach to investing inevitably ends in tears, as has been demonstrated by the fall from grace of companies like Netflix.
Interest rates will exert their pressure on indebted and loss-making companies, and the riskiest gambles will be the ones that will succumb first. Even more worrisome will be the second order effects, where traditionally well-considered companies that have over levered will find refinancing difficult after a decade of near zero interest rates. With whispers of more bailouts in the offing as tightening liquidity conditions move beyond the financial sector.
As realization sinks in that interest rates will likely remain higher for longer, combined with the deleterious effects of quantitative tightening, it is likely there will be another wave of downward pressure.
Structurally speaking, the overall return spectrum tilted towards capital gains will more likely shift towards income generation, as has been the case in times past when interest rates were high. Of course, markets are second order engines, and they anticipate not only the stress, but also the eventual rebound.
This time around, the bet remains on bailouts and lower interest rates to come to the rescue- as it has in times past. This is why advisors continue to recommend the standard Index ETF strategies, failing to acknowledge the growing concentration risk embedded in these indices.
A return to sound investing basics will help
On a more fundamental level, diversification is only required for investors who do not fully understand what is going on in the markets. Investing in loss-making companies (which has dominated the mindset for the last two decades) ignores the basic principles of sound investing.
For investors at home, difficult as it is for the narrative to take hold, it is equally obvious to note that a selective portfolio of highly profitable companies (domestically, regionally and internationally) will handily beat out any ETF-based strategy, as has been the case post-Covid.
Investors who have paid notice have been largely surprised to note that investing in large domestic listed developers have beaten the city-wise real estate price rises (despite the latter’s dominance in news headlines on a daily basis).
The dash for trash makes sense if the underlying assumption is driven by FOMO. Fortunately, investors in the UAE and the region do not need to yield to this temptation.
Interest rates have transformed the oil markets, currency markets and even had their effect on housing markets in the West. In all cases, it has exerted pressure on weak balance-sheets. What is on offer in the UAE is a strong antidote to this mode of thinking.