Dear client,
This is the first time I have the pleasure of addressing you as chairperson of EDM. My intention with this periodic dispatch is, as it has been, to share with you the information we consider most relevant as long-term investors and that we believe defines and distinguishes us from other entities in our sector.
Markets closed the first half of the year with sharp declines among bonds and equities, due to concerns about rising inflation, interest-rate hikes, and the threat these pose to the economic cycle in the medium term.
But let’s look at the issues one at a time.
Decline in bond prices
Traditionally considered less risky than equities (shares), fixed income securities (bonds/debentures) are financial assets whose size exceeds that of stock markets and, consequently, their fluctuations are more consequential to the markets overall, affecting other transactions where these assets serve as collateral.
The main component of fixed income is sovereign debt, which pools government issues through the various administrations, to finance spending needs or accumulated deficits. Since the interest rate is fixed for the issuer, the return for the investor is adjusted based on the evolution of the general credit conditions at a given time. Thus, in the face of rising interest rates, the price of bonds already issued at lower interest rates drops in order to maintain a relative return, and vice versa. Prices can also be adjusted based on an uptick in the issuer’s perceived solvency risk, causing investors to demand a higher rate of return on securities. At the moment, we are seeing considerable price declines due to investors’ anticipation of interest-rate hikes and higher inflation.
The table below reflects this situation:
In this context, our EDM Ahorro fund has registered a -3.7% drop this year, a correction considerably less than that of the indices, which has helped minimise the volatility of the mixed portfolios.
To conclude this topic, from a historical perspective, it is worth noting that we are seeing returns “revert to normal” after a long period of cheap money. Though painful, this process had to occur at some point and it indirectly allows many savers to generate income flows that, though lower than inflation, cap an era of zero or negative interest rates.
Thoughts on inflation
Year-on-year inflation (May to May) stands at roughly 9%, both in the US and Europe, and slightly above 10% in Spain. A large part of this inflation is rooted in higher energy and transportation costs due to disruptions caused during the pandemic. The war in Ukraine has put more pressure on inflation rates, especially in Europe, which is a net energy importer. There is no doubt that a ceasefire between Russia and Ukraine would trigger a significant drop in energy prices.
But, because the course of the war is unpredictable, the central banks—on the brink of losing their credibility as the ultimate guarantors of financial and price stability—reaffirmed their commitment to control inflation with tougher discourse and a policy reversal, more intense in the US and more moderate in Europe.
The goal now is to anchor medium-term inflation expectations slightly above 3% in the US, according to the University of Michigan index, such that it is communicated to all economic players that inflation is under control and that it is a temporary problem. Achieving this goal is essential to prevent wage hikes in the medium term that could transform a transitory inflation crisis into a more structural predicament, forcing the economy to endure higher interest rates for a longer period of time.
Given the foregoing and knowing we will have to wait and see if inflation eases in the coming months, it is my personal opinion that in the next decade we will undoubtedly have to live with higher inflation rates than in the last decade, mainly due to the impact of three factors: (1) less globalisation, (2) higher defence spending, and (3) costs derived from the European Union’s energy transition and security. As is evident, these are geopolitical issues we have been tracking for some time at EDM that we believe will materialise in the coming years.
A note on “asset allocation”: Shares as a hedge against inflation
Historically, listed shares have been an effective hedge against inflation, in the sense that they are generally able to deliver positive real returns (Inflation deducted). As such, it follows that long-term investors—like you—will have a significant portion of their portfolios invested in this asset class.
Because businesses suffer from higher costs (raw materials, wages, energy) in inflationary climates, it is vital to invest in companies with the ability to transfer these costs to the price of their products, thus safeguarding the profitability and value of the company.
This requires being extremely selective about the companies in which you invest. We are talking about i) businesses with cost structures that are relatively protected from higher energy costs (technology, healthcare, software); ii) companies that manage long-term, inflation-linked contracts; iii) businesses with a relatively low level of reinvestment versus cash generation; and, iv) in general, companies with a clearly dominant value proposition in the market that enables them to transfer the increase in costs and investments to prices without losing sales.
Listed assets have the added advantage of liquidity, which allows for the quick and free availability of cash at any time, with—however—the caveat of price volatility: without liquidity there is no volatility.
At the time of this writing, negative investor sentiment tied to the prospect of runaway inflation and an economic downturn has positioned valuations (P/E ratios) for most quality businesses at historically attractive levels for long-term investors.
Among the range of EDM companies, profits grow unabated, while suffering a collapse in P/E ratios. As a result, it is a great opportunity to invest in outstanding businesses at extremely attractive prices. In many cases, real bargains.
At EDM, we maintain our strategy of concentrating our investments in these quality businesses that, though they may fluctuate in price, their value remains intact and they serve as a repository of growing value.
I would like to take this opportunity to wish you a well-deserved summer holiday.
Many thanks for your confidence.
Sincerely,
María Díaz-Morera,
Chairwoman
