We prefer the protection afforded by profits generated today

Scotland has almost 1,000 mountains and hills, which is a lot for a reasonably small country. They are not always very welcoming at this time of year but offer fantastic views when the weather improves.

It feels like equity investors have just come off the summit of one mountain, formed during the days of quantitative easing, and are eyeing up the next, if or when any Federal Reserve-induced US recession has passed.

The problem is that the weather is currently poor, and visibility is not great.

This matters when assessing the depth of the drop between the two summits. In equity parlance, how great might the earnings downgrades be? And what does this mean for where share prices trough?

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At the risk of straining this analogy too far, there is probably still a narrow pass threading its way between the two summits (also known as a soft landing) but the chances of Fed policy delivering this to us seem to be dimming and investors are questioning the abilities of their mountain guide.

There is an ongoing tussle between credit markets and the narrative consistently espoused by the Fed.

The Fed is adamant that it will need to see services inflation cool, like that already seen in goods inflation, and some slack in labour markets before changing tack, but credit markets seem unconvinced – seemingly of the view that enough has been done already and that we are closer to peak rates than the Fed would have us believe.

The spread payable on BBB-rated debt, relative to government bonds, has come in during recent months and financial conditions have eased.

Recent equity market action, when an attempted rally was curtailed by more hawkish Fed speak, would suggest to us that it is too early to call which way the debate will evolve.

The fact that concept capital is continuing to plumb new lows as measured by the Renaissance IPO ETF certainly suggests that confidence remains very fragile, and we are not positioning the portfolio for a rapid return to the looser monetary conditions that these companies require to prosper or even survive, in some cases.

If you had invested $1 in the S&P 500 on the last day of 2017, you would have $1.44 as at the last trading day of 2022.

If you had invested the same $1 in the hottest IPOs of the day (as measured by the same ETF noted above), you would now have 85 cents and more grey hairs, given the extreme volatility observed in these shares over that period.

With private equity markets much less along the price discovery journey than public markets, 2023 does not look like a bumper IPO year either.

According to Mountaineering Scotland’s website, the most important thing if you have no clear path ahead is not to panic. As they say: “Do not simply start walking in different directions changing bearings every minute or two in the hope that things will be sorted.”

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This sounds like good advice to us too. We will not chase north into the unchartered landscape of cashless concept stocks. No more than we will head south into deep value.

We remain convinced that the future will look very different to the recent past.

Delivery of sales and profit growth will be ever more critical to share price performance. It seems unlikely to us that the areas that have sucked in the most capital over the last ten years will turn out to be those with the most unmet demand – think digital advertising, niche software applications or streaming services.

The recent glut of headcount reductions across big tech suggests that their management teams may also be beginning to share that view.

Instead, more pressing needs are presenting themselves – many of which have been underinvested over the last decade or longer. Defence and energy security have been very much front of mind over the last 12 months and are likely to remain so in our view. There are likely other areas too, where the stars are starting to align.

In conclusion, and to quote the great Scottish actor and comedian Billy Connolly: “There is no such thing as bad weather, only the wrong clothes.” Current equity market conditions dictate that you choose your investment attire particularly carefully.

In our view, buying profitless technology companies is like going up a Scottish mountain wearing flip-flops. You might get away with it, but the odds are not in your favour.

Instead, we prefer the protection afforded by profits (and cash) generated today – not at some unspecified point in the future.

William Low is portfolio manager of Nikko Asset Management Global Equity fund

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