Today’s uncertain economic outlook could dissuade some investors from buying shares. After all, inflation recently reached its highest level since 2008. This could prompt a more hawkish stance from the Federal Reserve.
Higher interest rates and a tapering of the Federal Reserve’s asset purchases could harm the economic outlook, thereby making operating conditions more challenging for many businesses and sectors. In addition, an increase in interest rates could cause investors to re-evaluate their valuations of a wide range of stocks. They may use a higher discount rate when calculating the present value of a company’s future cash flows.
Overall, this could result in the stock market appearing less attractive to some investors on a relative basis.
Constant uncertainty
However, in my view, the economic outlook is perennially uncertain. Risks and threats to economic growth may not always be on investors’ radars, but this does not mean that they are absent.
Indeed, last year’s events were an obvious example of this. Few investors felt particularly worried about the economy’s outlook in January 2020, but the country then went on to experience one of its most difficult economic periods. Other similar events have taken place throughout the stock market’s history. Often, the most severe economic periods come along without prior warning.
As such, trying to predict how inflation and interest rates will change over the coming months could be a fool’s errand. Doing so could cause conflict in an investor’s decision-making process that leads to an inefficient allocation of capital.
For example, investors may try to predict the future and purchase companies that are best placed to benefit from it. In the current circumstances, this could mean purchasing companies such as banks that may be beneficiaries of a rising interest rate. Similarly, investors may avoid attractive buying opportunities in areas including consumer goods because they are concerned that rising interest rates could inhibit sector growth prospects.
Focusing on company fundamentals
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) is known to pay little attention to economic prospects when managing capital.
“In the 54 years (Charlie Munger (Trades, Portfolio) and I) have worked together, we have never forgone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions," he once said.
In my view, it may be more logical to focus on company fundamentals instead of the economic outlook when apportioning capital. Investors have a vast amount of data available to them, such as a company’s debt levels, return on invested capital and track record of profitability, that can aid them in judging how it will perform in a range of economic scenarios.
Companies that have sound fundamentals may be better able to cope with a future downturn. Likewise, they may also be capable of capitalizing on economic growth to a greater extent than their peers.
As a result, investors who buy shares in sound businesses may have less reason to worry about the economic outlook. Instead, they may have more time to unearth the most appealing companies that can deliver relatively strong performances in a variety of economic conditions.
