How to Surf the Market Super Cycles..

Financial markets are always changing but it’s easy, especially for seasoned observers, to see patterns and think we’ve seen this story before. But some changes are so fundamental, so secular in nature, that they demand a fresh approach. Today’s massive outperformance of a handful of stocks – the Magnificent Seven US tech stocks and Europe’s GRANOLAS – and the challenges of artificial intelligence and decarbonization demand that we check our priors and think hard about where value truly lies. Good lesson for investing - and for life!

Thank you to Peter Oppenheimer and Huw van Steenis for a stimulating discussion. Some of our takeaways:

• We are all post-modernists now. The global macroeconomic environment has changed radically in the past few years and the ramifications are still filtering their way down into financial markets. Notwithstanding a dozen or so US recessions and bear stock markets since World War II, businesses and investors around the world spent most of the past four decades benefitting from a super cycle of growing globalisation, deregulation, disinflation, and a progressively cheaper cost of capital. Profits soared as companies raced to produce goods in low-cost economies while economics trumped geopolitics as the Berlin Wall fell and India and China joined the World Trade Organisation. But the outlook today has changed, perhaps for a very long time, because of wars hot and cold, a pandemic, and rising international tensions. Money is no longer free, labour and commodities are no longer cheap, and governments are distorting the flow of goods and capital with tariffs and subsidies. And most investors and CEOs have no lived experience with this kind of environment.?
• The concentration of market capitalisation in today’s stock market is extraordinary but not necessarily irrational. The so-called magnificent seven US tech stocks, which now make up roughly 30% of the Standard & Poor’s 500 index. They have grown their earnings by about 50% over the past year while the rest of the index is down about 2%, and they trade at less than half the earnings multiple of leading tech stocks during the dot-com bubble. This isn’t just a US phenomenon. The so-called GRANOLAS, a term Peter coined to describe 11 European stocks somewhat comparable to the magnificent seven, have profit margins much higher than the market average and enjoy stable earnings growth. And today’s high interest-rate environment enhances the competitive moat both groups of companies enjoy by virtue of their strong balance sheets. The biggest US tech stocks, for instance, will devote some $350 billion to capital expenditure and research and development this year, about the same as the stock market of the entire European Union (EU).
• Artificial intelligence (AI) and decarbonisation may be the next big secular shocks, or super cycles, but the way they play out may surprise you. Peter expressed optimism about the ability of AI to provide a productivity boost to economies “if we get it right,” while renewable energy sources have the potential to drive the marginal cost of energy toward zero, another big growth stimulus. Moreover, these two forces are linked in that it will take massive computing power, and the low-carbon electricity to fuel it, to unleash the full potential of generative AI. But even if AI really does change everything, it’s too early to tell if today’s tech stars will be the big beneficiaries. When the internet first took off in the 1990s, money initially flowed to telecom operators that were investing massively in the data pipes of the new economy, but fortunes accrued to innovators like Google and Meta that built new services off the world wide web. It’s just possible that generative AI will be déjà vu all over again, given that companies can bolt it onto their existing operations to gain efficiencies or develop new products and services.
• Whatever this new world brings, the United Kingdom and Europe start from a structural disadvantage. It’s not just the big head start their US rivals have in AI. British and European firms have significantly less financial firepower because they have lost favor with investors. Regulations like Solvency II on insurers and a trend toward liability-driven investing that heavily favors bonds have seen institutional demand for stocks evaporate. The average UK pension fund has reduced its equity holdings to about 5% of assets today from roughly 60% 15 years ago. Little wonder, then, that more UK and European companies are going private. The US dollar, meanwhile, remains dominant despite Washington’s mounting deficits and debt. The dynamism of the US economy continues to attract foreign capital while potential rivals have their own problems. New research this month from the Bank of England shows that the dollar has overtaken the pound as the main invoicing currency of British exports to non-EU countries since the Brexit referendum and subsequent depreciation of sterling.
• What’s old may become new again. Anyone nostalgic for days and economic conditions past might draw comfort from a revival of interest in old fashions. Consider that Europe’s most valuable company, LVMH, sells luxury clothing, jewelry, and wines and spirits. Artisanal bakery is now a nearly $100 billion dollar market, music on vinyl is cool again, and Europeans today buy twice as many bicycles cars. Peter calls it the nostalgia economy, and it’s possible that such a trend will return to finance. So called value investing went out of fashion when zero interest rates sent investors scrambling to pour money into growth stocks. As Peter put it, with today’s more normalised cost of capital, “diversification should be a very important part of portfolio management,” which could include broader geographical exposure and a renewed interest in value stocks.