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A painful phase transition
Peter Garnry
Chief Investment Strategist
Oversigt: As the world turns increasingly bipolar, equity markets face harsh times as they transition into the new reality.
Wandering into the darkness
Andrew Lo’s 2017 book Adaptive Market is a compelling thesis against the prevailing efficient market hypothesis, as it borrows key concepts from biology to explain things we observe in financial markets and more generally our economic system. In nature some species are more adaptable to a given environment and will therefore have a higher survival rate, win more resources and thus reproduce more successfully. These animals have a higher fitness, but sometimes through a random mutation or external changes in the environment, other species become more successful. Phase transitions in the environment can be brutal and outside the well understood causalities in physics, as when water turns to ice or steam, and our chaotic human societies become extremely unpredictable.
In the age of globalisation from 1980-2020 it seems the fittest were the multinational companies. During the late stage of the information technology age, software companies were the fittest due to fewer constraints in the physical world. Globalisation combined with cheap gas from Russia made Germany particularly fit. Low interest rates made venture capital, private equity firms and real estate very fit. What we saw in 2022 was that the fittest models and agents in our economy stumbled into the darkness because the world went into a phase transition, as globalisation as we have come to know it since 1980 has ended. What lies on the other side of this phase transition is difficult to predict, but our working idea is that what was fit during globalisation will be less fit in a world driven by geopolitics and the move to a bipolar world driven by two different value systems. In other words, all the models that have worked very well will not work well going forward. This equity outlook is about those broken models with these five implications being the biggest:
- Higher structural inflation because ‘geopolitical war’ is inflationary
- Lower corporate margins as labour is fighting back and taxes will increase in the new fiscal dominance over monetary policy
- Physical assets will outperform intangible and financial assets
- Self-reliance will drive optimisation for robust supply chains creating winners and losers in emerging markets
- Lower real growth rates and more macroeconomic uncertainty
The physical world is roaring back
Digitalisation had started already in the early 1990s with the Amazon start-up in 1994 as one of the early key events, but it was not until after the Great Financial Crisis that digitalisation began to dominate equity markets. Together with other companies dominated by intellectual property rights and intangible assets such as network effects, brands and patents etc, these intangible-driven companies vastly outperformed companies based on tangible assets such as machines, collateral value and buildings. The boom in the intangible world started around April 2008 and lasted until October 2020, the month before the news of the mRNA vaccines against Covid-19. The vaccines changed everything.
They made it possible to reopen faster than imagined. It caused a time compression of the fiscal and monetary stimulus that was meant to cushion society against the base case scenario that it would take around four years to get a vaccine. This faster-than-expected reopening reverberated through the global economy causing bottlenecks in the physical world as people had massively increased their wealth and income which could finally be spent outside the digital world. This unleash of demand in the physical world was on a par with the post-WWII stimulus when Europe was rebuilt and inflation naturally kicked in. Commodities rallied hard entering what might end this decade being a commodity super cycle. The tangible-driven industries are now in their third year of outperformance against the intangible world. In our view this trend has just started.
Two parts of the physical world did well last year. Companies in the commodity sector (agricultural, energy and mining) and the defence industry were among the only positive trends last year. Both themes seem fitter than digital companies for a world that is at ‘war’ over different value systems and where the US and Europe are in a race against time to invest in commodities supply security, infrastructure and defence, change global supply chains, and on top of it all transition their economies away from fossil fuel energy sources. The boom in intangible-driven companies delivering stellar returns for investors reduced available capital for the physical world and this phenomenon was already setting up the stage for the phase transition we are already experiencing, but the pandemic and subsequent war in Ukraine turbocharged the change.
Inside our positive view on commodities we are significantly bullish on copper and lithium miners due to the green transformation and the enormous political capital being invested in achieving this transition. Many argue that commodities are already up a lot and therefore the risk-reward ratio is bad. If we are in a decade-long super cycle then commodities will another eight years and in the previous commodity super cycles the spot prices on commodities rose 20 percent annualised. The new geopolitical environment will mean a massive boost for the European defence industry which should see double-digit growth rates close to 20 percent per year over the next economic cycle as the European continent doubles its military spending in percentage of GDP.
There are always exceptions to the rule. With a raging ‘war’ in computer chips due to the US CHIPS Act passed in 2022 we expect a massive investment boom, growth and tax incentives to help boost earnings for US and European semiconductor companies over the next decade. While semiconductors to some extent are very much in the physical world, the valuation of semiconductor stocks suggests that they are driven by strong intangible assets such as patents.
In a world driven by geopolitical upheaval and with a ‘war’ being fought in many other dimensions than the old-fashioned kinetic war, digital systems are vulnerable to attacks. Thus companies and governments will spend an enormous amount of resources on protecting digital assets and that will create a long path of growth for cybersecurity companies.
US vs Europe, EM and mega caps?
The strong fittest of the technology sector in the late stage of globalisation combined with low interest rates meant that the US technology sector measured by the Nasdaq Composite Index outperformed everything else. This led to a significant alpha in US equities over European equities with the latter stuck in the mud after the euro crisis. Europe basically lost the dominance in the digital world to the US. With deglobalisation kicking into gear, a war in Ukraine amplifying the energy crisis and a world in need of physical assets, Europe will stand to gain from this shift. European equity markets have many more of the companies that will thrive in this new environment across green energy technologies, mining, automation, robotics and advanced industrial components. Europe will also be forced to run larger deficits including the fiscal conservative Germany due to rising infrastructure and military spending which could lift growth significantly during this decade. When looking at equity market performance in USD total return terms, European equities actually outperformed US equities from 1969 to 2008 with several longer cycles during this period. But from mid-2008 to October 2022, US equities massively outperformed European equities in line with the rise of the intangible-driven industries driven by the digitalisation which the US won. While tangible-driven industries have begun outperforming intangible-driven industries, European equities have lagged until recently. If the new geopolitical environment plays out as we expect, European equities will stage a comeback. With the USD historically strong against EUR there is significant tailwind from the currency side if the USD weakens from here due to structurally higher inflation compared to Europe. When we look at equities valuations, Europe has an advantage with a 12-month forward P/E ratio of 11.9 vs 17.7 for US equities. This valuation discount cannot be ignored by investors and as Europe gets its energy supply fixed and the war in Ukraine comes to an end, investor flows will follow. Finally, with China reopening its economy and conducting a 2008-style fiscal expansion Europe, being China’s biggest trading partner, will benefit from this. European equities might be viewed as a good indirect way to be long China and their fiscal expansion.
On a country-specific level, export-driven countries such as Germany, South Korea, Taiwan and especially China were the fittest. This is likely not going to be the case in the new geopolitical environment. India, Vietnam and Indonesia look to be the winners in Asia. Closer to central Europe, Eastern Europe and some countries in Northern Africa could win on manufacturing being reshored, while countries south of the Sahara will experience an investment boom due to Europe’s hunger for energy and materials as Russia is cut out of the equation. Closer to the US, Mexico will benefit in manufacturing and countries in South America will benefit from the commodity super cycle.
Deglobalisation and self-preservation policies will also make life more difficult for the mega caps. Their combined market value peaked during the height of the pandemic setting a new record for market value concentration not seen since the 1970s. This will reverse and thus the new regime will not favour mega caps and companies with large geographical footprints, but instead smaller domestically oriented companies operating in niche industries delivering into the build up of the physical world.
Quality and high margin are less sensitive to wage inflation
The past 10 years will be remembered for the extraordinary monetary policy in the wake of the Great Financial Crisis and the euro crisis two years later. Lowering the cost of capital arguably lowered the threshold for return on invested capital (ROIC) and the environment of low interest rates reduced the cost for highly debt leveraged companies. Low interest rates also created enormous risk-taking and time value distortion most evident in the venture capital industry in which a new model beautifully melted with digitalisation and network effects. Funding loss-making businesses to ensure a market-leading position was no longer problematic because low interest rates opened the floodgates of capital streaming into ultra-high risk venture projects.
These dynamics created a large forest of technology start-ups and turbocharged the biotechnology industry that had been in hibernation since the dot-com bubble. Uber is one of the most iconic examples of this with 32 rounds of financing worth around $25bn, according to TechCrunch, over the 13 years since its founding. Uber still has a negative ROIC despite $29bn in revenue. WeWork, and the whole portfolio of technology start-ups financed by SoftBank, was another poster child of this era. In the current inflation and interest rate regime this model is broken. Companies that are the most fit for higher interest rates, a reset in wages, and high inflation are those with high ROIC or a high operating margin combined with less excessive equity valuations. The least fit companies are those with low margin, high debt leverage and unprofitable.