10 min read 23 Jun 20
Markets often experience prolonged periods in which a key driver is dominant. In the context of history, the handover from one driver to another is often conveniently located around major events, or more recently, changes in decade.
Simplistically, the 1990s was the decade of the ‘paper asset’, culminating in the TMT bubble in 1999.
The 2000s saw the re-emergence of the ‘physical asset’ as Chinese urbanisation drove spectacular commodity demand and strong global growth before the financial crisis of 2009.
As the world slowly recovered from this traumatic event, aided by the injection of unprecedented levels of liquidity into financial markets, risk aversion rather than risk taking came to the fore.
In our mind, the last decade could be characterized as the decade of the ‘safe asset’.
Stock prices are not only driven by well-established fundamentals, but often (and for uncomfortably long periods) by the collective psyche of market players. Narratives are formed to justify prices, with prices moving to reinforce the narrative.
People have come up with many ways to explain the decade-long phenomenon that has led to safe, high-return, stable companies and financial instruments doing very well and enjoying significant rerating; while companies that are more volatile, risky, low-return have been shunned.
Explanations include the prolonged low interest rate environment and changes in economic models that have given rise to (often monopolistic) disruptors and their enablers, with these and many other plausible factors being exacerbated by the rise of passive investing.
While many of these arguments are valid, and have been incredibly powerful, their longevity and allure have created such powerful feedback loops that we are now witness to one of the most extreme valuation dispersion episodes in market history; and the widespread belief that value investing is now dead.
We are unaccustomed to making bold statements. However, we would argue there is a high likelihood that the 2020s could well be the decade of the ‘cheap asset’.
We are comfortable saying this not just because of the incredibly-stretched valuation divide in the markets, but also because a number of fundamental factors that have driven this extreme look to be on the verge of playing out, running out of steam or even going into a full reverse thrust.
Perhaps the strongest influence driving long duration, stable, safe assets has been the 40-year downward trend in interest rates. With these now having effectively reached zero in most major economies; and a consensus that the flirtation with negative rates seems to have backfired; plus a severe global recession not decreasing interest rates materially; it feels reasonably safe to say this driver has pretty much played out.
If anything, there is a reasonable probability that vast central bank balance sheet expansion, plus the significant Covid-19 stimulus packages, and a mindset very attuned to Modern Monetary Theory (MMT) in many political frameworks, could well lead to an inflationary environment in the not-too-distant future. Safe, long duration assets on high ratings will not fit well in this sort of scenario. Nor will, we would assert, the asset-light companies that do not feel the need to own the capital that supports their business. As capital starts to have a cost again, owners of hard assets may well find themselves in a very good place.
Another dominant factor that has driven fundamentals and the narrative over the last 20 years has been globalisation. It has provided an incredible base for economic growth for much of the period since the collapse of communism.
Not only have companies enjoyed access to cheap labour in emerging markets, and hundreds of millions of ever more economically-viable consumers, but the world has benefited from open borders, increased movement of skilled labour as well as people accessing overseas travel and education. Companies able to access these benefits have done spectacularly well.
However, globalisation has not been without its casualties: just ask any business competing against a hyper-competitive, cost-of-capital agnostic or state-sponsored Chinese competitor. It does not take a degree in geopolitics to work out that, at best, globalisation may not still be on the same path and, most likely, has gone into reverse. In time, the US-China trade war will almost inevitably be referenced as the point at which globalisation peaked.
Whether the race to secure domestic supply chains is framed under the notion of national security or for national health reasons is inconsequential; the process of de-globalisation will have significant investment implications.
There will be significant investment required to re-balance, along with further adaptation of business models (and this is unlikely to be deflationary). Businesses built on global platforms, or reliant on a global customer base, could quickly find themselves caught out if expected growth markets are shut off, and may struggle to adapt without investing and re-orientating their business models.
Is it also unrealistic to expect that the restrictions being placed on companies like Huawei won’t be replicated against western companies in the future, especially in the area of technology? There are multiple unknowns here, but what is certain is that there is plenty of room for changing fortunes, and evolution of winners and losers, in the new environment.
The other ‘safe’ assets which have enjoyed a tailwind in the last decade have been the new monopolies. The likes of Google, Facebook, Amazon et al have seen extraordinary share-price growth and attracted a wide investor fanbase.
Most notably, this can be observed in the US, where the top 7 companies in S&P500 Index have the same combined market cap weight (25%) as the bottom 383 – that is (as the index name suggests) 383 out of 500 stocks. This is an incredible fact!
If these 7 companies, which employ fewer than two million people (versus ca. 11.7 million by the bottom 25% by market cap), are to continue to be winners over the next decade, how much of the market will they continue to represent? If their market cap grows further, what will a society where 7 companies take so much of the economic pie look like? Is this still capitalism? What kind of democracy can survive this framework? Or will politicians and regulators (and citizens) decide at some point that this is untenable, or undesirable?
Today’s well-loved stocks may continue to enjoy an extremely powerful ‘positive feedback’ cycle (where the ongoing rise in their stock prices adds to the sense of safety for investors), and may continue to propel their shares to further heights. However, if (as we suspect) the world of the 2020s looks vastly different to recent history, the market will have to ‘relearn’ a lesson it has now forgotten – valuation does indeed matter.
History tells us that when valuations become so stretched, it doesn’t take much of a shock for mean reversion to take effect in an equally powerful way.
With many of the prevailing narratives looking challenged, we can only be reasonably certain of one thing: the winners and losers of the next decade will be different to the last; as they almost always are.
If this is hard to imagine, then investors need only cast their minds back 10 years, when it was possible to pick up a market ‘loser’ on close to 10x price/earnings (P/E) with ‘no catalyst for change’. That stock today trades at more than 32x P/E, and is still called Microsoft.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.