The previous chapter in the history of investing began on Tuesday 16 December 2008 in the offices of the Federal Open Market Committee, where the board responsible for the interest rates and money supply operations for the world’s most important economy was concluding a two-day meeting.
It was the group’s eighth and final of a tumultuous year. Among a long list of world-saving gatherings taking place in Brussels, London, New York, Basel and elsewhere in Washington in the weeks prior and after, it wasn’t the most dramatic. Nor did it spark a reset in stocks, which continued to fall until the spring of 2009.
But the attendees’ decision to first slash interest rates to zero and then start the asset purchases that we now know as quantitative easing kicked off an era that lasted until 2022, when the Fed chair Jerome Powell began rapidly hiking rates to tackle surging inflation and an overheating economy.
The 2008 move set in train a dynamic with colossal implications for markets. Not only was capital now unprecedentedly cheap, but it became increasingly abundant. The stocks of companies that used this capital to quickly expand into nascent markets or tear up old ones with new technology ballooned.
Amazon (US:AMZN), with its appetite to underwrite aggressive pushes into new markets, was emblematic of this story. As it skilfully led the secular rise of ecommerce and then cloud computing, investors switched their focus from margins and free cash flow to the business’s many total addressable markets. If a scalable platform could be imagined, Amazon would build it.
When rates were low, investors were rewarded handsomely for taking such high risks. The mindset became entrenched. Talk of diversification was largely lip service: doubling down on technology, especially in the turbocharged period of the Covid-19 pandemic, was the trade to make.
Even if you didn’t follow the herd, you could hardly avoid it: at the end of 2021, the six FANMAG stocks – Facebook (now Meta), Apple, Netflix, Microsoft, Amazon and Google (now Alphabet) – made up more than a quarter of the S&P 500, as their growth fed into sky-high valuations. If you invested in a global equity tracker since 2009, you were invested in these stocks and those like them in a big way.
These stocks’ success, it should be noted, has hardly ground to a halt. Although they trade below their 2021 high points, all six are well up so far this year, while Apple, Microsoft, Alphabet and Amazon still occupy the slots of the four largest US companies by market capitalisation.
But they are no longer ascendant. And while analysts still expect each member of the group to deliver above-trend earnings growth over the next three years, everything once again hinges on the Fed. Until inflation is tamed, investors must lower their expectations for real returns. But if taming inflation requires higher-for-longer interest rates, the Fed’s medicine will raise the cost of capital, depress investors’ risk appetite, and knock economic growth – none of which augurs well for the past decade’s high-growth, highly-valued winners and their investors.
Making the connection could take time. The last generation of professional money managers, executives and analysts to have experienced sustained consumer price inflation above 5 per cent are now largely retired. For those running things in 2023, there is plenty of entrenched belief about what has worked for the past 14 years, and no playbook for what comes next.
Such dynamics breed “classic echo bubbles”, according to Rockefeller International chairman Ruchir Sharma. “Investors refuse to give up on ideas that recently made them a lot of money and so they keep piling back in,” he recently argued in the Financial Times. “The echoes gradually fade away, until serial disappointments kill the faith.”
For Steve Eisman, a senior portfolio manager at Neuberger Berman and one of the few investors to correctly bet on the 2007-8 US housing market collapse, investors have made a dangerous assumption in their implicit bet that rates will fall nearly as quickly as they rose.
“Powell has said that he’s going to keep raising rates, and the important sentence is ‘and he’ll leave them there’. If he leaves them there, I think we’ll have a paradigm shift,” Eisman told Bloomberg’s Odd Lots podcast in February. “I think he’s going to leave them there.”
Should this happen, it’s hard to see how a stock like Amazon can maintain a gravity-defying market price multiple of 56 times forward free cash flow, or – if it can – how those thinning free cash flow estimates won’t be squeezed further. In either scenario, the shares could face pressure.
Still, almost a year and a half after the post-2009 bull market peaked, it’s not clear what follows the tech-led narrative. Even if we have glimpses of the answer, we’ll only know it with hindsight.
Just how this paradigm shift plays out may be the biggest question for equity investors in the coming years. We know it will happen in some form for the simple reason that paradigms change all the time. Before tech stocks ruled the roost, it was financials (until they imploded rather spectacularly). And before the mid-2000s banking boom, the big story was the internet (until that also blew up). Head back further, and it was Japan in the eighties and commodities and defence stocks in the seventies.
What then is the next big multi-year story? And why does it feel increasingly necessary to answer this perennial question for stockpickers now? We can’t claim to have definitive answers. But what follows are some sketches of the next possible paradigm, and the conditions required to support them.
The commodities complex
Which companies made out like monopolists in 2022? If you said ‘energy producers’, receive your $25 consultancy fee; if instead you answered ‘energy traders’, advance to go and collect $200bn.
In Russia’s invasion of Ukraine, and the scramble to re-route the flow of world trade that followed, intermediaries in the movement of raw materials did very well. If inflation and a decaying world order are now a feature and not a bug of markets, resources stocks might be the next big story.
After a decade in which investors thought more about connectivity, platforms and data centres, it was probably inevitable that attention would eventually swing back to the primary economy. Out with intangibles, in with the rock, sweat and tears of the physical commodities that underpin everything.
This isn’t just a wilfully contrarian view. Steve Wreford, a fund manager at Lazard who thinks inflation could prove stickier than most expect, argues investing in “what was most out of fashion 10 years ago” might be a smart move. After falling from grace, it can take a while for companies to repair themselves, and even longer for market trust to be restored.
In the case of resources stocks, it hardly helps that volatile commodity prices take so much out of their hands. Although the shares of London’s largest listed miners and energy firms may be near all-time highs, they aren’t loved. If they traded in line with the broader market, the sector would be worth 40 per cent more.
In recent months, basic materials producer shares have been hit. Broadly, prices aren’t expected to be as strong this year as they were in 2022. But this observation belies the way resources companies are primed to profit handsomely in the coming years. This isn’t because they’ve all figured out how to improve profitability. Where a mine or well sits on a cost curve is largely an unchanging function of geology and geography. It’s because in several markets, demand is set to outstrip supply.
One market in which this mismatch could be pronounced is copper. A 2022 report by S&P Global suggested that the demands from the accelerating electrification of the economy mean demand for the red metal will double to 49mn tonnes by 2035, and remain there until at least 2050. Because permits are hard to come by, building mines is hard, and much of the high-grade ore has already been exploited, much of the supply growth will have to come from a colossal expansion in existing mines’ capacity.
Even if this were incentivised by high prices – Goldman Sachs expects a near-term rally to $15,000 a tonne, up from the current spot price of $8,800 – the report found that it might not be enough to bridge the looming shortfall. If the global economy is to grow in the coming decades, copper miners should be among the first in line to be paid.
Glencore (GLEN), the only large publicly listed commodity trader, is also a significant miner, smelter, refiner and recycler of copper. As its recent tilt at Canada’s Teck Resources (US:TECK) demonstrates, the Swiss-headquartered group not only wants to scale up further in the metal, but is prepared to reorient its entire strategy in that pursuit.
So do higher prices translate to higher profits? That’s the theory. In reality, producers are regularly beset by operational and economic issues. To take just one example, Chile-focused copper miner Antofagasta (ANTO) saw its net cash costs jump 34 per cent in 2022, due to a combination of drought, inflation and higher input prices. As the past year has shown, nations can also be quick to change the fiscal rules if they think excess profits are being made – or that they can get away with it.
To their credit, the largest resources firms are better run than they were a decade ago. This shift – prioritising shareholder returns over investment at a time when capital was cheap – may now look like a wasted opportunity, necessitating big-ticket M&A in the years to come.
But given the ballooning demand profiles and underinvestment in some commodities markets, the primary economy’s simple business line may be a big winner in the years to come.
American exceptionalism
It is often said that the next great market story is green. In 2020, the former Bank of England governor Mark Carney put it memorably when he described the ambition to reach net zero the “greatest commercial opportunity of our time”.
Given the scale of the job ahead – from switching to lower-carbon sources of energy and transport, to reducing waste and pollution in food production, and reconfiguring myriad industrial processes – it is hard to find fault with Carney’s conclusion. But it is an altogether different story to identify obvious winners from this opportunity.
For a start, pretty much every major global listed company is alive to the megatrend. This is especially true in the primary and secondary economies. As growing producer bets on lithium, copper and gas show, even those laggards in the natural resources sector are thinking hard about the transition.
Second, decarbonisation at scale will invariably be more capital intensive and lower margin than the paradigm that preceded it. Where solutions for the energy transition exist, it is capital spending (rather than network effects) that will make the difference. The likes of renewable infrastructure investor Greencoat UK Wind (UKW) therefore look like smart ways to play the multi-year megatrend.
However, renewable energy, like electric vehicles, is a relatively small part of the puzzle. As the Canadian scientist Vaclav Smil points out, we are still a long way from having green alternatives to the production of ammonia, cement, plastics and steel. Solving these kinds of problem – cutting-edge technological development – requires a different investment focus.
Identifying technological winners won’t be straightforward. It never is. And as the major teething issues in Britain’s burgeoning green battery industry show, the task of building niche, specialist industries requires a fine balance of state support and private risk taking.
But if one nation can do it, it is America. In Joe Biden’s climate bill, it could be argued that the world’s largest economy is finally putting its weight behind a greener economy. From another angle, the legislation shows the world’s largest economy sees in the green economy a technological race.
There's nothing new about the idea of American success or exceptionalism. The momentous rise in the S&P 500 isn’t just a recent phenomenon; it’s a multi-decade one. While richer valuations and financial market depth help explain the dominance of US equities in global stock portfolios, the truth is that the country’s brand of capitalism, together with its hard and soft power and huge geographical and demographic advantages, make for a world-leading investment case.
In a deglobalised world, this case might even be strengthening. Faced with its own weak internal growth rates and an increasingly assertive China, America is intent on boosting its economic output by aggressively reshoring (or near-shoring) its supply chains and luring the world’s best talent, companies, and ideas.
The energy transition is just one front on which this is already unfolding, as is the US stock market. To play this paradigm, investors need not simply look to American blue chips, but to the stocks of companies who are betting big on another American century.
More of the same
New epochs are rarely led by the old guard. If that is true of the current shift in financial markets, technology investors don’t appear to have received the memo.
No sooner had doubts about the future earnings of software and internet giants started to sink in, than artificial intelligence (AI)-mania began. Since OpenAI’s release of the ChatGPT-3 large language model at the end of 2022, the world has been abuzz with the technology’s potential applications, ushering in breathless forecasts of its supplanting of hundreds of millions of jobs in the coming years.
So far, it is largely promise and hype. Semiconductor giant Nvidia (US:NVDA), which supplies chips to the software groups racing to embed, has emerged as the posterchild for the trend. Since October, its shares are up 141 per cent. But investors have been quick to jump on the opportunities for the broader technology sector in general, and for OpenAI backer Microsoft in particular.
And while the focus has been AI, and the possibilities for advancing our ability to search for and make use of information at scale, the episode serves as a reminder of two of the sector’s biggest draws.
The first is that the best technological developments are by their very nature deflationary. From the wheel to the fax machine to software that can pass the US medical licensing exam, technologies that offer breakthroughs in efficiency and productivity are inherently desirable. If the best business ideas are those that solve problems, then the tech sector still holds the greatest promise.
Second, it is hard to escape the fact that in a digital age, it only takes a small team of computer engineers to build a $1bn product in a few months. Such value creation – unprecedented in the history of capital formation, despite the lack of capitalisation that occurs in this intangibles-dominant sector – can't be overlooked by investors.
Nor is this capacity confined to the start-up world. Take Microsoft’s OpenAI collaboration. In a matter of weeks, the second largest company in the world has managed to integrate ChatGPT-4 into its Bing search engine and enterprise software offering for its Office products, known as Co-Pilot.
This helps to explain why technology stocks remain the single largest bet out there. Yes, the sector has had its wings clipped, and will struggle to maintain the lofty valuations of recent years. But that doesn’t mean the most profitable can’t continue to outperform. Almost wherever you look, from cloud infrastructure to cyber security, to online advertising, software and connectivity, the incumbents remain well placed to benefit from above-trend growth stories.
Even if this cluster of companies are no longer the number one story in equities, they are not going to disappear in the way banking stocks did post-Lehman. The wholesale digitisation of our economy isn’t about to be regulated into the margins. Several – Microsoft, Apple and Alphabet chief among them – continue to generate enormous amounts of free cash flow, even if their margins shrink.
Something else
Major stock market successes often involve companies cannily responding to their moment. But investors should always be alert to where the balance lies between opportunism, luck, and skill.
Around the world, there are thousands of companies looking to nimbly deploy their resources in the most efficient way, for the highest returns. Some even possess a degree of power to bend the rules in their favour. But whether in an autocracy or a democracy, no company writes the rules, and profits can never be made independent of the economy.
Unfortunately, the forecasts for the world economy aren’t glittering. Last week, IMF managing director Kristalina Georgieva said she expects global output to expand at an average annual rate of around 3 per cent over the next five years. That’s the weakest estimate for medium-term growth since 1990, when the modern era of globalisation started to take hold.
This doesn’t mean conditions were entirely benign until very recently – since the financial crisis, the IMF has repeatedly downgraded its growth forecasts – or that booming economic growth has been a pre-requisite of strong equity returns. Evidently, corporations have been more successful in capturing global growth than societies writ large.
But it is the nature of the more recent obstacles to growth which have some spooked. Georgieva highlighted Russia’s invasion of Ukraine as a threat to “the peace dividend we have enjoyed for the past three decades”, which looks set to add frictions in trade and finance. The World Bank, whose economic projections are even gloomier than the IMF’s, has warned of a “lost decade of growth”.
Given this, it is possible that the next big equity story is more complicated or bleaker than our previous candidates: defence.
More than a year into the conflict, it is hard to see a resolution in Ukraine. Nor is it clear how relations between the US and China begin to thaw. Nor, while we’re at it, how a creaking peace dividend will lead to anything but greater geopolitical tension and more hawkish defence spending. Shares in BAE Systems (BAE), up 84 per cent since the start of 2022, speak volumes about the current trajectory.
However, we shouldn’t be too given to see the very recent past as a guide to the near future. While the impulse for expanded military budgets is heightened, wars are deeply unpopular. Budgetary constraints, particularly in the high-spending democracies of the west, will emerge soon enough.
For this reason alone, defence stocks probably won’t be ultimate winners of the 2020s. Multi-year stock market successes require fewer hard limits to growth.
Enormous growth opportunities combined with corporate vision and a supportive financial backdrop help explain a lot of the most recent paradigm. But that isn’t the whole story, and the best-performing US stocks of the 2010s were a much broader bunch than the Silicon Valley narrative implies. Among their number: orthodontics devices group Align (US:ALGN), aerospace components manufacturer Transdigm (US:TDG) and self-storage real estate investment trust Extra Space Storage (US:EXR).
The UK picture is similar. Since markets bottomed in March 2009, the three best stocks you could have continuously owned have been Games Workshop (GAW), Ashtead (AHT) and 4imprint (FOUR). And yet no one thinks of the past 14 years as the age of the fantasy figurine retailer, equipment rental firm, or the shipper of corporate branded hoodies, pens and coffee mugs.
Often, the most spectacular equity market stories aren’t the biggest or the most richly valued. Sometimes, being brilliant in a humdrum or niche industry is all that’s required to beat the rest.
