In our Q1 Outlook we said that the commodity sector would perform well under rising inflation expectations, that the interest rate sensitivity has increased, and that growth stocks could hurt from rising interest rates. We also questioned whether the bull market in green transformation stocks could continue. In this quarterly outlook, we focus on what the world and financial markets are short of and how that translates into equity markets.
The world is short of physical capacity
The biggest trend since the great financial crisis is the divergence in earnings growth between Nasdaq 100 and the global equity market, highlighting the grotesque relative success of the online economy over the physical economy. Nasdaq 100 earnings are up 828% per share since Q4 2003 while MSCI World earnings are up only 114%. This trend has sent out a powerful market signal to investors that the future is about digitalisation in all its forms, and as a result capital has flowed towards e-commerce, software, payments, gaming, etc.
Underpinning this trend has been a rapid decline in interest rates, lowering the cost of capital for fast-growing, equity-financed technology companies. Regulation is hopelessly behind in the digital revolution and this has provided the sector with an unprecedented benign regulatory regime. Energy costs have constantly declined, lowering the marginal costs of adding users, training neural networks and processing information. The online world has been able to expand on the foundation of the physical world that supports it, but now many of the tailwinds seem to be turning.
The success and higher return on capital of digital companies has caused an underinvestment in the physical world to the extent that the World Economic Forum estimates that the world will have a $15tn infrastructure gap by 2040, mostly in emerging market economies but also in the US. We have seen this underinvestment on full display in the past nine months with rapidly rising commodity prices, container freight rates ballooning, bottlenecks at ports, shortage of semiconductors holding back car manufacturing, and rising last-mile delivery. These events are causing pricing pressure on the supply side, which most likely will be superseded by demand pressures when societies re-open, extending the inflationary pressures.
Our view remains that during this coming reflationary environment investors should increase their exposure to the commodity sector and high-quality companies with low debt leverage. What about leisure stocks as the economy re-opens? The leisure segment has been rising to record price levels, reflecting an over-optimistic rebound scenario. It simply represents a bad risk-reward ratio.
The rising interest rates are likely to create a downward adjustment of equity valuations in the most speculative growth segments such as bubble stocks (stocks with high EV/Sales ratios and negative earnings forecasts), e-commerce, gaming, green transformation, and next-generation medicine stocks, as we observed in late February and early March. These pressures could very well continue as the interest rate moves higher.
Overall, we are not worried about equities with the MSCI World currently valued at a forward free cash flow yield of 5.8% still offering an attractive equity risk premium.
Inflation is coming and it will challenge equities
Everyone agrees that a jolt of inflation is coming due to stimulus, base effects, and rising energy prices driving Chinese producer prices higher, but the disagreement starts over whether inflation will persist. This is probably the most fundamental question in financial markets over the coming years and something that will have a great impact on investment returns.
The US economy is currently running a 16.2% deficit to GDP, and that is before the new $1.9tn stimulus bill kicks into gear. As vaccinations are rolled out the US economy will re-open and quickly close the output gap. When that happens the US economy will be in a situation with very high stimulus and no output gap. This has the potential to unleash real inflation for an extended period and anchor inflation expectations at a higher level.
Politically this will be accepted both by the Fed and the US government as higher inflation is a stealth way of transferring wealth and reducing wealth inequality, as well as dealing with high levels of debt. We are essentially moving into an environment where labour will be favoured over capital and that will underpin inflation.
In a recent study we looked at US equity returns since 1969 during different inflation regimes and our findings are that an inflation rate above 3.1% is bad for real equity returns (they still look good in nominal terms), and that months of rising inflation are associated with lower relative real equity returns compared to months with declining inflation. One needs to understand that inflation raises the cost of capital and introduces volatility, making it more difficult for companies in their decision making.
Finally, the green transformation and ESG trend will also add to inflationary pressures as it makes it more costly to expand both non-renewable energy sources and mining capacity in the much-needed metals for the electrification of society. These higher costs of production-linked carbon emissions are viewed best through the EU carbon emission allowances which have just hit the highest price on record.
The EU has long been fighting the US technology giants, and China has stepped up its efforts to increase competition and reduce monopolistic behaviour. Under the new Biden administration, the US government is hiring big critics of the technology giants to the Federal Trade Commission in a sign that Washington will increasingly regulate big companies, especially in technology. We expect more negative antitrust and regulation headlines to hit large technology companies in the US. The world is simply too short of competition.
Everywhere we look we see higher input costs, and maybe we will reach an inflection point where inflation returns in an ugly way. Higher inflation, higher cost of capital, more regulation and more antitrust cases will likely eat into profit margins and reverse the tailwind that companies have enjoyed for decades.