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Equities: Higher cost of capital is getting painful
Quarterly Outlook
Summary: The fight against inflation has raised the cost of capital to levels that have triggered open cracks in the global economy. At the same time, the US fiscal cycle is turning, which, combined with high interest rates, could push the economy into a stagflation lite environment. This will be bad for cyclical stocks, with AI-related stocks carrying the highest risks in such a scenario. Higher cost of capital has also illuminated the fragility of the green transformation, and here potentially lies the biggest catalyst for lower interest rates outside the weakening economy, as fast decarbonisation will only happen under a lower interest rate environment.
Move into defensive sectors in preparation for stagflation
Since July 2022, the US fiscal impulse (increasing fiscal deficit) has delivered 5%-points to GDP or roughly USD 1trn in additional spending from the US government through various spending programs from the Biden Administration, such as the CHIPS Act and Inflation Reduction Act. This growth impulse offset the negative impulse coming from higher interest rates and basically averted a potential recession this year. The significant fiscal impulse was implemented while the US economy was estimated to run at miniscule output gap and tight labour market dynamics which added to structural inflationary pressures, forcing the Fed to tighten more than otherwise.
As the US fiscal cycle is likely turning from positive to negative, the US economy will begin to slow, while both Europe and China are stuck with weak economic growth. This sets the world up for a potential stagflation lite environment, in which real economic growth is slowing, while inflation remains significantly higher than the historical average. The last time the world feared stagflation was back in the summer months of 2022, but those fears could quickly come back and haunt equities.
If the economy is entering a stagflation lite environment, then the key assessment for investors is how equity markets are impacted. If history is any guidance, then it would have a negative impact on equity returns, and based on the limited sector dataset since 1989, data suggests that the best sectors during stagflation are the defensive sectors such as health care, consumer staples, utilities and energy. The sectors that often fare worse as economic growth slows and either inflation or unemployment are rising are real estate, financials and information technology. The latter is particularly interesting, given the gains in technology stocks this year and excess exposure to technology stocks among many investors.
Adding further to our cautious outlook is the fact that, despite clear signs of the global economy being impacted by higher interest rates, equities have risen back to valuation levels that are around one standard deviation above the long-term average since 1995. This naturally lowers the long-term risk-reward ratio in equities.
The green transformation is squeezed by higher bond yields and geopolitics
As stated in our introduction to this Quarterly Outlook, real interest rates are too high to support the green transformation, acceptable living costs for new home buyers, and consumers with low savings rates using credit to consume. The higher interest rates and higher commodity prices have drastically altered the assumptions behind offshore wind power, which was otherwise seen as one of the key energy sources to deliver on the green transformation. Many offshore wind projects in the global pipeline were negotiated on assumptions of permanently low interest rates and cheap industrial metals.
As the world has turned upside down after the pandemic and Russia’s invasion of Ukraine, these projects are no longer viable, forcing Orsted, the world’s leading offshore wind developer, to take significant write-downs. Siemens Energy has struggled with faulty designs on its wind turbines, taking significant charges, and Vestas, the world’s largest wind turbine manufacturer, has seen its business stagnating. However, it is not only wind, but all things related to the green transformation that have been hit hard by the changing landscape. The three worst-performing theme baskets over the past year are renewable energy, green transformation and energy storage.
Research into the role of capital costs in decarbonising the electricity sector shows that solar and wind are, by far, the energy sources most sensitive to higher capital costs, as these energy sources have a higher share of initial investments in percentage of total costs. The next two most-sensitive energy sources are nuclear and coal with carbon capture storage. The electricity source with the lowest sensitivity to higher capital costs is natural gas, and thus the higher cost of capital incentivises burning fossil fuel overall if the lowest marginal cost of energy is an objective. Within renewable energy, higher capital costs are a tailwind for nuclear power, which has seen a complete change of winds as policymakers are slowly realising that nuclear power is going to be key to decarbonising the global economy in the short run. As time goes, there will be an increasing pressure to lower interest rates for the sake of the green transformation.
The green transformation has been hit by higher cost of capital, but to make things worse, the flooding of cheap Chinese electric vehicles (EV) have pulled EVs into the fragmentation game we wrote about in our Q2 Quarterly Outlook. Semiconductors are part of the geopolitical friction between the US and China, and now it looks like EVs will be geopolitical friction between Europe and China. The world is fragmenting, and this process will continue to make the green transformation impossible unless real bond yields come down.
When will the AI gold rush turn into gold mines?
In our last Quarterly Outlook, we looked at how AI enthusiasm had staged a rally in equities, especially among the AI-related stocks which we said were now in a bubble based on dangerously high equity valuations and falling search engine interest in keywords such as ‘AI’ and ‘ChatGPT’. Another quarter has passed and the data after the Q2 earnings season is not suggesting that the AI gold rush and massive buying of Nvidia GPUs are turning into gold mines just yet. Microsoft and Adobe, two companies with large distribution and part of the content production ecosystem, both failed to underpin the AI hype. On their conference call, Microsoft said that AI sales would be gradual, and Adobe’s outlook did not reflect an eruption of AI growth.
While Nvidia is still selling plenty of GPUs as companies are rushing to capitalise on the new large language models, the overall revenue growth of AI-related companies excluding Nvidia is falling with the average Q2 revenue growth y/y at 2% down from 27% a year ago. Our AI theme basket consisting of 20 AI-related stocks is also valued at a forward equity valuation that is 33% above the Nasdaq 100 Index, almost twice as expensive as the MSCI World Index. If bond yields decline from here due to a slowdown in economic growth, then it is not certain that this lower discount will help AI-related stocks, as their sensitivity to the growth outlook is much larger and thus AI-related stocks carry some of the highest risks in Q4.