Themes.

Updated quarterly, our evolving views on the thematics shaping the markets around us

Equities

WHY IT MATTERS | Equity markets are, in our view, the most interesting part of financial markets given the interplay of macroeconomic and microeconomic forces. Equity markets are the $95 trillion industry where the actions of central banks and the design of a marketing campaign on Instagram are simultaneously considered.

THE TAKEAWAY | Equity markets do not, currently, represent the real state of the economy as their performance has been distorted by the current market structure (explosion of passive inflows) as well as central bank policies around the world. Whilst equity markets outside the US have not moved much since 2014, US equities continue to hit new all-time highs thanks to the performance of its Technology sector (currently in a bubble). How long these trends last will be a result of changes in the regulatory landscape (i.e. will US Tech be broken up? Will passive investing be more regulated?) and in stimulus programs from governments and central banks, rather than company fundamentals.

 

OUTLOOK

  • Wall Street is generally upbeat with regards to the performance of the stock market in 2021. We believe this generally makes sense given the current market structure and the already well-established rationale that markets do not need to represent the economy (meaning they don’t need to move accordingly).

  • US Big Tech is likely to continue to do well, as it did in 2020, given it’s the main beneficiary of passive flows into market-cap-weighted indexes and target-date funds, and in times of distress also tends to trade as a bond proxy given the strength of their balance sheets and their ability to generate free cash flow.

  • In Q4 of 2020, Emerging Markets did well on the back of increased excitement around the reflationary narrative. Inflation is generally good for these economies as most of them are commodity-exporting countries (commodity prices track inflation) and receive the benefits of increased global prices. Should this narrative continue to gain traction, EM assets should continue to outperform, especially if the US dollar continues to weaken.

 

KEY IDEAS TO FOLLOW

Monetary and Fiscal Stimulus | We risk being repetitive to ensure this point is clear – stimulus affects pretty much everything in financial markets. In equity markets specifically, more stimulus means cheaper lending to companies and consumers (i.e. less bankruptcy risk and more ability to borrow), as well as higher discretionary spending potential as a result of higher income for consumers (direct money transfer from governments) and companies (consumer spending = higher revenue). Additionally, the Zero Interest Rate (ZIRP) environment we currently operate in allows for justification of higher intrinsic values across the board as the risk-free rate has essentially come down to zero (lower discount rates = higher valuation).

Passive Inflows | Today, passive investing is the primary mechanism by which market participation occurs. As new funds enter the equity market through passive strategies, typically in the form of ETFs and Target Date Funds, the custodians (i.e. Blackrock, Vanguard, etc.) use those funds to indiscriminately buy equities following the market-cap weight of a company in a certain index, such as the S&P 500 or the NASDAQ. The larger the company, the larger the market-cap weight, and hence, the larger the allocation of capital towards it. This ensures that there is a constant stream of demand for those large companies (#FAAMG) independently of changes in economic conditions or underlying fundamentals, which ends up driving the stock price up, increasing their weight in the index and leading to an even larger percentage of new funds being allocated to them (driving the price even higher). And this is how $2 trillion market-cap companies with relatively small top-line revenue growth and flat margins are created.

Competition and Regulation | Competition promotes innovation, and currently, we’re witnessing oligopolistic and monopolistic forces in many different markets, especially within those that rely heavily on technology, which concentrates profit generation and slows down innovation. This is the reason why Jeff and Elon can make Tony Stark’s bank account look modest. This concentration of power will continue to be the case for as long as the regulatory landscape allows, but in Europe, and to a certain extent the US, we’ve seen some politicians

Broad-based change in asset allocation | Conventional portfolio construction has been to allocate 60% of a portfolio to equities, and 40% to bonds – with each side balancing out the other in different parts of the market cycle. But with the current set up of yields so close to 0%, there is not enough for the bond part of portfolios to offset a collapse of the equity side. The bond market is huge (+$100 trillion), and some of that allocation will need to move out of bonds into other assets, such as US Tech (which are seen as a bond proxy given their balance sheet strength and cash flow generation), gold (safe heaven), commodities (inflation-hedge) or any other alternative asset class that PMs might think to be suitable to un-correlate from equities.

Retail Investment | In 2020, one of the most amusing developments was to follow the financial markets’ takeover by retail investors through Fin-Memes accounts. Bored at home and financed by stimulus checks (and a lack of bars and restaurants to spend on), retail took ownership of their financial lives and began buying up bankrupt companies and bidding up the wrong tickers. Online brokers saw unprecedented amounts of new accounts opened, with many of these retail investors performing better than professional Hedge Fund managers. That being said, a high level of retail participation tends to be common in financial market bubbles, and we would worry if we have to continue discussing, with our 13-year old cousin, the implication of time-decay on option pricing as they get closer to expiry.

Valuations | We won’t digress too much on this as being in the ‘everything bubble’ fundamentally means that multiples are inflated across the board That’s where relative valuation comes into play: while stocks are expensive compared to historical multiples, they look ‘cheaper’ when compared to bonds. There is no catalyst that we can single-handedly point to that will force valuations to revert to their mean, implying we don’t want to fight the Fed and passive flows and take the short side of the momentum trade.