There’s a new reality taking shape in global equity markets.
It feels as though many investors have come to expect a quick return to so-called normalcy. Once inflation subsides and the central banks stop raising interest rates, the thinking goes, the same dynamics that propelled the stock market in recent years will reemerge.
But I think these views are too simplistic and don’t account for significant and potentially long-lasting shifts that are unfolding around the globe. Put simply, the world is undergoing fundamental change that could define global equity markets in the coming decade. Investors will need to reset their expectations about what constitutes a typical investing environment.
For example, I believe there will be higher inflation and interest rates, but also broader market leadership that will benefit investors who are attuned to the shifting conditions. I also think there’ll be a greater emphasis on physical goods — fewer social media companies and more manufacturers. Add it all up and this means that equity returns could be qualitatively different in the next decade.
These are big shifts, but ones I find to be exciting rather than intimidating. To put this moment into perspective, keep in mind that market dynamics were uncommonly conducive to investors in recent years. Economic and business conditions are always evolving, and it’s only natural for some of the salutary trends to recede. Change doesn’t often come at the speed and scale it is today. But when it has, it has often brought many new opportunities.
The market is grappling with a macro environment it hasn’t experienced in a long time. Inflation is at its highest since the early 1980s. And until recently, interest rates had been declining for nearly 40 years. That’s longer than most investment managers’ careers, if not their lifetimes. That helps explain why the market is struggling to adjust to a new reality.
It’s easy to assume these are market dislocations that will quickly reverse — bond markets, for example, are pricing a return to 2% inflation within a mere two years. But these cycles often last much longer than people anticipate, and there is reason to believe higher inflation is structural and likely to persist.
In this new environment, I’m especially cautious of highly leveraged companies or those raising substantial amounts of new debt. Money isn’t “free” anymore, so a larger slice of earnings will go to service debt. Companies with the ability to fund their own growth, as well as those with strong pricing power and dependable cash flow, will remain attractive in a world of higher inflation and cost of capital.
I think the market is going to be much less narrowly concentrated. The last decade was dominated by a handful of tech stocks that investors basically had to own to keep up with the market. Many of those companies were deeply invested in digital assets, such as online marketplaces, streaming platforms, search engines and social media.
Digital-first companies are not going away, but I believe they won’t carry the same import. Instead, I think investors will place greater emphasis on commodities and producers of physical assets. After all, you can’t build a new economy without conventional physical industries.
I expect opportunities to arise from a variety of companies, industries and geographies. Well-managed businesses beyond the tech sector may have their chance to shine.
Meanwhile, businesses that had been at the forefront of change may confront impediments of their own. For example, e-commerce companies have gone from being disruptors to being challenged themselves. They often feature very low margins, are expensive to scale and have daunting delivery logistics. Very few have done it well. Some traditional retailers that have combined the benefits of brick-and-mortar stores with compelling online shopping experiences are starting to take market share from pure e-commerce rivals.
Other trends, such as the shift to renewable energy, might seem like threats that will squeeze out incumbents in traditional sectors such as industrials, materials or energy. On the contrary, there may be winners among businesses that help other companies become more energy-efficient — whether that’s smart buildings, power management or HVAC systems that reduce gas emissions. Other global trends, such as grid modernization, reshoring and energy security, may cause a boom in capital investment across industries. Smartly managed companies in these areas might enjoy a real renaissance.
After the market dive in 2020, I expected leadership to broaden, and it has done so. In my view, this is a healthy development and supports why I have been trying to de-concentrate the portfolios that I manage. In theory, this should be a positive backdrop for stock pickers over indexers.
The globalization of supply chains is another multidecade trend undergoing a seismic shift. For a generation, companies moved manufacturing to foreign soil to cut costs and boost margins. But the limitations of placing efficiency over resilience are now clear. Rising geopolitical tension and pandemic-induced disruptions have led companies to consider bringing supply chains closer to home.
While bottlenecks caused by COVID shutdowns have improved, many companies are still impacted. The auto industry is a prime example. Major automakers have tens of thousands of unfinished cars waiting for final parts, and a missing component is often as minor as an inexpensive semiconductor. Now, companies are creating supply chain redundancies so that a single disruption doesn’t derail an entire operation.
Even as pandemic-related issues ease, I believe increased geopolitical conflicts are here to stay and will continue to fuel change. Today’s environment reminds me of the 1970s, with tension between Russia and the West, more aggressive confrontations with China, the rise of authoritarian leaders around the world and less global cooperation. After the fall of the Berlin Wall, there were more than 30 generally peaceful and prosperous years. But there are more risks now, and this backdrop suggests lower valuations are warranted and “surprises” should feel less surprising.
Consider Taiwan Semiconductor Manufacturing Company, the world’s dominant manufacturer of cutting-edge semiconductors. After having concentrated the bulk of its capacity in Taiwan — a focal point of geopolitical concerns — the company is building its first manufacturing hub in the United States. It’s also constructing a new plant in Japan. That regionalization should create a more secure supply chain for some of its top U.S.-based clients, including automakers and technology companies such as Apple, Qualcomm and Broadcom.
Many newer investors got comfortable with stocks being very expensive over the last five to 10 years and now assume valuations will return to those levels during the next bull market. When rates were near zero, the market could support loftier multiples, but I think those days are over.
When evaluating the portfolios I manage, I often ask myself this question: “What if stocks don’t return to 25x earnings in 2027? What if they only trade at 15x earnings?” If I can make a stock work at that level, then I can probably limit my downside. Using that lens, I’m trying to find emerging and growth-oriented companies that are not valued as such. I like those that may also offer potential upside to the valuation, but where the investment thesis doesn’t depend on it.
If multiple expansion is limited in the next bull market, stock returns will have to be powered by earnings growth. That means markets aren’t likely to be as patient with unprofitable companies. Stocks whose business models depend on cheap money are going away. Companies that funded losses while trying to scale rapidly even where the economics didn’t work are going away. Markets once paid up heavily for future growth but are less willing to now with higher interest rates. The market is calling time on business models that don’t work when money is no longer free.
The combination of low rates and rising markets made the last 10 years feel like one long sunny day at the beach. While some rain showers have now driven beachgoers indoors, they’re still looking out the window, waiting for the storm to pass. They don’t realize that there’s a new weather system upon us with more clouds, lower temperatures and much stronger winds. In other words, it may be wetter, cloudier and colder.
That may sound like a dark outlook, but I actually see this as a very exciting time to be an investor. As a Capital Group portfolio manager, I can look globally across many sectors for opportunities. This flexibility helps me adjust my portfolios to the new reality.
For example, some of my fellow portfolio managers and I have been shifting from high-growth sectors, such as consumer discretionary and information technology, to health care and industrials over the past few years in anticipation of this new reality. Changing market environments present new opportunities, and experience and flexibility can be essential in navigating them.