Our thesis is that the baton switch from one to the other may not be smooth. After the gains in risk assets year to date, with most world markets delivering double-digit returns, a note of caution is warranted. However, given the extraordinary amount of capital that has flowed from governments and central banks into the global economy over the past year, companies, banks, investors and consumers are awash with liquidity. This liquidity is already getting put to work in all forms of growth assets, both public and private, and at a price that is advantageous to business with record equity, buyout, venture and growth-investing flows.
On the micro side, established companies are investing to become more digitally and green enabled, while investment is taking place in new and disruptive businesses that can take advantage of converging technologies such as 5G, artificial intelligence, machine learning, move to the cloud and quantum computing, to name but a few. Meanwhile, consumers are slowly emerging from their 18-month forced hiatus to enjoy life without restrictions, fuelling demand for services of all types. The housing market has also received a boost: shortage of supply in many of the key developed markets has combined with increased demand to spur residential investment.
While we may not repeat the growth rate of the first quarter, which saw in the US, for example, consumer spending up 11.4%, business investment up 11.7%, and residential investment up 13.1%, growth will likely still be above average. However, the catalyst of GDP growth will slowly switch from government accommodation to private-sector enabled.
Cornerstone Macro, an independent research firm, expects that GDP growth in the US will slow from 8.5% this year to a still strong 4% in 2022; while global growth will slow from circa 6% to 3.5% in 2022. In other words, we have probably seen ‘peak growth’ in terms of rate of change, but GDP growth next year and beyond could still be far higher than the last decade’s average pace of 2.3%.
However, passing the baton from one growth catalyst to another may not be smooth or linear in form. There are still risks, not least of which is ongoing virus contagion from the Delta variant and maybe other new mutations. Thus, we believe that markets could well remain volatile, switching from one narrative to the other:
- Not enough to too much growth
- Growth to value styles and back again
- Inflation fears to worries about disinflation
- Bond yields up and then down again
Markets, the world and investors will constantly try to look ahead to judge the efficacy and strength of the real economy and the degree to which inflation trends are transitory (or becoming entrenched) as the world settles into a new post-pandemic normal.
In this quarterly piece, we aim to explore:
- What are some of the macro headwinds that can cause markets to swoon and worry?
- What are some of the micro dynamics that will power private sector growth?
- Why active management and diversification remain critical in this transition.
Our conclusion is that the environment remains favourable for growth assets, though we expect bouts of volatility ahead. While embracing risk, investors should remain well diversified across asset classes, both public and private, where appropriate. Many of the mega themes we are seeing in new businesses, digitalisation and new green technologies are best accessed in private markets, while diversification across sources of return helps to protect portfolios at a time when bonds no longer serve as reliable ballast.
In this new normal, the pace of investment in innovation and change is faster than ever. Active management is critical. Investors need to identify the right type of companies that are leveraging digital capabilities in growing parts of the economy, and which have durable and sustainable business models too. In a world of capital-light, technology-enabled businesses with strong – and in some cases exponential – growth, investors also must understand how to price, and not overpay, for these shares. Businesses undergoing green, digital or cost transformations can also provide attractive opportunities for valuation re-rating.
Hence, we recommend remaining well-invested in quality growth assets, but selective in price, opportunity and exposure.
Slowing and more uncertain macro
After the global financial crisis, the baton switch from government and central bank support to a robust private-sector growth never really happened. The recovery was the weakest coming out of a recession in history. The Brookings Institution reports that businesses reversed their normal role as net borrowers by withdrawing more income than they put back by way of investment activity. Consumers were cautious and paid down debt, while governments pursued austerity policies. In a word, every sector of the economy was in some form of retrenchment. It took six years to reach prior levels of GDP.
This time is already different. By the first quarter of 2022, the US output and employment gaps are likely to be fully closed. This will be the quickest gap closure for both at this stage of an economic recovery on record. Governments and central banks have embraced unprecedented fiscal and monetary accommodation, and in the case of fiscal policy are using the crisis to focus on strategic priorities, with an emphasis on infrastructure to improve digital capabilities and country competitiveness while also aiming to achieve carbon neutrality goals.
Hence support from government spending in one form or another is likely to be with us for years to come. However, the magnitude and nature of that support are changing. Getting the ‘just right’ mixture of fiscal and monetary stimulus so that economies can generate longer-term sustainable growth is complex. Too much stimulus risks overheating and run-away inflation, while withdrawing too early risks the private sector never really taking off.
Debt and deficit levels are high across the developed world, more than 100% of GDP in the US and UK by way of example. To have any chance of reducing these debt burdens, economies need above average growth, powered by the real economy with modest levels of inflation.
As we look ahead, we see several macro risks that could prevent this from happening, or at least derail an orderly transition, making ‘getting it just right’ harder to achieve.
- Covid-19 is still with us and Delta is on the rise
We have all read about the spread of cases. The risk is that this could spark more restrictions, which could dent the recovery and force governments to maintain stimulus spending and debt and deficits to continue to rise.
The increase in cases is high, with growth rates of 50% or more even in countries with high vaccination rates. Delta is now responsible for more than 90% of infections in several countries, including Israel, the UK and Russia. However, vaccines have significantly softened the link between cases and hospitalisations, implying that the surge in cases may be less of a worry than in the past.
The Delta variant is a bigger concern for countries where vaccination rates are low. Pfizer is seeking clearance from the FDA to distribute a booster shot of its vaccine to heighten protection, which will be taken up by countries such as Israel. Is a new round of booster vaccinations on the horizon?
Hence, the virus represents a persistent risk to global growth.
- Supply bottlenecks impact readings on growth and inflation
As economies have reopened, demand has come on more strongly than supply at a time when supply chains themselves are changing, with many shifting onshore. These supply side issues are impacting the ability of companies to satisfy orders and are putting upward pressure on prices.
Recently, there have been several weaker than expected readings on the economic front. For example, the global manufacturing PMI (a survey measure of global activity) fell modestly in June, while the US ISM services index (a similar measure) also fell more than expected. Meanwhile, China recently cut its reserve ratio, a form of liquidity to banks, in recognition that its economy was beginning to slow. The most recent GDP prints in the US and China confirmed a lower trajectory of growth than in the first quarter.
Inflation numbers have also been high. In the most recent release, the US CPI came in at up 5.4%, well ahead of expectations. However, one third of the monthly increase was due to rising prices in the used car and truck markets. Buyer demand has been strong, but the production of new cars has been delayed due to shortages in semiconductors and electronic components. Labour supply constraints have also been a problem, particularly in services, causing above-average wage and (in some cases) double minimum wage increases.
We expect price increases to decelerate as the year progresses and as pandemic-induced supply constraints ease, allowing supply to catch up to demand and taking the pressure off prices. With unemployment levels still high, the availability of labour should also improve as government income support tapers off and people feel more comfortable venturing back to work.
But until these supply challenges are resolved, lower growth and higher inflation are risks to the orderly transition narrative.
- Thrust from fiscal stimulus will decline
Investors are still waiting to see what size and form of infrastructure package President Biden can get approved. Expectations are that the American Jobs Plan, if enacted, could boost US GDP growth by 0.8% in 2021 and 0.9% next year.
However, there is a growing recognition that Biden may not get all he wants. As the economy recovers, there are rising calls for less stimulus, even from those Democrats whose support is critical for Congressional approval.
Moreover, irrespective of the size of the package, fiscal stimulus is on the wane. This is because infrastructure spending is spread out over multiple years and new spending is likely to be financed with some increased taxes, a form of fiscal tightening. The previous Covid packages were immediate transfer payments into the economy; $2 trillion in Covid aid went directly into consumers’ pockets. Thus, $2 trillion in infrastructure spending over multiple years is not the same boost to immediate growth.
Taxation is also a clear part of the Biden financing plan, with the president keen to enact increases in corporate and individual taxation. The G20 has already agreed to implement a minimum global tax of 15%, expected to be in place by year end.
Passage of any of these tax proposals is usually watered down and fraught with delays and political wrangling. However, investors are likely to be increasingly concerned about the magnitude and impact of a fiscal cliff in 2022 and beyond, unless and until the private sector picks up the baton of growth.
- The Federal Reserve has signalled caution on ‘easy forever’
Monetary policy will also not be accommodative forever and there is a risk that the Fed may have to tighten sooner than expected.
The minutes from the June Federal Open Market Committee (FOMC) meeting depicted the Fed’s pivot away from an “extremely dovish and patient” stance and flagged a possible interest-rate hike by the end of 2023. They also revealed the existence of two camps: a core group favouring a dovish outcome-based policy stance, and a hawkish group of regional Fed presidents favouring a more hawkish approach to QE tapering and rate hikes next year.
For now, bond yields seem to agree that the Fed is more likely to tighten sooner rather than later, with interest rates both lower and flattening over the quarter. For now, investors are taking a rather sanguine view that recent increases in inflation are transitory in nature. For the moment, we agree.
Moreover, history has also shown that productivity gains tend to be cyclical, rising strongly in periods of recovery and expansion. Thus, even if wages increase from here, improvements in productivity are likely to keep the wage component of inflation at bay.
This is probably why Federal Reserve officials have cited rising house prices, and not wages, as one reason to consider a policy adjustment. So far, while house prices have risen by about 15%, rents and owners’ equivalent rents have shown no acceleration from May.
However, any sign of entrenched inflation expectations would cause Fed hawks to win the day.
- Credit growth has fallen off
Private credit growth has slowed substantially from its 2020 peak, especially in the advanced economies. In the US, lower corporate borrowing is now a significant drag on broader credit and money growth.
OECD reports that broad money growth has started to slow from 30% to 14% y/y in April, although, that is still double the average rate of the last two decades.
Some have argued that this is further evidence of a potential slowdown in the making. More likely, what is driving the slowdown in credit is the abundance of cash that many corporates are enjoying. The Covid crisis and consequent lockdowns have swelled cash deposits not just for households but for corporates too. As a result, credit is slowing because companies have less need to borrow to finance investment plans.
The credit picture is worth watching, but for now, we do not see tightening in credit conditions as a threat to growth.
- The heavy hand of regulation
Governments in both US and China have recently become much more hawkish on regulation.
President Joe Biden has announced plans to sign a sweeping executive order aimed at promoting competition everywhere, from technology to financial services. The directive seeks to address the sharp increase in consolidation of industries over the past two decades, which has raised worries that the biggest companies are choking off competition and innovation.
Meanwhile, China’s regulators have also come out fast and furious. Didi, for example, which appears to have rushed ahead with its initial public offering in defiance of government concerns, is now suffering severe restrictions and potential fines on its business. Recent curbs on education and delivery companies have cause significant market turbulence. After years of behind-the-curve oversight, the Chinese government is asserting control.
Big technology companies are under the microscope because of their enormous size, allegedly anti-competitive practices, unaccountable control of consumer data, and potential to create financial risk. Beijing and Washington seem to be on the same page in this regard.
History has shown that regulatory changes do not have a lasting economic impact as companies tend to adjust and, some might argue, these types of regulatory changes can even benefit larger companies as stronger players have more resources to comply. However, any significant threat to the large tech companies, which have powered stock markets higher over the past year, could certainly cause markets to correct. The market’s reaction to China’s admittedly heavy-handed regulatory moves has certainly unnerved investors.
Each of these areas represents ongoing risks to the macro-economic environment, any one of which or in combination could slow the speed and trajectory of the private-sector recovery. It is an extremely complex environment for policymakers to navigate, with high levels of uncertainty for investors.
Vibrant and dynamic micro
However, we see plenty of evidence that the private sector is alive and well and is poised to rebound even further. Business confidence is at record high and growth assets should continue to benefit.
If earnings are any guide, companies across the board are experiencing vibrant demand. As we enter the second quarter, year-on-year earnings-per-share growth is expected to top 63% for the three months to the end of June, following an increase of 52.5% in the first quarter of 2021. Looking forward to 2022, earnings are expected to slow but still post double-digit gains. Corporate productivity gains can help keep earnings on a solid footing. Data on inventories also shows that companies have run down their inventory levels, which will need to be replenished. Renaissance Macro Research predicts that inventory rebuild will contribute positively to growth in 2022.
Meanwhile, measures of liquidity are extremely high: cash at commercial banks has swelled from $1.7 trillion to $3.8 trillion, an all-time high, while the Fed’s money on deposit with commercial banks stands at $17 trillion and money market accounts are now close to $4.5 trillion. With earnings, orders and cash flow visibility improving, companies have every incentive to look for ways to deploy that liquidity, including increased investment and acquisitions.
In the US, where data is more readily available, there are plenty of signs of liquidity flowing into the private sector.
- Public equity flows: About $580 billion has been added to public equities in the first half of 2021, putting the category on track for record inflows. The Bank of America estimates that if the pace continues at this level, equity funds (think corporate America) will take in more money in 2021 than in the previous 20 years combined.
- IPO market: Excluding blank cheque companies, 215 companies have listed on US exchanges so far this year, raising more than $85 billion. That’s the most ever for the period and keeps 2021 on track to be the biggest year ever for traditional IPOs.
- Private equity flows: Private equity firms have put $139 billion to work in the first half in the US, nearly as much as the whole of last year, and the 2020 figure was itself an annual record.
- Venture capital: Global venture capital funding in the first half of 2021 shattered records, as more than $288 billion was invested worldwide. That’s up by just under $110 billion, compared to the previous half-year record, which was set in the second half of 2020.
- Unicorns: There are now close to 900 unicorn companies across the globe – private companies valued at $1 billion or more — with an average of two new unicorns being added per working day. These companies are valued at close to $3 trillion and have raised $564 billion. Sixteen have gone public, valued at more than $10 billion, the highest count in the past decade.
- M&A: The first six months of this year have led to the highest M&A volumes in history. Companies have struck $2.8 trillion of deals since the start of January, up a record 129% from the same period last year.
Strong market gains and rising valuations have meant that companies have had access to capital at highly advantageous terms, but higher valuations have also meant that more money needs to be put to work to buy the same level of comparable assets.
Not all investments will be long-term winners. Indeed, whenever there is too much liquidity, marginal ideas will get funded. Speed of deployment is certainly a worry. Companies that seem like sure-fire disruptors today can get disrupted tomorrow. Too many players in one area will cause returns to diminish. Not every company can grow at the valuation implied by recent funding rounds. We have seen this playbook before in 2000.
However, access to capital can also be a positive and self-fulfilling dynamic. Capital can drive innovation, which creates further need for capital investment.
Tiger Global Management argues (admittedly from its own perspective) that it has never seen a better time to put growth capital to work. Internet penetration has increased at a time when the profitability of technology-enabled companies has also risen. In its view, the addressable potential market capitalisation of growth opportunities benefitting from innovation has doubled over the past 18 months.
Corporate dynamism comes at a time when the consumer is looking to spend again. Up to now, a large part of consumption growth during the pandemic was driven by income subsidies and government support. Assuming the health situation continues to improve, consumers are likely to put some of their excess savings, $2.5 trillion and counting, back to work.
Consumer spending should be buttressed by the prospect of a growing economy, good availability of jobs and wealth created by recent stock market gains. Housing has also been strong, with high demand for residential investment in many key markets of the developed world.
Cornerstone Macro believes that consumption and investment activity will continue to fuel above average gains in GDP and earnings growth. The private sector seems poised to break higher in a more durable and sustainable way.
The importance of active management and diversification
Since the pace of investment and innovation is faster than ever, investors need to be even more careful to identify the right type of companies with durable business models in the right sectors, which are delivering sustainable profits.
So, what makes a good long-term investment?
- Large addressable market opportunity
- Truly value-adding product or technology
- Culture of innovation
- Evidence of traction and scale
- Sizeable competitive moat
- High or improving profitability margins and returns on equity
- Evidence of a best practice environment, and social and governance (ESG) standards
- Commitment towards net-zero impact on the environment
But valuation is also an important consideration. With stocks now trading near the highest price earnings multiples since the dot-com era, even the best of companies’ value must be justified by the pace of growth. Innovative companies make attractive investments when they have a clear path to profitability and have built up enough competitive moats to enable them to maintain superior levels of growth over time. Downside risk is also a concern. Cathie Wood of ARK Invest believes that close to 50% of the S&P 500 could face serious competitive challenges from emerging business models over the next decade.
Valuations have never been more challenging, with investors needing to view value through multiple lenses:
- Companies with exponential growth and declining cost curves can enjoy continued high valuations, although not every company receiving new capital will be a long-term exponential winner.
- More established businesses that grow in line with (or above) GDP, but embark on significant value and green transformation can experience earnings and re-rating potential.
- Companies that underinvest in digital or green enablement or suffer from Me Too propositions may face significant downside risk and valuation pressure.
Investors must imagine which companies will evolve – or re-emerge – as economic return “winners” at a time when disruption is impacting every sector. Cost curves are declining in ways we have not seen before. Data is now a competitive tool to be collected and used to power better customer insights and engagement, while cyber-security spending (an increase in cost to protect that data) is expected to exceed $1 trillion, up from $120 billion in 2017.
These themes know no global boundary and will transform every global sector:
- For example, in the healthcare sector, the cost of DNA sequencing has declined a millionfold in the span of two decades. This kind of cost decline is changing the way doctors diagnose diseases and researchers discover new treatments.
- A focus on green and green-enabling investments to help reach net-zero targets is driving investment in new technologies in areas such as battery and green hydrogen, helping to commercialise whole new areas in renewables.
- The future of factories is changing, powered by robotics and artificial intelligence to automate processes with far greater efficiency and yield throughout the production cycle.
- Fintech is one of the fastest growing markets, with new forms of digital currency and contactless payments being widely adopted across the globe. Buy now and pay later is taking the retail sector by storm, allowing people to smooth out their bills over time without paying high interest charges on credit and store cards.
- Newer areas of consumer engagement such as trends in Metaverse, virtual reality applications, are on the rise. Mark Zuckerberg’s recent comment on his vision to shift Facebook from social media to Metaverse leader may be just the beginning.
While disruptive innovation remains one of the most exciting and relevant areas of investment, rigorous research is needed to identify opportunities that are best poised to win the disruption game. And even if we achieve an orderly growth transition, bond yields are likely to increase over time leaving cash-flow discount rates to rise and bonds’ role as portfolio ballast much diminished.
We aim to build portfolios that can benefit from these secular growth opportunities, while embracing diversification to mitigate risk. Exposure to private markets, absolute return, equity hedge and dynamic credit strategies play an ever more critical role in constructing portfolios.
Alvarium is an independent, global multi-family office offering tailored investment solutions for leading global families and foundation clients. We provide bespoke investment management and a powerful network for co-investment, collaboration and connection. As well as acting as trusted advisors in the financial markets, we are able to offer proprietary direct co-investment opportunities, outside traditional asset classes, with specialisms in real assets and the innovation economy.
Alvarium has more than 220 employees and 28 partners, working across North America, Europe and Asia Pacific. We advise assets in excess of $20 billion in value.