Regime change in markets: A capital cycle perspective - Angles & Perspectives

Regime change in markets: A capital cycle perspective

We believe that the Covid-19 pandemic marked the start of a major inflection in market cycles. While the previous decade was one of extremely accommodative monetary policy, we are now in a much tighter liquidity environment. As liquidity returns, investors should ask whether we will we see money flowing to new market leadership. Our view is that the sectors that drove the previous market cycle – long duration assets epitomised by developed market bonds and the big tech stocks – will be poor investments in the future. Those who position their portfolios for a return to the status quo that prevailed during the previous market cycle, are likely to be disappointed.

The ruling narrative

The past decade or so has seen markets embrace a growth scarcity narrative. This narrative characterised the global economy as in a secular stagnation, with low growth and inflation justifying extremely accommodative monetary policy. Long duration assets, epitomised by the US tech giants – the FAANGs: Facebook (now Meta), Amazon, Apple, Netflix and Google (now Alphabet) – which could grow in the growth-scarce world, deserved premium ratings. These premia were further boosted by the lowest bond yields in recorded history. Investment returns were largely determined by a handful of decisions: overweighting US equities and within that overweighting tech.

We believe that the Covid-19 pandemic marked the start of a major inflection in market cycles and have talked about this view on many occasions (for example: Thriving in a major market inflection depends on duration and mandate, PSG Angles & Perspectives, Third Quarter 2021). Certainly in 2021 and 2022, the global economy has shown high inflation and high nominal growth. Bonds have been sold aggressively and yields have been rising as central banks attempt to normalise monetary policy. There has been a rotation in performance with ‘short duration’ assets such as low-rated old economy sectors and resource-rich emerging markets (EMs) delivering good returns despite the backdrop of declining indices and big price declines from long duration assets like the FAANG stocks.

The exceptional price appreciation of the FAANG stocks and their speculative adjacencies (loss-making tech, special purpose acquisition companies (SPACs) and crypto) is just the latest of many liquidity-driven market cycles. We are now in a much tighter liquidity environment, and the cycle has come to an abrupt halt. Will it restart once liquidity returns, or, as is the historical pattern, will we see a shift with money flowing to new market leadership?

“This time is different…”

The market consensus is not that we are in a major regime shift, however. While the ratings of many growth stocks have declined somewhat, there has been little adjustment to earnings expectations: record operating margins are expected to be maintained perpetually. In addition, the yield curves of most developed markets imply a rapid return to the low growth/low rates paradigm. That the majority of investors cling to their previous narrative is to be expected, for a myriad of reasons:

• Every powerful narrative is built on a truth (e.g. economic growth was severely impacted for years coming out the Global Financial Crisis; Google is a wonderful business that benefited from the increase in digital ad spend).
• Early adopters are to be admired – for many years, those who embrace the narrative the most, make the most money.
• This validation makes for a strong belief that this is a permanent change in how markets work, so if you disagree, “you just don’t get it”.
• The existing regime becomes massively represented in equity indices and hence becomes a huge part of passive portfolios. Also, most active mandates have become very benchmark cognisant and it is considered ‘too risky’ not to have substantial positions in the current index giants.

You see, the vast majority of market participants have little memory or experience of operating in a market cycle where growth and technology were not the central narrative driving performance. They have not experienced multiple market cycles, or the most recent experience is so vividly recalled that it drowns out previous regimes. Crucially, there is confusion over the fact that it is the liquidity environment that supports the narrative, not the other way round.

The consensus belief appears to be that markets are still in the previous regime. External one-offs (Covid-19 and the Russian invasion) have caused a temporary disruption, but we will revert to the growth-scarce world once the inflation problem is dealt with. Investors just need to wait to buy back what worked previously. However, our capital cycle analysis shows this is very unlikely, implying the consensus may be poorly positioned for the years ahead, and this time is not, in fact, different.

A capital cycle perspective

Capital cycle analysis is a key pillar of our research process. We focus on the analysis of the supply side of specific sectors (existing capacity and likely changes in future capacity) rather than spending lots of time and effort on forecasting future demand. The excellent and forward-looking data available for supply side analysis (e.g. capex spending plans with long project lead times) contrasts with the difficulties of evaluating future demand, which is often volatile and, if we are honest, unforecastable. A tight supply side can imply excellent pricing power in the future, and should we be prepared to focus on an appropriately longer time frame, the vagaries of year-to-year demand fluctuations become less important.

Here we apply a supply side lens to the tech sector. An analysis of the R&D and capex spending of five tech giants shows dramatic growth over time. Yet the past three years has seen a huge further acceleration in spending. We surmise that the Covid-19 lockdowns served to validate the world view of the leadership and they went ‘all in’. R&D spend totaled US$190bn and capex $159bn in the trailing 12 months to September 2022, growing by 81% and 100% respectively from the pre-Covid base!

This is some $350bn of investment by just five companies in 12 months and is also a peak when expressed as a percentage of revenue (24%). What returns will this $350bn generate?

Big tech cuts back

Of course, the key capital asset in the tech sector is engineers, and their remuneration forms the majority of R&D spend. Headcounts of our five tech giants grew 109% over the past three years. But by the fourth quarter of 2022, it became clear that the world had not permanently changed post Covid-19, online shopping slumped back to its previous trend and the vast majority of people still preferred real-world experiences and face-to-face interactions over more screentime. In the face of a looming recession, for the first time, we are likely to have sharp reductions in R&D and capex spend, as telegraphed by the start of headcount reductions across the tech sector.

In summary, our supply-side analysis of the tech sector shows:

• It has been awash in free capital and talent for many years.
• Big tech spent vast sums on growth opportunities and moon shots, peaking in our five-company example at some US$350bn over the last 12 months, or 24% of sales.
• US venture capital funds raised $150bn in the first nine months of 2022, more than in the whole of 2021, and an all-time high.
• It appears every idea with a reasonably coherent founder and shiny slide deck got funded – if not by VCs, then Masa Son’s Vision Fund was good for a few $100m.
• Speculative assets went crazy (crypto, SPACs, loss-making tech).
• When the best they can throw money at is crypto, the metaverse and flying taxis, the opportunity set is well and truly scoured clean.

With that backdrop, to expect the FAANGs to immediately resume market leadership once liquidity returns is not supported by the supply side evidence.

What could lead the next cycle?

In sharp contrast to the tech sector, the ‘old economy’ sectors such as energy, mining and shipping have been starved of capital over the past decade or so. A similar situation exists for most EMs. This is not surprising given the terrible returns generated over the past decade and the massive losses incurred in the likes of US shale oil. In addition to poor returns, over a typical asset manager’s lookback period, these sectors have displayed high price volatility, almost universally regarded as a proxy for risk. The situation has been exacerbated by a high proportion of the market utilising an ESG process based on simple ratings that tend to penalise old economy sectors. In addition, the weight of these sectors in the indices has collapsed. Energy dropped from over 15% of the S&P 500 Index in 2008 to a low of 2% in 2020 and some 5% currently. Passive and benchmark-hugging active mandates cannot dramatically deviate from these weightings. All in all, there have been few reasons to own the old economy.

This starving of capital can create a very conducive supply side; in other words, the surviving companies could have strong pricing power for many years to come. When we do a capital cycle analysis on the energy sector, this indeed appears to be the case. We aggregate five large energy companies below. In sharp contrast to big tech, energy capex has declined 16% over the past three years and over 50% from the peak. As a percentage of sales, capex is just over 5%, a level last seen in the early 2000s, having reached nearly 13% at the end of the previous cycle. Exploration spend has shown an even steeper decline, i.e. down 43% since 2019 and some 75% from the peak. Similarly, as a percentage of sales, exploration spend is just over 0.5% compared to peak levels of 1.5%.

It is clear that current levels of capex and exploration are extremely depressed. Given the long lead times between initiating and completing projects (some eight years for deep water wells) and the muted capex plans over the next few years, there is little evidence of significant new supply in the future. When one considers the steady depletion rates typical of the industry, the supply side is in fact likely to tighten significantly over a longer time frame of some three to eight years.

Against this are projections that even in a well-managed energy transition, oil demand will only peak between 2030 and 2040, with a gradual subsequent decline. In summary, the supply side analysis shows there is a high probability that the energy sector will benefit from strong pricing power for many years ahead. This outcome is not reflected in the sector’s ratings – for example, Bloomberg consensus shows Shell trades on a PE of 5.5x forecast 2023 earnings.

In conclusion: Conflating different time horizons

We believe there is a high probability that we are in the midst of a regime change in global markets. The sectors that drove the previous cycle – long duration assets epitomised by developed market (DM) bonds and the big tech stocks – despite likely bounces with recovering liquidity, will be poor investments in the future. After being capital-starved for many years, old economy sectors and resource-rich EMs have gained substantial pricing power, yet most trade on very cheap ratings.

Finally, our supply side analysis is focused on long time horizons, and we expect demand fluctuations to inevitably impact prices near term. This is likely for sectors such as energy, mining and shipping, traditionally viewed as very economically sensitive. Should the supply side thesis for these sectors remain intact, these fluctuations will provide attractive opportunities for investors to further increase positioning in the years ahead.

PSG Asset Management is a wholly owned subsidiary of PSG Konsult Group.