A Painful Transitional Phase - A Step into the Darkness

A 2017 book by Andrew Lo "Adaptive Markets" ("Adaptive Markets") makes a compelling case against the dominant efficient-market hypothesis, as it borrows key concepts from biology to explain what we see in financial markets and, more generally, in our economic system. In nature, some species are more adaptable to their environment, so they have a higher survival rate, acquire more resources and, as a result, reproduce more successfully. These animals are better adapted to survive, but sometimes - due to random mutation or external changes in the environment - other species become more successful. Environmental transitions can be brutal and transcend cause and effect relationships commonly known in physics, such as when water turns to ice or steam and our chaotic human societies become extremely unpredictable.

In the era of globalization in the years 1980-2020, international companies seemed to be best adapted to the conditions. In the late phase of the information age, software companies were best suited because there were fewer constraints in the physical world. Globalization coupled with cheap gas from Russia has made them particularly well adapted to survive Germany. Due to low interest rates, companies of the type were very well suited to the conditions venture capital, private equity and entities from the real estate sector. In 2022, we witnessed a situation where the best-fit models and actors in our economy entered the dark as the world entered a transition phase. Globalization as we have known it since 1980 has come to an end. It is difficult to predict what we will find after the end of this transition, but our working concept is that what was well adapted during the period of globalization will be less adapted in a world shaped by geopolitics and the process of transition to a bipolar world based on two different value systems. In other words, all the models that have worked very well so far will fail in the future.

This stock market outlook is dedicated to these broken models and covers the top five implications:

• Higher structural inflation because the "geopolitical war" is inflationary
• Lower corporate margins as workers fight back and taxes rise due to the new dominance of fiscal over monetary policy
• Physical assets will outperform intangible and financial assets
• Self-sufficiency will help optimize supply chains, creating winners and losers in emerging markets
• Lower real growth rates and greater macroeconomic uncertainty

The physical world is back – and with a bang

The digitization process began in the early 90s, and one of the first key events in this regard was the establishment of the company Amazon in 1994. However, digitization only began to dominate capital markets after the global financial crisis. Along with other companies where they were leaders intellectual property rights i intangible assetssuch as network effects, brands and patents, etc., companies based on them performed much better than companies based on fixed assets, such as machinery, collateral value or buildings. Period prosperity in the world of intangible assets started around April 2008 and lasted until October 2020, i.e. until the month before the news about the development of mRNA vaccines against Covid-19. Vaccines have changed everything.

They allowed the economy to restart faster than expected. As a result, the implementation period of fiscal and monetary stimulus, which was supposed to protect society from a baseline scenario in which vaccine development would take about four years, has been shortened. The faster-than-expected resumption of economic activity resonated widely in the global economy, causing bottlenecks in the physical world as people widely increased their wealth and income and were finally able to spend it outside the digital world. This kind of release of demand in the physical world was comparable to the stimulus implemented after World War II, when the reconstruction of Europe took place and inflation took off naturally. Commodity prices have skyrocketed, entering what could turn out to be by the end of this decade raw material supercycle. Fixed asset industries outperform the world of intangible assets for the third year in a row. In our opinion, this trend is just beginning.

Two segments of the physical world did well last year. Commodity companies (agricultural, energy and mining) and defense industry were the only ones to show positive trends. Both of these segments seem better suited than digital companies for a world where there is a "war" on different value systems and where the US and Europe are racing against time to invest in security of supply, infrastructure and defense, modifying global supply chains , and, on top of that, shift their economies to non-fossil fuel sources of energy. The boom in intangible asset-based companies offering fantastic returns to investors has reduced the amount of capital available to the physical world, laying the groundwork for the current transformation. However, the real turbocharging was provided by the pandemic and the subsequent war in Ukraine.

Within our overall positive outlook for commodity markets, copper and lithium mining companies stand out particularly constructively due to the green transition and the huge political capital invested in its implementation. Many experts say that commodity prices have already increased significantly, making the risk-reward ratio unfavorable. If we have indeed entered a ten-year supercycle, commodity prices will remain high for eight more years, and in previous commodity supercycles, spot prices have increased by 20% per year. The new geopolitical environment will mean a huge boost for the European defense industry, which should record double-digit growth in the next business cycle, around 20% per year, as the Old Continent doubles its defense spending as a percentage of GDP.

However, there are always exceptions to the rule. Given the intense "war" of Fr computer microprocessors American as a result CHIPS Act From 2022, we expect a significant investment boom, growth and tax incentives that will help increase profits for US and European semiconductor manufacturers over the next decade. While semiconductors are very much tied to the physical world to some extent, semiconductor stock valuations suggest that the industry is driven by strong intangible assets such as patents.

In a world shaped by geopolitical upheaval, where "war" is fought in many other dimensions than old-fashioned kinetic warfare, digital systems are vulnerable. Therefore, companies and governments will devote significant resources to protecting digital assets, and this will create a long growth path for companies in the industry cybersecurity.

US vs. Europe, Emerging Markets and Top Caps?

Well-adapted to surviving the tech sector in the late phase of globalization, coupled with low interest rates, the US tech sector as measured by the Nasdaq Composite easily outperformed everyone else. This led to an alpha rise in US stocks relative to European stocks, with the latter lagging behind since the Eurozone crisis. Europe has basically lost the fight for dominance in the digital world to the United States. With advancing deglobalization, war in Ukraine compounding the energy crisis, and global demand for physical assets, Europe will stand to gain from this shift. There are many more companies on European capital markets that will be able to thrive in this new environment. It's about e.g green energy technologies, mining industry, automation, robotics i advanced industrial components.

European countries – including fiscally conservative Germany – will also be forced to run up deficits due to rising infrastructure and defense spending, which could translate into significant growth this decade. In terms of equity performance in terms of total return denominated in USD, European equities actually outperformed US equities between 1969 and 2008, with several longer cycles occurring during this period. However, from mid-2008 to October 2022, US equities outperformed European equities. This was due to the progress of digitalization contributing to the development of sectors based on intangible assets - and this competition was won by the United States. While asset-based industries are beginning to outperform intangible industries, European stocks have lagged behind until recently. If the new geopolitical environment turns out to be in line with our expectations, European equities will come back into play. With the US dollar historically strong against the euro, the currency side could provide strong support if the US currency were to weaken due to structurally higher inflation compared to Europe. With regard to stock valuation, Europe shows an advantage as twelve months C / Z ratio is 11,9 compared to 17,7 for US stocks. Such a discount in the valuation will certainly not be ignored by investors, and after Europe secures its energy supplies and after the end of the war in Ukraine, the influx of investors will begin. Finally, as China reopens its economy to the world and embarks on a 2008-style fiscal expansion, Europe, China's largest trading partner, can only benefit. European equities can be seen as a good intermediate way to go long in the context of China and its fiscal expansion.

At the country level, typically exporting countries such as Germany, South Korea, Taiwan, and China in particular, were best adapted to the conditions. In the new geopolitical environment, this situation is likely to change. In Asia, the winners appear to be India, Vietnam and Indonesia. And closer to Central Europe - Eastern Europe and some North African countries can win by relocating production there, while Sub-Saharan Africa will experience an investment boom due to Europe's energy and material hunger once Russian supplies are excluded. Approaching the geographic vicinity of the United States, Mexico will benefit from production, and South American countries will benefit from the resource supercycle.

Deglobalization and self-preservation policies will also make life more difficult for companies with the largest capitalization. Their combined market value peaked at the height of the pandemic, setting a new market value concentration record, last recorded in the 70s. As this reverses, the new system will not favor such large-scale companies and entities, but rather smaller, companies operating in niche industries, supplying products for building the physical world, to the domestic market.

Quality and high margin are less sensitive to wage inflation

The last 10 years will go down in the annals of the extraordinary monetary policy in the aftermath of the Great Financial Crisis and the Eurozone crisis two years later. Lowering the cost of capital probably lowered the threshold for return on invested capital (return on invested capital, ROICs), and the low interest rate environment reduced costs for the most heavily indebted enterprises. Low interest rates have also contributed to significant risk-taking and value distortion over time, most notably in the industry venture capital, in which the new model blended beautifully with digitization and network effects. Financing loss-making companies to ensure market leadership was no longer a problem as low interest rates allowed capital to flow into projects venture of extremely high risk.

Such dynamics created a veritable forest of tech startups and turbocharged a biotech industry that had been dormant since the dot-com bubble. One of the most iconic examples of this phenomenon is Uber – according to TechCrunch, with 32 rounds of funding worth around $25 billion in the 13 years since the company was founded. Uber still has a negative ROIC despite revenue of $29 billion. WeWork and the entire portfolio of SoftBank-funded tech startups was another role model in this era. In the current set of inflation and interest rates, this model is broken. The companies that are best suited to higher interest rates, wage resets, and high inflation are those with high ROIC or high operating margins combined with less overpriced stock valuations. Companies with low margins, high financial leverage and low profitability are the least adapted to the new conditions.

About the Author

Peter potter - director of equity markets strategy in Saxo Bank. Develops investment strategies and analyzes of the stock market as well as individual companies, using statistical methods and models. Garnry creates Alpha Picks for Saxo Bank, a monthly magazine in which the most attractive companies in the US, Europe and Asia are selected. It also contributes to Saxo Bank's quarterly and annual forecasts "Shocking forecasts". He regularly gives comments on television, including CNBC and Bloomberg TV.