Is structural change or the economic cycle driving global share markets?

Global share markets are always driven by both structural change and the economic cycle to some degree. It is the weighting of the two drivers that varies over time. Given current monetary policy and the limitations of fiscal policy, it is more likely that innovation aligned to secular growth themes will drive equity returns for the foreseeable future.

“There is nothing permanent except change”
– Heraclitus, ancient Greek philosopher

What is the economic cycle doing for share markets?

The global economy is now in the later stages of the cycle, with interest rates having peaked and the first cuts expected this year in most major developed economies. However, the lagged effect of tighter monetary policy means the economic slowdown will last some time.

While there has not yet been much sign of major credit disruption impacting the real economy, the economic growth outlook looks a bit gloomier. Interest rates are expected to remain ‘higher for longer’ and most governments need to reduce borrowing over the medium-term, slowing economic activity.

Nonetheless, inflation has fallen significantly and share markets are able to look through near-term slowdowns, leading to the recent rally in global stocks. Lower interest rates will (eventually) be supportive of equity markets, but this is now more fully reflected in share prices.

How do structural growth trends impact company earnings and valuations?

Earnings growth is becoming incrementally scarcer and more concentrated in limited areas of the market. Important secular trends bring big shifts in economic activity, creating an ocean of losers, but also a select pool of winners exposed to underappreciated structural growth.

The Pengana Axiom International Ethical Fund analyses these through its framework of the ‘4 D’s’ – the four long-term trends driving returns:

• Disruptive technologies – Innovation gets adopted faster; companies aligned to technological change can grow earnings independently of the consumer spending cycle
• Demographics – The world’s population is ageing rapidly, affecting savings and consumption; it is driving spending on healthcare, transforming medical treatments
• De-globalisation – Supply chain security, market access and dependence on imported components are key issues to global businesses, which will impact stocks differently
• Debt – Public sector debt is at peace-time highs, crowding out private sector investment; as interest rates stay ‘higher for longer,’ investors should study balance sheets carefully to help avoid zombie stocks

Axiom was early to spot the increase in the total addressable market for digital advertising – an example of a disruptive technology – a decade ago. When Facebook shares first floated, people were already spending almost as much time on their device as their TV, yet digital advertising was a much smaller market than TV advertising. Most investors underestimated the explosive growth in the digital advertising market and thus the earnings of the handful of companies that would successfully exploit it.

Why do so many investors struggle to identify sources of future growth?

Investors often miss these really big structural shifts in the economy, as they can take time to be reflected in sell-side analysts’ forecasts.

Analyst research tends to be anchored to historic earnings growth and company managements’ forward guidance. This is usually quite conservative so companies can exceed it, supporting steady share price growth (and executive share option values!) This creates an information deficit for long-term investors to exploit.

Disruptive change creates unmet demand within markets, enabling innovative companies to grow cash flows much faster than consensus expectations.

Sedentary lifestyles and fast food create demand for weight loss treatments, delivering massive cash flows for companies that secure drug approvals. Shortages of skilled workers performing structured tasks create massive demand for cloud computing augmented by AI techniques; these require the most advanced chips, a market which remains weakly penetrated.

Institutional investors are notoriously poor at identifying these secular shifts that transform the size of markets which can be addressed by well positioned businesses.

What should investors do now?

A market environment of economic weakness and falling inflation is one which should favour growth stocks aligned to these big secular growth themes.

The Pengana Axiom International Ethical Fund identifies companies which are dynamically growing more rapidly than expected. This means finding businesses undergoing positive change not yet reflected in medium-term earnings expectations (and thus share prices) which deliver sustainable earnings growth.

Their investment thesis often proves to be way more attractive than the market consensus, bringing exciting opportunities to outperform. Identifying a market’s potential to expand massively in a short time period is critical, which is something most institutional investment processes do not prioritise.

Tim Richardson CFA, Investment Specialist

Stay tuned for follow-up articles delving into each ‘D’ and the opportunities they present for investors, as we navigate the evolving landscape of equity markets.