On 11 March 2020, the World Health Organization declared Covid-19 to be a global pandemic. In four years, we’ve experienced a pandemic and shutdown of the global economy, wars and a once-in-a-generation surge in inflation, record interest rate increases, and now talk of a technological revolution and an equity bubble.
Why the US continued to outperform other markets
A notable feature of the past four years is that the United States equity market continued to outperform other markets, stretching back to 2009. There was a moment when it seemed China would emerge from the pandemic in a stronger position than the West, and this was reflected in market pricing. The exact opposite happened, and the MSCI China Index is still 30% below pre-Covid levels today.
There are several reasons for this. A strong US dollar over this period penalises the returns of other markets. US economic growth has been far more resilient than in other developed economies. For instance, when the Russian invasion of Ukraine sparked an energy crisis across Europe and other regions, the US, a major oil and gas producer, experienced a much smaller impact. When the Federal Reserve started hiking rates, the impact on households and firms with fixed-rate debt was limited, whereas in many other countries variable-rate debt is common, and borrowers had to take it on the chin.
The US government’s seemingly endless willingness – and ability – to borrow money also helped. The Coronavirus Aid, Relief, and Economic Security Act was followed by another stimulus injection in December 2020, the $1.9 trillion American Rescue Plan in March 2021, and President Joe Biden’s signature (but misleadingly named) Inflation Reduction Act. The latter, among other things, provides multibillion-dollar support for the construction of microchip and battery manufacturing facilities. The flipside is that US government debt will continue to rise steadily in the years ahead.
And then there is technology. The rapid forced shift to work-from-home was a major boost for technology companies, although short-lived in some cases. Zoom’s share price jumped sevenfold in 2020, but it is trading at near pre-Covid levels today. The excitement today is not so much about video conferencing, online shopping, or streaming entertainment. It is about generative artificial intelligence (AI).
Nvidia, supplier of the high-spec microchips that are used to run AI models, came seemingly out of nowhere to become the world’s third most valuable company and featuring among tech giants Microsoft, Amazon, Apple, and Alphabet (parent company of Google). These are all US firms.
These companies were born as ideas in the heads of founders, who are often students at America’s elite universities. To turn these ideas into businesses requires an entrepreneurial, risk-taking culture, but also funding. The US has an unrivalled financial ecosystem with venture capital firms that specialise in investing in all the growth stages of these start-ups. Increasingly, US markets are also attracting international technology firms when they list for the first time. Firms can access a much larger investor base and earn higher valuations this way, much to the chagrin of politicians in their home countries.
Led by these tech companies, US earnings growth has been stronger than in other markets. But investors have also been prepared to pay for this growth. US price-earnings (PE) ratios have risen much faster than elsewhere. The S&P 500 traded on a similar forward PE ratio to non-US equities in 2010. Today, it is substantially more expensive.
Recovery in Japanese stocks
It is not as if non-US equities have gone nowhere, however. In particular, Japan, the land of the rising sun, seems to be rising again, or at least its stock market is. The Japanese Nikkei 225 Index finally surpassed its all-time high level (excluding dividends), 34 years later.
For a long time, the Japanese market was the retort to the idea that equities always rise over time. The point, though, is that there was a massive bubble in the late 1980s, not only in Japanese stocks but also in real estate. The Nikkei traded at 40 times forward earnings at its peak, compared to only 15 times today. Buying into such an overvalued market virtually guaranteed poor returns for many years. It was complicated by the long-term damage done to the Japanese economy, particularly the banking sector, by the bursting of the property bubble. Equity bubbles tend to have limited impact on the real economy when they pop, but real estate is typically bought with debt that weighs down economic activity for years.
The recent strength in Japanese shares is largely driven by companies becoming more shareholder-focused over the past decade. There is still room to unwind cross-shareholdings and return cash to investors. The long-term prospects for the Japanese economy remain constrained by a declining population. Nonetheless, the Bank of Japan might finally have the confidence to end its eight-year experiment with negative interest rates.
While the rest of the world has been debating whether the inflationary surge of the past two years will recede, the question in Japan has been whether it will stay. The recent annual round of wage negotiations between unions and large firms looks set to deliver the biggest wage increases in a decade. It would be ironic if it took a global pandemic to shake Japan out of its long deflationary funk.
Is AI creating another tech bubble?
The long, painfully slow post-bubble recovery of the Japanese market forces us to ask whether there is a similar risk to the current AI euphoria.
Bubbles are difficult to spot in real time, because there are always good arguments to be made for why the investment in question is trading at lofty levels. Wall Street Journal columnist James McIntosh put it succinctly: “The problem in a bubble isn’t usually that the story is wrong, but that the price is wrong, because investors are wildly over-optimistic about how fast or how profitable the changes will be.”
Think about the 1990s dotcom bubble. We all use the internet today, so the dotcom boosters weren’t wrong, and some of the big names of that era are still around today. But investors underestimated how long it would take for this revolutionary technology to take off and become entrenched in daily life, and therefore overpaid for the shares.
The problem with AI is that we don’t yet know who the real winners will be. It is an expensive, specialised business, so the current front-runners are the deep-pocketed Silicon Valley giants. These are not speculative businesses, but already cash-generating machines.
However, competition could still emerge from anywhere in this new field. Remember how the pioneers in the mobile phone business – Motorola, Nokia, and BlackBerry – have long since surrendered leadership. The ultimate winners might also turn out be firms in other fields – finance, medicine, retail – that use AI models on their internal data to cut costs and improve processes, products, and services. We just don’t know.
So, although the short answer is no, it doesn’t seem as if we’re in bubble territory, there is reason to be circumspect. A lot of good news is priced in already, not just in AI but across US equities.
A vaccine for your wealth
The world that has emerged from the pandemic is a very different to and much more uncertain than the one that went into it.
However, throughout this tumultuous period, investors would have benefited from time-tested investing principles. Think of it as a vaccine for your wealth. Trying to time the market in these chaotic years would probably have resulted in failure. Staying invested in a diversified portfolio throughout the ups and down would have served most investors well.
Izak Odendaal is Old Mutual Wealth’s chief investment strategist.
Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies.
