Market heatwave

“If it bleeds, we can kill it” (Dutch – Predator)

In spite of the many obstacles put in her path, the world economy appears to be accelerating. War, energy shocks, higher borrowing costs and a hegemon waging a trade war (on itself¹) are just some of the overlapping and interacting headwinds. This week we explore the global economy’s resilience and whether it can continue.

More lessons from the millenium

The parable of the ‘Dotcom’ boom and subsequent recession is generally told as a warning of the dangers of extrapolative excess. ‘What goes up, must come down’ we are told. In this telling, the economic and markets hangover of the early noughties is framed as righteous payback for the wild exhuberance of the late 90s boom.

There is of course some truth in this interpretation when it comes to capital markets. The rush to price the possibilities of the internet and communications revolution certainly disconnected the prices of various investments from reality. Reality’s inevitable revenge was painful for many investors for many years. However, the story was quite different in the real economy. The fact is that a lot had to go wrong for the US to endure what turned out to be a brief and shallow contraction in late 2001, one that much of the rest of the world avoided.

The two quarter recession occured during a period that contained the tragedy of 9/11 - the complete closure of American airspace, billions of dollars of physical damage, a sharp additional decline in stock market prices and all the terror and uncertainty that understandably characterised the period. Throughout 2000, energy inflation was running at double digits in percentage terms, sapping consumer health. Meanwhile US manufacturing jobs were starting to rapidly evapourate under the heat of China’s gathering swagger among other factors.²

The point being that sometimes the desire for simplicity and moral clarity warps our perspective when interpreting historical episodes. A more detailed qualitative analysis often helpfully muddies the story, which is important when we are trying to use that history to put our current moment into perspective.

As it goes, the market pop around that steadier underlying economy was likely not wasted to the extent suggested by the parable above either. As we’ve frequently observed, large profits and high valuations have proved a necessary incentive over multiple past revolutions. These motivate not only innovation but also investment in all kinds of related activities, including altering elements of the economy’s structure to adapt. They are the carrots that induce agents in the economy to attempt leaps in the unknown and to solve the various associated problems. This may also be part of solving the puzzle of getting those who ‘know’ to collaborate with those who ‘do’. This is a trick which at least one recent Nobel prize winner sees as the key to why many previous advanced civilisations didn’t manage escape velocity.³

The problem in the Dotcom bubble was not that investors had miscalculated the growth potential of the technology overall but rather attributed too much future value to the companies that built the technology and infrastructure to provide it. The ultimate winners were those able to free ride off this spending and utilise the capacity to build business models that could leverage the technology and provide new products and services. Many of the winners didn’t emerge until the onset of the smartphone in 2006 and the proliferation of apps that then spawned a growing industry of platform companies, from ride sharing to food delivery.

As the above suggests, history contains plenty of examples of investors over-fixating on the originators of a new technology. Within this there is a tendency to underestimate the impact of subsequent competition and thereby overstate the returns on capital invested by these early innovators. That is perhaps understandable in the early exchanges. The size of the future potential profits pie at the heart of all market pricing is always nebulous, a matter of informed guesswork. That is even more the case in times of accelerated technological change.

Investment conclusion

This latest earnings season has so far reaffirmed that it is not so much the size of that future pie that is being debated in markets, but how it is likely to be shared between the various sectors aiming for a slice or two. That may explain why much of the volatility and market violence we are seeing these last few months has been below the surface of the major indices. That doesn’t have to remain the case. If wider questions emerge about monetisation, the pace of corporate adoption or even the pace of improvement at the frontier, then we could begin to see more chop even in well diversified portfolios. Nonetheless, our multi asset class funds and portfolios continue to balance skin in the AI game, with exposure to some of the dustier and more inexpensive corners of the global capital markets complex. Stay the course. The key is diversification as usual. Not just across (and within) stock and bond markets but well beyond. Look to the plight of many leveraged Korean investors if you want a parable on the price of concentrated investing.

¹ Incoming evidence demonstrates that it is US consumers and businesses that are footing the bill for the US trade war. Who Is Paying for the 2025 U.S. Tariffs? - Liberty Street Economics ² The ‘China Shock’ refers to both a 12-year surge of Chinese imports into the United States and the first series of academic papers that analyzed it. The shock coincided with two important events: the 2000 passage of US law granting China PNTR status, which cemented for Chinese imports the lower tariffs that the United States applied to imports of almost all other nations, and China’s official accession to the WTO in 2001, which required the approval of all 142 WTO members, including the United States. In the decade that followed, Chinese imports into the United States accelerated—thus it has been called the China Shock. There remains plenty of dispute on the size and impact of this shock. The “China Shock” Demystified: Its Origins, Effects, and Lessons for Today | Cato Institute³ Joel Mokyr speaks to the question of why none of the Roman or other great empires prior to the European industrial enlightenment struggled to break free of Malthusian restraints. His answer is that frequently the scientists and those who ‘know’ operated in very different circles from the artisans and others who ‘did’. This link began to be made in the various societies that cropped up like Mushrooms in Britain in the 17^th century. An example is the Royal Society where academics and entrepreneurs mixed to debate the scientific frontier and how it could be commercialised.¹ Joel Mokyr speaks to the question of why none of the Roman or other great empires prior to the European industrial enlightenment struggled to break free of Malthusian restraints. His answer is that frequently the scientists and those who ‘know’ operated in very different circles from the artisans and others who ‘did’. This link began to be made in the various societies that cropped up like Mushrooms in Britain in the 17^th century. An example is the Royal Society where academics and entrepreneurs mixed to debate the scientific frontier and how it could be commercialised.