LO Funds
Generation Global

MARKET OVERVIEW

Equity market started 2025 on a weak note as US 10-year rate approached 5%, leading to a stronger USD, on the back of strong US economic data (ISM manufacturing, payrolls) and a more hawkish shift in the US rate outlook. However, over the course of the month, sentiment turned more constructive thanks to a good start to the earning season from the US banks. In Europe, the ECB minutes confirmed growing concerns about economic weakness and potential inflation undershooting revealing an increasing easing bias. Despite weak economic activity in some of the key European countries, European equities have been strong over the month, catching up only marginally from their 2024 lagging performance.

In the later part of the month, the DeepSeek news, Chinese AI chatbot, roiled the US tech stocks. Additionally, the new Trump’s administration issued a series of executive orders and statements spanning climate policy, health and energy. These had been well-publicised in advance and contained few surprises. Though the tone of the messaging may be hostile to the transition, we believe the removal of political uncertainty, a pro-business environment, a focus on deregulation and reshoring could well prove ultimately positive for private investment in infrastructure, grid and networks, semiconductor manufacturing and smartification.

INVESTMENT THESIS

The historian Adam Tooze uses the term ‘polycrisis’ to describe a situation in which multiple problems – from climate change to populism to a resurgence of war – interact in ways that amplify each other, creating destabilising global dynamics. In Generation’s view, financial markets are now experiencing their own ‘polycrisis.’ This is happening on two fronts: political and technological. The polycrisis in markets complicates the process of capital allocation. It creates distortions in market pricing, especially in the short-term. The focus of the market veers between the very short-term and a couple of years at most.

However, there is a silver lining. It opens up tremendous opportunities for investors who are willing to take a genuinely long-term view. As the saying goes, the market is a voting machine in the short-term but a weighing machine in the long-term. What ultimately matters are long-term cash flows. Generation believes that the market has become exceptionally efficient at pricing short-term information, but in a way that amplifies inefficiencies in the long-term. They are optimistic that the team can capitalise on these inefficiencies to create long-term excess returns. (1)

Let’s outline these changes in turn.

First, the politics of investing have undergone a profound change in recent years. Populism is on the march. Companies find it increasingly difficult to operate across international borders, especially when China is involved. Politicians are more willing to enact measures that damage companies for political gain, such as trade restrictions.

The politics of sustainability have always ebbed and flowed. During the COVID pandemic it became wildly popular, even as people had lost interest during the global financial crisis. Sustainability is currently in a down market. An ESG backlash is having a negative impact on sustainable investment and corporate sustainability. In the investment arena, it has weakened the collective voice of asset managers on climate: large US managers have left Climate Action 100+ and reduced the ambition of their engagement. In the corporate arena, the backlash has affected efforts to improve diversity, equity and inclusion, and some companies have loosened their climate commitments. Generation expects the re-election of President Trump to fuel the backlash. (2)

These are concerning trends. The year 2024 was probably the warmest on record, and Generation is troubled that finding solutions to the climate crisis has become tribalised. In their view, investments into alleviating the climate crisis are not only good for society; they often stand alone on their economic merits. They have fast paybacks and rely little on subsidies. When companies invest to become more efficient and reduce their carbon footprint, they are voting with their wallet.

Second, the technology of financial markets has changed. Technological change is nothing new, of course. First you had the rise of electronic trading, then the rise of hedge funds and then the rise of quantitative trading strategies. All of these have shifted the investment world along a continuum of technological improvement. In Generation’s view these shifts have accelerated in recent years.

Thanks to social media, information about companies travels more rapidly than ever before. If the market is a voting machine, then voting happens a lot more rapidly than before. The incorporation of artificial intelligence (AI) into investment strategies is another piece of the puzzle. Enabled by technology, passive investment funds in the US recently surpassed active funds in assets under management.

Another more recent trend is the rise of the multi-manager hedge-fund structure characterised by autonomous teams (‘pods’) of investors operating independently within a broader organisation. The assets under management of the biggest shops have roughly quadrupled in the past decade, and they now probably account for more than 20% of equity trading volumes – a breathtaking statistic. (3)

A large body of research finds that all these changes are upending financial markets. One recent paper notes that the rise of passive investing has “amplified price movements, decreased liquidity, [created] potential macroeconomic inefficiencies, and [led to] a disproportionate concentration of market influence in a few dominant stocks.” (4) The investment team are intrigued by Clifford Asness’s idea that social media has made financial markets more prone to bubbles. (5) Information now moves so rapidly that excitement about a company can easily feed on itself. The IMF’s latest Financial Stability Report notes that the rise of AI could lead to “increased market speed and volatility under stress, especially if trading strategies of AI models all respond to a shock in a similar manner or shut down in response to an unforeseen event.” (6)

There is less academic work on multi-strategy hedge funds, since they are relatively new. Yet, there is a growing consensus that they may increase the market’s focus on the short-term (and create connected volatility). These funds are highly levered, and recently leverage has become more expensive. The managers therefore need not only to be right, but right fast. All these technological changes also interact with each other. If the rise of passive squeezes the potential alpha pool, and more of that alpha pool is driven by multi-strategy funds that are very driven by the short-term, that affects the alpha left for long-term investors in the near term.

Generation is not a group of finance professors, of course. They are practitioners, and must operate in the market that they have been given. But something is different. You could think of markets as an ecosystem. It is interesting to ask how an ecosystem can evolve or break down (i.e., lose diversity). From Generation’s vantage point, they have noticed that several things about investing have changed.

Markets move between cycles of ‘greed’ and ‘fear.’ Under a polycrisis, however, they see both cycles existing simultaneously. On the one hand, market participants are enormously concerned about the future of US-China relations and the possibility that society is moving towards a world of structurally higher interest rates and inflation. Quantitative measures of uncertainty are well above historical averages. (7) On the other hand, investors are excited by the potential returns of AI, as well as the ability of corporate America to continue to deliver strong earnings growth. So, you have global instability at the same time as continued strong stock market performance. The market is playing by different rules.

There is little doubt that, in many sectors of the market, pricing is rich. The market capitalisation of cryptocurrencies is now roughly equal to the market capitalisation of the Russell 2000. (8) There are around 1,200 start-ups worth more than USD 1 billion, even as there are fewer than 2,000 public companies valued the same. MicroStrategy, a business-intelligence firm that had a market capitalisation of USD 50 billion, recently announced plans to raise USD 21 billion over three years to buy bitcoin. Following this, its stock surged 74%, valuing the company at 292% above the value of its bitcoin holdings, reflecting investor excitement over its strategy despite its struggling software business. In Generation’s view, at least some of this market pricing has become detached from underlying economic realities.

In 2024 the S&P 500 posted a historically strong year. (9) A small number of big companies (notably, the ‘Magnificent Seven’ group) is largely responsible for these returns, sending measures of market concentration to historical highs. The top 10 stocks account for well over a third of the S&P 500’s total market capitalisation, easily exceeding the roughly 20% average of recent decades. A single company, Nvidia, was responsible for 5% of the S&P 500’s returns in 2024, and recently achieved a bigger weighting in the MSCI World Index than France. (10)

Some claim that the strong share price performance of the Magnificent Seven in recent months simply reflects rapidly improving economic fundamentals. Valuations, proxied by the ratio of price-to-earnings, have not blown out. Share prices have appreciated, but crucially earnings have grown rapidly, keeping price-earnings ratios fairly constant.

However, Generation believes that the market is not sufficiently distinguishing between these companies. The ‘Mag7’ moniker is one clue here: Tesla is a fundamentally different company to Amazon. Does it make sense to put Tesla and Amazon in the same club? (11) Some companies’ future earnings seem more durable than those of others. Microsoft and Amazon, Generation believes, are set up for long-term success. As communicated in previous letters, Generation has more questions about Nvidia.

(1) A recent paper on this topic caught Generation’s eye. The paper concludes: “There is a lack of attention paid to the long-term return profile [of securities]. Investors who don’t face career concerns attempt to take advantage of this lack of attention by buying the most attractive stocks within this subset, and then hold them for a long time horizon. Given the lack of focus on these stocks, they expect they will generate higher expected returns over long periods of time. In this paper, I test this theory. I do find that the stocks that are held for the longest period of time tend to outperform those held for shorter periods.” See “Career concerns and time arbitrage,” Kalash Jain, May 2024.

(2) Generation plans to publish an Insights piece this year on the consequences of the ESG backlash.

(3) Internal analysis based on Goldman Sachs research.

(4) This has a range of consequences for market functioning. See von Moltke, Felix, and Torsten Sløk. “Assessing the Impact of Passive Investing over Time: Higher Volatility, Reduced Liquidity, and Increased Concentration.” 2024.

(5) Asness, Clifford S. “The Less-Efficient Market Hypothesis.” Forthcoming in the 50th Anniversary Issue of The Journal of Portfolio Management, 2024.

(6) International Monetary Fund, “Financial Stability Report,” 2024.

(7) See Baker, Scott R., Nicholas Bloom and Steven J. Davis. “Measuring economic policy uncertainty.” The Quarterly Journal of Economics 131, no. 4 (2016): 1593-1636 and follow-up data.

(8) For the facts in this paragraph, Generation is indebted to a recent edition of Grant’s Interest Rate Observer, 22 November 2024.

(9) See article https://www.reuters.com/markets/us/sp-500-counts-final-mag-7-push-best-year-this-century-mcgeever-2024-10-29/.

(10) For this observation and others, Generation is again grateful to Grant’s Interest Rate Observer, 22 November 2024.

(11) Generation would note that there is substantial retail participation in Mag7. As noted in a recent Goldman Sachs Financial Services Conference, on some platforms 70% of trading is in these names.

PERFORMANCE REVIEW

Generation's process is underpinned by a bottom-up approach to stock selection, the manager refers to the stock attribution attached for the drivers of performance during the month of January. As long-term investors that integrate a sustainability lens into their analysis, Generation is focused on their long-term outlook for the companies in the portfolio and whether their thesis remains intact, despite any near-term headwinds and share price movements. The top performers during the month included Thermo Fisher, Mercardolibre and Charles Schwab. The bottom performers included Microsoft, Kingspan and Danaher. Whilst these companies are experiencing short-term headwinds, the Generation team retains his conviction in the long-term thesis on these names and others in the portfolio. Generation is focused on strong execution of its process and has made adjustments on areas the manager identified for improvement.