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    Growth addiction and tightening cycles: learning from the dot.com bubble

    Growth addiction and tightening cycles: learning from the dot.com bubble
    Didier Rabattu - Head of Equities

    Didier Rabattu

    Head of Equities
    Pascal Menges - Head of Equity Investment Process and Research, Client Portfolio Manager

    Pascal Menges

    Head of Equity Investment Process and Research, Client Portfolio Manager

    At a glance

    • Equity market are currently characterised by a focus on growth companies to an extent that echoes the dot.com bubble. This is evident from the recent outperformance of the growth factor, an unusual historical pattern. In addition, in the US, top growth companies represent 25% of the current market, close to the 30% peak of 1999, and above long-term average of 20%.

    • We also find that this focus on growth tends to favour companies that do not self-fund their growth and are highly reliant on external financing to achieve their financial equilibrium, through either equity raises or debt. In the US, poorly-funded companies account for almost 40% of top growth companies, similar to the situation in 1999.  

    • Back in 2000-2001, an abrupt closing of access to finance market for these unfunded growth-focused companies triggered the ‘dot.com’ burst. Tightening monetary policies was a material trigger, in our view. Fed effective interest rates moved up by about 200bps from 1999 to 2000, the yield curve started to invert, while headline inflation rose from 1.5% to 4%. The proportion of high growth companies in the US equity market more than halved, down to 10%.

    • Current debates on the nature of inflation – whether it is transitory or structural – and the central banks’ reaction is critical as it could potentially lead to a 2000-01 funding-type crunch. True, the situation today is different as while spot inflation is at a similar level to where it was in 2000, current interest rates are 400-500bps lower. A funding crunch would take us from the current historically unique context of very negative real interest rate (-300-400bps) towards positive real interest rates. A ‘policy mistake’ that overly tightens monetary conditions, while inflation and growth eventually recede, could lead to such a scenario. We recognise that the  situation remains fluid and that a strong tightening cycle is not yet a given. Indeed, monetary conditions could remain overly accommodative (and real cost of capital still negative) as central banks may worry far too long about making a ‘policy mistake’. 

    • In our view, in such an environment, investors might still be willing to capture growth opportunities but they need to be wary of tightening conditions. Therefore, it makes sense to adopt a barbell approach when it comes to portfolio construction. The current focus on unfunded growth has left behind many lower-growth quality companies that are cheap (which we term ‘DEER1 companies’  in our framework). These companies tend to outperform strongly during a rising rate environment. In parallel, focusing on growth companies that can self-fund their growth would allow investors to continue to participate in the growth-party with a much diminished drawdown risk.

    • We have adopted this approach across our equity product range. Our strategies (regional/thematic) focus on companies that can grow above indices with a more resilient funding profile, and structurally generate attractive excess economic returns overtime. For example, our global strategies (Natural Capital, Climate Transition, World Brands, Golden Age, FinTech,) or regional strategies (Asia High Conviction, Europe and Swiss Small & Mid Caps, Emerging High Conviction) all share these characteristics of higher growth and higher quality than reference indices.

    Sources : 1  DEER=discounted Excess Economic Returns (LOIM’s definition of attractively priced quality companies)

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