An investment columnist’s job always involves the juggling of narratives. The economist Robert Shiller, rightly in my view, thinks that investors are far less focussed on hard numbers than they say they are and much more impressed by financial narratives. Take for instance a boring measure such as price to earnings ratios based on forward earnings ratio. In the good/bad old days, if that number was much above 20, investors would frown and mutter ‘expensive’ under their breath. But once the narrative of technological disruption becomes attached to the PE ratio and the investors can combine the narrative of tech change and corporate adaptation (currently called digitisation), then suddenly 20 looks laughably cheap.
And so, narratives are important. Which brings me to this column. I was toying with the idea of investigating the wave of M&A activity within the digital infrastructure sector and the wall of private equity money heading into the sector. But another narrative screams out at me: market mayhem or, less elegantly, the possibility of an imminent equities sell off.
As I write this, the US markets in particular seem to be shaking off the growing number of alarm bells. As a literate audience you’ll be able to tick off the obvious ones such as (in no order of importance): China; inflation; Covid not quite going away; faltering recovery as stimulus dies down. I could also mention valuations, slowing earnings growth projections for mid-2020 and a few other bond market flashing sirens, but for me the most obvious factors are the least discussed, notably faltering momentum and declining global liquidity flows.
For this observer, the logic of market gains over the last decade isn’t terrifically complicated. Central banks have flushed money into the financial system, bought out bond holders and encouraged investors to take the view that there is no alternative except to invest in equities. This liquidity driven push into equities takes on a form of momentum over time, pushing yet more money towards sectors, sometimes unconnected to fundamentals.
Quite a few hedge fund-oriented research outfits keep a close eye on these flows and many are now saying that their liquidity measures are flashing red. For instance, one London based outfit called Cross Border Capital only this week observed that “both US private sector liquidity and US cross-border capital inflows have already turned lower from exceptionally high levels, whereas US Fed liquidity remains unusually elevated”. If the US Federal Reserve was to start to aggressively taper, they think we’re guaranteed a big stock market correction.
It’s also the case that as liquidity tightens, equity market momentum falters. In that scenario the marginal buyer of equities – the ones who felt they had no choice other than to invest in equities – head for the hills, sell equities en-masse and start to re-appraise their bond portfolios. We are now at one of those possible turning points.
Most measures of relative strength within US equities are beginning to point downwards. That said, one shouldn’t get too carried away with crystal ball gazing. Market volatility levels are still low – the classic measure, the VIX, is languishing below 15, significantly below the 25+ point mid-September, though it’s also worth noting that that level is still quite elevated compared to FX volatility (CVIX Index) and rates volatility (MOVE Index). As for earnings, Corporate USA Inc still looks in good shape as we head into another earnings season. According to BlackRock “companies representing more than half of the S&P 500 Index market value have reported third-quarter earnings. Over 80% of them have beaten expectations on profit and more than three quarters have exceeded revenue estimates”.
Obviously, we need to take all this debate around signals with a large household cup of salt but when you combine it with the macro and geopolitical warning signs I’ve already listed, then maybe it’s time to sit up and take notice. Which prompts my next question – what happens to the publicly listed digital infrastructure space if we do head into a downturn?
As luck would have it, I’ve been crunching numbers across a number of sectors in recent weeks looking at what happened in past stock market sell offs. The big table below contains the fruits of those efforts.
I’ve looked at six S&P 500 sell offs over the last 15 years or so since QE properly started. Declines in the US benchmark index have varied between just under 10% through to 48% in 2008/9. I’ve also pulled out the biggest stock market listed digital infrastructure businesses – which happen to be the leading holdings within the Digital Infrastructure Investor Index (DIGITAL) – and analysed how they performed during those periods of maximum distress.
I’ve also included peer group data for general tech stocks – I’ve used Microsoft as a surrogate – and traditional infrastructure funds, in this case two long established UK listed investment funds, HICL and INPP which have both been around on the London market for two decades. These two funds invest in ‘classic’ infrastructure such as public private partnerships and they are the very definition of what it means to be an alternative fund.
First the good news. By and large the leading digital infrastructure businesses – mostly US listed of course – have fallen by less than the market index (the S&P 500). Unfortunately, that relative out- performance isn’t actually that impressive. Take the February/March 2020 sell off – the S&P 500 fell 33% but my average for 11 large cap digital infra businesses declined 23%. By comparison Microsoft was down 23% while even my two ‘classic’ infrastructure names were down around 20%. Or take the 2008/2009 sell off. The S&P 500 was down 48% but digital infra stocks were down 44%.
Now the bad news. I’ve also included measures of share price volatility which clearly show that the daily dispersion of returns is much, much greater for my digital infrastructure businesses. It’s also on average in excess of Microsoft and the ‘classic’ infrastructure plays.
Stepping back from the wall of numbers I’d make the following observation. Many big institutional investors choose to invest in the digital infrastructure for two reasons. The first, much voiced by the sector, is a thematic one based around growth. I would argue that an equally important reason is that investors like the bond-like dependability of the sector: steady cashflows unaffected by the business cycle should provide some diversification benefits in the event of a sell off. In effect this pigeonholes digital infra stocks as a form of low volatility, quality stock. But the numbers above don’t really support this notion of digital infra stocks as being even remotely alternative. In reality, digital infrastructure stocks display very few of the qualities I’d expect from a genuine alternative – in fact they sell off nearly as aggressively as growth stocks in a high volatility regime. If the current market moves from its current levels of market volatility to a proper sell off – a big if I grant you – then my worry is that digital infrastructure stocks will provide no safe haven.