The View Beyond: What's really driving markets?

Hello and welcome to this edition of Julius Bear's Moving Markets, The View Beyond podcast. In these episodes we delve a little bit deeper into the current topics on Investors' minds, and today I'm very happy that I have not won but to guess, Eve Klenk, who is the head of client coverage and advisory here at Julius Bear, and Marco Radavitch, senior portfolio manager and head of alternatives. Together we're going to talk through some of the most important topics in financial markets at the moment. Just before we start, I would ask you to please listen to the end of the podcast to make sure that you hear the important legal information. But now welcome to both Eve and Marco, thank you very much for joining me today. Hi Helen, hello Helen. So maybe I could start by asking you both what you would consider has been the biggest surprise for financial markets this year, over to you, firstly Eve. For me it's not really a specific data point, it's rather how well the markets have performed relatively in front of a big adversity this year, and let's just recall what all happened. I mean, just to name a few, we had to spill over from the whole tariffs on certainty from last year, and all the related back and forth. We had massive geopolitical tensions, we have two wars, we have inflation concerns globally, which have been rising significantly, this mainly driven by energy prices, and many, including me, we would have expected this all causing much more disruption in financial markets than it actually did. Yeah, I mean, where do I start? I think Eve did a great job of listing out a lot of the surprises that happened this year. There's been, it's been certainly a rollercoaster year. But if I look at sort of one thing that Eve maybe didn't mention just to add, is we started the year with investors projecting two rate cuts by the Fed, and we're actually today we already had one rate hike, and we're expecting another rate hike before the end of the year. So that's 100 basis points delta in Fed funds rate. On top of that, of course, rates have risen about another 100 basis point. So if you look at the 10 year rate, it's still at 5.1 percent today. And just to add to what Eve was saying, the resilience of capital markets has been absolutely stunning. If somebody would have told me that oil prices would be above $100 today, and rates would be at 5 percent, and yet global equity markets would be generating double-digit returns. I would have said that's impossible, right? And yet here we are. Of course, there's still a lot of uncertainty. But at the same time, it's very surprising how resilient capital markets have been. One of the reasons is, of course, that we have this unprecedented innovation super cycle, capex cycle that's driven by artificial intelligence investments. OK, quite a few surprises then, but pretty resilient markets overall. Now, in our latest market outlook in September, we noted that we expected equity market performance to broaden. How is this playing out, Mark? Well, it hasn't really played out so far, given that I think the market has been pretty much one-dimensional this year. As I mentioned in the previous question, driven by the AI capex cycle. That said, those regions that are directly beneficiaries from the spending like Korea, Taiwan, to some extent, Japan as well. Of course, the United States have benefited immensely. If you look at the market performance, if you look at the S&P 500, just to give you an idea how concentrated the performance has been, 57 percent of stocks are actually 20 percent below their all-time highs. In some sectors, it's as high as 80 percent. If you look at the Mag 7, which has been the driver of capital returns over the past 15 years or so, only two out of the seven stocks are outperforming the S&P 500. One other, I would say, phenomenon that has transpired this year is that since we've had these massive bottlenecks across the supply chain, across the AI supply chain, what has happened is that lower quality stocks have outperformed higher quality stocks. Because, of course, when you have a shortage, you trade down. It's been something that's been extremely difficult for active investors to grasp. That has driven these lower quality stocks, for example, in some cases where barely profitable or even lost making, they have outperformed the higher quality stocks. Of course, with AI disruption, a strong balance sheet, good or strong profitability metrics, high free cashier margins don't really help you because your terminal value is disrupted. From that standpoint, it's very difficult for active managers to discern what will be the winners and what will be the loser. From that standpoint, the broadening has been extremely difficult and the concentration has been extremely high given the geopolitical disruption as well. The two sectors that have worked the best have been the AI beneficiaries or tech hardware and oil and gas. Apart from that, it's been an extremely tough environment. Yes, I agree. I see exactly that and I discuss the same with investors. It's particularly difficult if you talk to an investor who's keen on stock picking because exactly what Marco mentioned that some market performances are really driven by a few stocks. If you didn't own these stocks, then obviously your performance didn't look like the overall market and there we have interesting discussions now. That makes, in general, active investing much more difficult and what you alluded to that you try in active investing to choose the good companies or the better companies. If those perform less well than the worse ones, then obviously you've got a problem and it's very difficult to navigate. We deal with that with investors also by going broader. If we look at investing in certain regions or sectors to really look at, on the one hand, you have AI, on the other hand, you have non-AI investments and then to go broad in that because you cannot predict really the single stock beneficiaries and then you have seen in the current of the year, particularly in July or in October, very pronounced rotations but which were quite abrupt and also at times short lived. Then again, you have this interplay between AI, the underlying theme, but then on the other hand, health care stocks, staples, I would mention also Switzerland and if you just look now in October, Switzerland is doing great which was not the case for some other parts of the year. You have this interplay to deal with. For now, this broadening hasn't really worked out so far. In terms of diversifying then where could investors look Europe and we also still like equities in parts of Asia as well? I would just add to what Eve said, I think, balancing your AI exposure with some non-AI exposures makes sense. You mentioned Switzerland which is having consumer staples and health care. Those are the two sectors that have been the poster child of the anti-AI place. Europe is in dire straits in general, of course, given the events that have transpired over the last weekend in France. I think that volatility will most likely persist going into the elections in April, so expect some volatility in Europe to continue. Of course, valuations are extremely attractive in Europe, so for bargain hunters, it makes sense to dip your toes into Europe. Europe is of course impacted much more heavily by the situation in the state of Hormuz because it's energy dependent. If we do see a relief on that front, I think Europe will perform well. Having some exposure into the cyclical sectors in Europe like industrial and financials probably makes sense also because the valuation differential compared to the US peers is substantial. I think having some of that exposure dipping your toes at least into Europe into those couple of sectors probably makes sense, but I think diversifying in broader terms what Eva has already mentioned, having some AI exposure and non-AI exposure is what really makes sense in your portfolios. Yes, and also geographically, we still like the emerging markets area a lot, both in equities and fixed income. We see still a benefit in diversifying, for example, in the currency area. You can have a look at the Aussie dollar. We discussed that together earlier this year, Helen. It's maybe a bit less attractive at the point, but still okay. Helen, you have also dynamics regionally, so for example, if you look at the career trade now going a bit, softening a bit, that might be beneficiary for other areas in the Asian equity space. You have seen Japan doing quite well a year to date, so that has panned out for investors, and yes, there we see still opportunities and benefits of setting up a diversified portfolio. I think we also need to mention the midterm elections coming up in the US. We can look at what's expected. We can't of course predict what is going to happen, but any market turbulence could create opportunities. Is that fair to say, Marco? I would say so. And I think if you look at the midterm elections expectations. across sort of betting markets and polls. They're point pointing to a Democrat sweep. If you look at sort of what Donald Trump ran on, which was raining in the affordability crisis and not getting in Tangle and foreign wars, he's pretty much done the opposite of that. So I think this will probably be a referendum on his performance. Now with that said, the pollsters have chronically, I would say, underestimated the performance of the Republicans, the Senate. There's I think seven seats that are tossed up. We'll see what happens. But at the same time, I think if you look at it historically, empirically speaking, a divided Congress has always been a positive for capital markets. It provides, I would say, a bigger check on the balance of power within the United States. And I think that volatility going into the midterms is probably an opportunity for investors. With that said, there's maybe one risk that we should probably mention is that Democrats have said that potentially, they would block data-centric constructions. Construction, remember, we've talked about AI so much so far. It is the biggest driver of economic growth today in the United States. It's responsible for about 60% of GDP growth. So if there is any pause in that data-centered construction, that will, of course, dampening or Republicans' chances even further going into 2028. Now, behind closed doors and the people that we talk to that are close to the Democrat party and some of the governors across the United States, they also will tell you that they are the ones they are proponents of data centers because they see the actual benefits, the positive economic impact that they bring. In some cases, for example, if you look at a meta- data center in Louisiana and the south of Louisiana, which brought massive economic growth to that small community, in some cases, increasing teacher salaries by $50,000. So I think that the economic benefits are there. Data centers bring economic growth. Small businesses come into the town and I think the wealth is being distributed. With that said, it is sort of a wild card. We'll see what happens, but that's sort of one risk on the horizon that we should keep in mind that Democrats could potentially try to block further construction data centers. That of course will be a negative for the market because AI has driven most of their trends this year. But of course, it would be a positive for the rest of the sectors that we mentioned are sort of the ones that you want to be also balancing out your AI exposure to. - For such events online, I always recommend investors to have on the one hand their personal shopping list ready. So looking at their portfolios and seeing, for example, what you mentioned Marko about AI or non-AI, do you have any need to enhance your portfolio on the one end or the other end? And then to really strike when prices are very attractive driven by the volatility. And on the other hand, volatility can be monetized as well and a great way to do that is with structural products. So to really be ready for the great price things which will be available when volatility is higher and then to be ready to actually lock these prices in and add them to your portfolio. - I'd like to touch on private markets now quickly as well because with more capital going into companies that stay private for longer and more and more value creation happening before businesses become public, private markets are becoming an increasingly important part of the investment universe, right? What are your thoughts here, Eve? - There are two elements which are important in my view when you talk about private equity. For example, there you have an important distinction that what you mentioned about public and private markets that we don't say you need to do either or. Our view is really to do both, to really be able to cover the opportunity set. The second element we discuss is not really a question if you're doing it but how you're doing it. And there you have two ways to access it, one which is rather recently emerging which is the evergreen structure where you have also some sort of sunshine liquidity I call it and you're also immediately invested and the other more known since longer they kind of close the end fund structure where you really have a normal drawdown structure which you know for long. And in our view, investors also there it's not either or but really our view is to do both ways how to invest in private equity and private markets. - Yeah, I mean, I think I would agree with that Eve. If you look at sort of private markets, how far they've come, as you said they can't, they can't really be ignored anymore. Because most of the value creation is actually happening in the private markets. We can see some of the examples even this year, some of the largest companies which will probably go public either this year or next year, one of them has already gone public this year. The majority of their value creation happened while they were private. So I think from that standpoint, really private markets cannot be ignored anymore. I think and the reason for that, why they're staying private for longer is that they're able to raise capital in the private markets. It's very simple, there's much more liquidity. And so from that standpoint, also not having to deal with some of the disclosures that are related to becoming a public company really incentivizes them to stay private for longer. Now you mentioned the two different structures ever green versus closed end. I think they're extremely complimentary to each other. Whatever green has allowed us to do as investors is really if you look at sort of your target allocation private markets, whether that's 5%, 10%, 50%, whatever that is, it allows you to get closer to that target instead of going only through closed end structures, right? Because just going through drawdown structures, it's very difficult to hit that target. Sometimes you're let's say your target is 10%, sometimes you're at eight, sometimes you're at 12, you're never really at 10. And whatever green structures allow you to do is really come closer to the target. Now on top of that, of course, you mitigate the J curve effect. You invest it immediately. Now from on the other side, closed end structures are much more pure private markets exposures, whereas in the ever green structures, given that what you mentioned, that sunshine liquidity factor, you do have some liquid securities that allow you to have that liquidity. So I think they're very complimentary to each other and they should be considered in a portfolio context together. But it's really important to start sort of from your strategic asset location, how you want to be allocated across the private markets, and then look at what instruments really fulfill that need to achieve that strategic asset location. And of course, to generate the returns that you're expecting. I'd love to ask both of you what you think is the single most important theme driving markets right now. Maybe we start with you, Marco. Well, I guess, stayed in the obvious. I mean, we've talked about it so much. AI is certainly the biggest theme that's driving the market so far. I think if you look at it over the short run, it's probably inflationary, but over the long run, because it's driving demand, the demand curve to the right, but over the long run, it's probably going to drive that supply curve even further out to the right, actually, being in this inflationary force in the markets. And that really, you have this tug-of-war, this sort of interplay between AI and rates, which are sort of increasing the cost of capital and how that plays out will be something that we will be watching very closely. But certainly, this unprecedented amount of capital expenditures continues. And those that are direct beneficiaries are going to continue benefiting their stock prices, are going to continue benefiting. For example, this year, we're expected to hit more than a trillion dollars in capital expenditures next year, about 1.5 trillion dollars. That we're getting close to 5% of GDP in the United States. This is one of the biggest capex cycles in the history of the corporate world. And so I think it's something that we should lean into. We should have exposure to AI. But at the same time, we talked so much about not only being invested in AI, because these rotations on the surface, these rapid fire rotations, as I like to call them, can happen very quickly. And you can get hurt quite a bit. And the good examples that Eve had mentioned previously are July and in this month, October, where AI has been hurt substantially and other segments, other anti-AI segments, other more defensive segments have worked well. So I think having a well-structured, well-diversified portfolio is something that is evergreen. I totally agree with you, Mark, on the importance of that AI bit in the equation. I would zoom in into one aspect, which is the battle between, on the one hand, AI-driven productivity optimism and, on the other hand, higher for longer rates. The question is ultimately, will AI be able to generate enough productivity and earnings growth to overcome the constraints we didn't really expect at the beginning of the year of higher rates and all the trade fiction? Now, what does that really mean for investors in the end? And there would be two things, which I would like to highlight. is on the one hand don't take rash decisions upon market movements we discussed today it can backfire we have rotations in the markets which can be quite short lived and turn around quite quickly and the second element is don't take this resilience we discussed today together of the markets this year just for granted what we should do is construct together portfolios which are resilient and actually the easiest way to do it what we discussed together with market today is diversification let's look at AI non AI for example in the equity space and but these elements are really important for investors to continue to have resilient portfolios excellent thank you both very much for joining me today great to have you both on the podcast thank you Helen thank you Helen so that concludes this week's view beyond podcast I hope you enjoyed this episode and that you'll join us again for the next edition next week in the meantime remember to check out our daily moving markets podcast which is available every weekday on the same channel bye for now the information and opinions expressed in this podcast constitute marketing material and are not the result of independent financial or investment research please refer to www.juliespaer.com/legal/podcast for further other important legal information