Sean Ashton, Head of Investments at Private Clients by Old Mutual
There is a growing sense among many that the current bull market must be approaching its end. It’s perhaps a reasonable fear – after all, we’re in year four of a bull market (notwithstanding periodic short technical bear markets along the way, such as in early 2025)Long-term US Treasury yields have also moved sharply higher, fiscal deficits remain large, and the AI investment cycle has reached extraordinary proportions. After several years of strong returns, it is natural for investors to ask whether the good news is already priced in.
But being further into the market cycle does not necessarily mean being at the end of it. We are clearly not early, but neither does the current environment look like the end of the cycle. Rather, this is increasingly an earnings-led market, characterised by strong earnings delivery alongside some healthy valuation compression. Contrasted against the tech boom of the early 2000s, we saw parabolic multiple expansion at the end of that cycle.
The US bond market provides an important part of the backdrop. The long-term decline in interest rates that defined much of the period from the mid-1980s through to the early 2020s has clearly ended. Thirty-year Treasury yields have recently risen to levels not seen for many years, reflecting persistent fiscal deficits and a market demanding a greater return for holding longer-dated US government debt. We do not think this is symptomatic of merely an inflationary concern, but rather a new period of investment-led growth in the real economy, augmented with US deficit spending at unusual levels outside of recessionary periods (where government stimulus is necessary).
The US Treasury has responded by signalling increased purchases of longer-dated debt, providing some additional support to the long end of the yield curve. But this does not change the underlying issue: the US government is running sizeable fiscal deficits, and debt has risen materially relative to the size of the economy. This has also brought the so-called dollar debasement trade back into focus, with investors turning towards gold, Bitcoin and other assets seen as alternatives to fiat currency.
There is, however, an important counterpoint to concerns about US fiscal policy: Public deficits are, by definition, surpluses elsewhere in the economy, and government spending becomes income for the private sector and, ultimately, supports corporate revenues and profits. As the saying goes – “be careful what you wish for” – the US government suddenly “finding religion” as far as expenditure is concerned would likely not be well-received by equity markets as this source of stimulus is removed from the corporate profit pool.
That brings us back to the most important driver of equity markets: earnings.
NVIDIA’s latest results provide the perfect context for what we see playing out in the AI investment landscape – a notable pattern of disbelief that the cycle can continue, yet sustained upside surprises keep coming. Investors are still underestimating the strength of this cycle. Nvidia’s revenue rose by more than 100% year on year, while management indicated that it expects revenue growth of around 70% in the next fiscal year – around 25% higher than most analysts had expected for next year, off an even larger base.
And yet the market’s reaction to this strength is increasingly complicated -the better the numbers become, the more investors seem to worry that the cycle must be approaching its peak. This is becoming a common theme, reflected in compressing valuation multiples – at a forward 17x P/E, Nvidia is now as cheap as it was in Q4 2018, at which time they were effectively issuing profit warnings on the back of falling demand for chips used in Bitcoin mining. So much for investor ‘euphoria’!
This is, in fairness, a familiar feature of late-stage growth narratives. Investors become so accustomed to strong numbers that even exceptional results can be interpreted as evidence that expectations have become unsustainable.
And to be clear, there are legitimate questions around the AI investment cycle: Nvidia is experiencing some pressure on gross margins as memory costs rise, and the scale of investment taking place will ultimately need to be justified by their customers seeing a sustainably good return on their investment.
Importantly, we regard this valuation compression as a welcome and healthy development. Markets become more sustainable when earnings grow faster than valuations, rather than relying on multiple expansion to drive returns.
Periodic resets in positioning can also help. The sharp sell-off in semiconductor stocks in South Korea in July, where leveraged retail traders were margin-called, was a good example. These episodes can be uncomfortable, but by removing excess leverage and optimism, they can ultimately help extend a market cycle.
So where does that leave investors?
The risks should not be ignored. Higher long-term interest rates create a different environment from the one investors enjoyed for much of the past decade. Fiscal deficits are becoming a more important consideration for bond markets, and the sustainability of the AI investment cycle will eventually be tested by the returns generated on all that capital. But none of these factors necessarily point to the end of the equity cycle today.
The context for higher yields today is also important – we are no longer in a world of ‘secular stagnation’ that characterised the post-GFC era, but rather one of reindustrialisation of the West – centred principally on capital formation around AI as a new factor of production for entire economies. America is leading the world in this regard.
When the market is considered in aggregate, valuations still offer reasonable value, underpinned by the strongest earnings cycle we’ve seen in years. Importantly, the companies underpinning the investment driving this growth have the firepower to continue doing so. An increasingly, new pools of capital are being mobilised in this regard – notable private equity.
The distinction between an earnings-led bull market and a market driven primarily by expanding valuations is important: if earnings continue to surprise positively while valuation multiples remain contained, there is no reason why the current cycle cannot continue. Bull markets don’t die of old age, but rather a catalyst – most of which are only obvious in hindsight. Trying to call the top simply because a cycle has run for some time can be just as costly as ignoring genuine signs of deterioration. For now, the focus should remain on what companies are delivering. And so far, the message is encouraging.
ENDS
