Competition For Capital

Exhibit 1Downgrades Peter Oppenheimer et al from Goldman Sachs (GS) weighed in on the same topic with Competition for Capital:

"There are two themes dominating our investor conversations: the impact of AI and the rise in interest rates. The two issues are linked as demand for capital from both the private and public sectors increase. In the private sector a surge in capex spending to fund AI infrastructure has eaten into free cash flow and forced companies to raise more in debt and equity markets. Meanwhile, government borrowing needs have increased as priorities shift towards upgrading critical infrastructure, energy security and defense at a time when cyclical inflationary pressures driven by higher energy prices are also resulting in higher policy rates. The combination has pushed up the cost of capital. As recently as 2022, for example, 30-year bond yields in Germany and Japan were close to zero ... A rise in yields, together with more uncertainty (over geopolitics and the future impact of AI) have, in combination, pushed up the cost of capital."

As one would expect from the professionals there is a lot to digest in their report. Below the fold I discuss the details.

Exhibit 3Equity Risk Premium (ERP), the extra you are paid for investing in stocks over bonds because the risk is greater:

This rise in yields comes after a near-record period of equity outperformance relative to bonds over 10-year holding periods

As equities have continued to outperform bonds, equity risk premia have fallen back to levels last seen in the late 1990s, leaving equity markets more vulnerable to further increases in bond yields. That said, in the US and Japan, the ERP has bounced off recent lows

Remember what was happening in the stock market in the late 90s?

Exhibit 5just fine:

But despite the rise in yields, nominal GDP and profit growth remain strong and, until recently, the impact of rising bond yields has been offset by the strength in corporate profits. Earnings growth has been the main driver of equity returns over the past 18 months in all regions (Exhibit 5). This strength has meant that PE multiples have either been flat (Japan and Europe) or have fallen (the US, Asia and EM).

In the US, in particular, the forward PE multiple for the S&P has come down from 22x at the start of the year to 19x, in line with its long-run average, despite the market being close to its all-time high.

Note that the standard explanation for the valuation of a stock is that is the Net Present Value (NPV) of the company's future earnings (or more strictly its future free cash flows). An increase in interest rates decreases the NPV of these earnings, and thus decreases the stock's PE. GS flags this:

The combination of higher cost of capital and greater capital intensity in the tech sector has reduced the value of their future cash flows and triggered a de-rating in the biggest companies. The dominant capex hyperscalers in the US now have a forward PE close to the average of the rest of the market.

Exhibit 8growth of hyperscaler borrowing:

While technology profit growth has remained strong, the surge in capex spending among the hyperscalers has increasingly eaten through their free cash flow (Exhibit 8) prompting companies to look for alternative sources of funding, in the credit and equity markets. The capex spending growth for AA-rated issuers has been substantial: the 65% year-over-year growth in Q2 marks the 10th consecutive quarter that aggregate AA capex growth exceeds 35%. They have also turned to the convertible bond market where volume has also increased year to date reaching $135 billion in the US, with AI-related borrowers driving 44% of total issuance, on our estimates.

The other sectors don't have this problem:

Supportive profit growth has been accompanied by positive earnings revisions, with 2026 and 2027 estimates moving higher across major regions. There are four broad areas which have been driving much of this profit growth. First, technology earnings continue to be very robust. Second, rising energy prices have pushed up profits in the commodity sector. Third, banks have generally enjoyed strong earnings backed by positive nominal GDP growth, steep yield curves and strong private sector balance sheets. Finally, sectors such as Industrials have benefited from the surge in AI capex spending which has spilled over into improved revenues for the ‘pick and shovels’ of AI infrastructure. The breadth of the earnings' growth has also increased the opportunity for investors to diversify across sectors as well as countries.

Exhibit 11sustainable:

Bubbles in earnings, rather than valuations, have occurred in previous periods. The Bank sector, for example, briefly became the biggest sector in the S&P 500 in the run up to the financial crisis of 2008/09 (Exhibit 11). Unlike the technology bubble of the late 1990s, or the Japanese bubble of the late 1980s, Bank stocks did not experience a major valuation bubble at the time, but the surge in earnings that drove the sector's outperformance proved to be unsustainable.

GS is squarely in the economic mainstream here. Heather Stewart and Pippa Crerar's Three international bodies warn of risks of rising debt and soaring borrowing in major economies points to other worriers:

The Paris-based Organisation for Economic Co-operation and Development (OECD), the International Monetary Fund (IMF) and the International Institute of Finance (IIF), the voice of global banking, on Wednesday highlighted the dangers of soaring interest rates on $365tn (£275tn) in global borrowing.

In its quarterly debt monitor, the IIF predicted a “structurally debt-intensive future” as governments and companies scramble to invest in new technologies and bear the costs of ageing societies.

“The buildup in global debt is set to accelerate as governments and corporates compete to boost growth and secure their positions in an economy reshaped by structural changes,” it said.