Can Growth Survive the Higher Cost of Capital?

SPEAKER_1 (0:00)

I do wish you were here for this one, Sam, because we have a fabulous guest joining us in studio. Mamadou Abou-Sarr is here with us today, co-founder and president of V-Square Quantitative Management. Mamadou, always great to have you in, and Sam set you up beautifully. She said, as you're looking at the market, equities, bonds, and commodities may look like they're telling three different stories, but you say they're ultimately all reflecting the same underlying issue. So what is that issue? What question are all of the markets trying to answer right now?

Mamadou Abou-Sarr (0:29)

So first of all, great to be back.

For me, it's one particular question. Can the growth sustain the high cost of capital? And that's the big question mark. And we are in month-end and quarter-end, so allow me to give a sense of the snapshot. On the equity side, the word I will use will be resilient. We are landing probably flat for the month, and the S&P5 will probably be close to 0.3 at the month-end, but the quarter-end looks about 2.8 percent. So, for me, the story remains an earning growth story on the AI side supporting equity, but actually the rotation on the performance is very critical. Large cap growth outperforms small cap drastically this month.

A real asset started to have a bit of a puff out with gold down and also reach down as well, and we've seen DM still outperforming EM, but the underlying theme remains AI and resilience for equity. Fixed income, a different story. This morning, the PC gave us a bit of a sense that the early part of the curve is releasing a bit, but it will short-lived. We're always back to a longer-term story on fixed income, which is about inflation risk and cost of capital, Marli.

SPEAKER_1 (1:39)

As you look at it, if equities are pricing in confidence in earnings and AI, and the AI-driven productivity and the continuation of the buildout, but bonds are pricing in inflation and the potential for this higher cost of capital, which signals do you find yourself paying the most attention to?

Mamadou Abou-Sarr (1:58)

So it's fixed income. And for me, it's been a story of the past quarter. We've seen a large sell-off happening this quarter. So I pay a lot of attention on the medium term of the curve because it's still mean that my hurdle rate is higher. It impacts discounting rates. It actually impacts small cap. That's what we've seen this quarter, and also impacts the longer hand of the curve. For me, this is where investors need to pay a lot of attention.

I think we're hearing three stories here. The first one is basically the nominal growth. So we have a higher nominal growth. But the second part of that is that we're also committing for capital. So you can place your money in government bonds and earn 5% plus or place it in subsidizing AI infrastructure. So that's the dilemma. The last part is how do we deal with long-term fiscal risks? So these are the three things for me are driving and making attention more on fixed income this quarter.

SPEAKER_1 (2:49)

So if we look at the 10-year north of 5%, today we were north of 5.3% and we're looking at higher for longer, the potential for higher for longer at levels that we haven't seen in years. At what point do we need to have a conversation about the higher cost of capital starting to overwhelm this earnings growth?

Mamadou Abou-Sarr (3:09)

That's my concern and I think we are getting there. We're waiting to see the micro number this afternoon to see if we still have that's what I call AI a hard moment. But I think it's going to be time for repricing on the earnings growth side. The more you have a higher rate, the more it penalizes large cap growth that is expensive capital, but also small cap as well. So these two part of the markets are already showing us signs of stress as you have a higher for longer theme here. But here is my take. We got accustomed to lower rate for so long post-financial crisis. I think we're getting to what I call a normalization of fixed income rates, which means that we'll have to get used and accustomed for higher for longer money.

SPEAKER_1 (3:47)

So you brought up a great point there because people have gotten very used to these low rates, and that's a lot of the issue that we're seeing just broadly across the market, particularly in the housing market, people just can't digest these new levels. What does a portfolio that is built for this 5% plus 10-year look like compared to the portfolios of the past decades that were accustomed to those lower rates?