We're on Bubble-watch

We entered 2026 with optimism for markets broadly, but growing concern that the market was starting to exhibit bubble like behaviour and characteristics.

Elements such as increased meme stock trading, broader speculation, excessive valuations in pockets and increased leverage in the AI ecosystem with some of the deals being done, but also increased leverage in elements of retail investing and margin lending.

So with this in mind and the expectation that this bubble was to continue, it's really important to know what matters in an environment like that and know what to track more closely.

Our aim is not to definitively call the timing of a bubble, but being aware you're in one is just as important.

And there is five key dimensions we're tracking that'll change our sentiment and our posture in the portfolio as this cycle evolves.

These dimensions include interest rates, both the level of interest rates, but also change in expectations for interest rates, the health of the economy and employment.

It's also the AI super cycle.

Will scaling laws remain intact?

Will we continue to see this AI CapEx grow?

We're going to see elements of leverage that need to be tracked more closely, but also geopolitics broadly.

As I sit here today, geopolitics are clearly in a different place and we have to track the friction and the conflict that we're seeing in the Middle East and the flow on effects of that because higher oil prices may flow through to impacts to inflation, to interest rates and potential economic and demand destruction.

But on the other side of that, we have an enormous innovation cycle in AI, which continues to show very strong growth and our expectations that will continue to grow further.

So what does this all mean for investors if we remain in a bubble like environment, We have a framework that we believe will allow us to be more active, to be more tactical.

And by identifying what matters, we believe as a bubble and the cycle grows, we will more quickly be able to identify turning points where we need to become more defensive for our investors.

Because in this environment, the absolute returns, but also capital preservation are increasingly important.

And we believe we'll be able to act more quickly and decisively with a capital preservation mindset as a result of this bubble framework.

Well, let's take a look then at perhaps market positioning, how you should be interpreting what's going on in the Middle East at the moment.

Joining us is Sam Ruiz from T Rowe Price.

Sam, welcome back.

Good to see you, Andrew.

Now, of course, no doubt your strategy at the beginning of the year is somewhat different to what we're seeing right now.

So let's begin with the immediate, then the ceasefire, very fragile.

I just mentioned there the gulf between the US and Iran are huge.

Given the list of demands, how are you treating this from an investor point of view?

I think we know nothing and I think that's something that all investors need to sit back and be humble about.

We have potentially seen a strategic misstep by the US, I think they've underappreciated Iran's weaponry and also potentially emboldened Iran with the control they have over the straight now.

Iran wants to be compensated for all the damage, whether the US does that directly or not.

I think it stood out to me some of the headlines around Trump saying, well, maybe we can talk about some of these sanctions we've got on you.

Maybe that's a way of other countries effectively paying for it.

What this all means, I think, is investors have to sit back and appreciate that the backdrop before this all began was actually really strong.

We had earnings growth, we had economic momentum, We had cyclical reacceleration, particularly in the US economy.

And the big debate right now is have we done too much damage that effectively stops all of that momentum?

And we can see the market was really desperate to rally overnight because they're saying, well, are we getting back to this environment where things can be off to the races?

I'd just sit back for a second and realize that we've set in motion something that might last for longer.

The time it takes to rebuild a bunch of these inventories can take time.

The straights are not officially even open yet and we have quarterly earnings just about to begin.

So personally, I'm really interested to sit back and see what CEOs are going to tell us in a couple of weeks time.

You talk about the damage already been done.

So even if there is no more fighting, even if the straight does reopen that impact to global economic growth, we've seen those forecast by the IMF.

How is that going to affect earnings going forward, do you think?

Yeah, well, the problem is we don't know yet because we don't know the timeline.

And it's about one to three months to get this crude flowing to where it needs to be.

Can actually take around 300 or more days to get the inventories in refined stock back to where they were, which is probably going to put elevated prices or leave us in a in an environment of elevated prices for longer.

The problem is we're starting to already see price rises in bed around the economy.

So even the US Postal Service locally, if I just think of an anecdote, Uber, Uber is all of a sudden adding, I think it was a 6% price hike and companies are going to start embedding higher funding costs because we can see in Australia versus the beginning of the year, it's now about an 80 basis point increase to expectations for the RBA's cash rate by the end of this year.

In the US, the markets expecting those two rate cuts that we were going to get are now entirely wiped out.

So these are all things that in this uncertainty, maybe we just see stickier pricing and governments and central banks are going to worry that's going to embed into the economy and we might already be seeing that happening.

So Sam, given the heightened volatility that you're saying essentially is going to remain at this point, how cautious do you want to be?

Yeah.

So we have incrementally pivoted to more defensives in our portfolio.

So overnight, we saw the relief rally and some of the stocks we've been more cautious on in financials and industrials, for example.

But we're at this point increasing a little bit more to staples, to utilities, even a little bit to energy because of the inflation hedge that does provide us.

And some people might say it's too late to move into energy because of oil prices already being biased to the downside.

But there's a lot of longer duration exposures where this sets in motion things like oil field services and increased construction that's likely to place.

These are areas in the portfolio. We just think we need to build up at the moment and have been prior to the war, we were talking about those AI opportunities, the disruption that's been caused, the cesspocalypse. How are you treating that trade now?

So still very optimistic that within AI, I think, I think there's two steps here.

Firstly, if we start to see economic impact, that's going to lower the cash flow for a lot of the big spenders on AI, the hyperscalers.

So we have to realize there's some reflexivity there.

But underlying the anecdotes we're getting from the supply chain, the picks and shovels that are actually enabling the AI compute capacity that we're seeing being built out, they're telling us they're still sold out for two years plus.

So we still think that these are companies that are going to supply AI as long as the economy doesn't turn too badly and the funding is still going to be that Capex intentions still seem to be biased to the upside.

So we're seeing there's a really important thing that everyone should monitor, it’s scaling laws basically, which says every incremental dollar that we keep spending on AI, we get better outputs, the models keep getting better.

And that is something that's going to lead to productivity growth and there's two camps here.

It's either something that this productivity growth means we sack a lot of people and we can do the same level of economic output with less people, or we can keep these people, re-engineer them into new roles and effectively do more.

There's a big debate there.

We're leaning more to the second option, which actually means this could be positive for real GDP growth going forward.

And I don't think a lot of people are even thinking about that.

Any particular companies you're focused on at the moment then?

So we're focused on balancing the portfolio for all the uncertainty, more defensives.

I'm gonna take a completely different tact and everyone's talking about energy and oil, everyone's talking about AI.

What we're really focused on is once we balance the portfolio and try to get uncertainty under wraps is where can we find idiosyncratic opportunities where regardless of those outcomes, we can do well.

One really interesting stock we're looking at the moment is a company called Sea Limited.

It's actually listed in in the US, It's based in Singapore.

Best way to think of this is this is the Amazon of Southeast Asia and they've effectively also moved into Brazil.

They've got 400 million active customers in e-commerce.

They've got 20 million unique customers last year in their mortgage online lending business and it's around 100 million active daily gamers because they've got a digital gaming franchise companies off about 30% in the last three months. Part of that is because they've announced an investment cycle.

They're actually going to take the Amazon playbook and they're going to do something similar to Amazon Prime with a VIP Network and they're going to expand the logistics network to improve the time to customer.

So that means the market's now effectively planning for a flat year over year earnings growth scenario and flat margins.

We though have a lot of faith in conviction that the company will get from about 60 basis point margins in e-commerce up to about 2 to 3%.

And if that if we're right in that the company's trading at 2023 through valuations and we're going to get the valuation expansion and the operating leverage coming out.

So accelerating earnings growth that the markets really not looking at the moment.

So with a two to three-year lens, as we really see that investment cycle play out through this year, we think you're getting paid to take that risk for a stock that has an incredibly large captive audience and as a number one player in their markets.