Great expectations

Equity markets rode an Artificial Intelligence (AI) wave in 2024 and while the ‘Trump Trade’ took over following the US Presidential election in November, a rising tide did not lift all boats. It was a year that saw a small number of technology stocks drive indices higher with narrow performance leading to increased concentration in mega-cap names. Markets continued to advance in December, as quantum breakthroughs, Guinness shortages, and soaring cocoa prices hit the headlines.

Looking to 2025, will the tech winners continue to lead, or will performance broaden out to sectors left in the dust by high expectations for AI? Forecasts for interest rates cuts in the US have declined but the European Central Bank is set to ease monetary policy much further and this may entice investors currently in thrall to US exceptionalism. Meanwhile, with Trump’s victory on a promise to cut taxes, slash regulations, hike tariffs and deport illegal immigrants - the return of governance by tweet could see markets buffeted by plenty of noise.

In a ‘picture of resilience’, the OECD (Organisation for Economic Co-operation and Development) sees a slight strengthening in global economic growth to 3.3% in 2025 and 2026. Inflation is projected to return to central bank targets in almost all major economies by the end of December or early next year. Curbing this optimism, uncertainties include the risk of geopolitical tensions disrupting energy markets and supply chains, or protectionism constraining competition, boosting prices, or impeding productivity.

America first

At the aggregate level global equities are trading at a premium to long term averages, which isn’t surprising after two years of double-digit returns. But valuations have been pushed higher by the United States, which now accounts for two thirds of the global index. Excluding the US, developed world equities are trading bang in line with long term averages.

The S&P 500 is on 22 times 12-month forward earnings compared to the long-term average of 17 times. Now you can argue that the composition of the index has changed over time, the weighting of asset-intensive industries is lower than it used to be, potentially justifying a higher multiple. In 1980, asset intensive sectors such as manufacturing, financials and real estate - were 70% of the index. Today, asset-light, innovative companies are 50% of the index. But you always need to be wary of people saying that things are different this time.

In 2024, the gap in performance between the US and Europe was the widest since 1976, which was also a US presidential election year, with Jimmy Carter beating Gerald Ford. A resolution of the war in Ukraine or a loosening of government purse strings following elections in Germany, could see sentiment towards Europe improve.

In the US, earnings are forecast to grow at a double-digit pace in 2025. Typically, analysts’ earnings estimates are trimmed as the year progresses. Lower expectations for European profit growth provide a less demanding starting point.

Dominant technology

The top performing sectors over the last twelve months were Communication Services, Technology and Financials. While the weakest sectors were Materials, Healthcare and Energy. The so-called ‘Magnificent 7’ stocks - which includes Microsoft, Apple, Nvidia and Alphabet - drove the returns in Technology and Communications. The tech sector alone accounted for well over a third of global equity performance. Drilling down to stock level, AI chip designer Nvidia contributed almost 40% of tech sector performance.

It was US companies that propelled the Financials sector higher. JPM Morgan climbed 41%, as the banking giant raised revenue guidance through the year and increased its dividend twice. In the first nine months of 2024, the four biggest US banks – JPMorgan, Bank of America, Citigroup, and Wells Fargo – captured their largest share of the industry’s profits in almost a decade. Financials may benefit from the deregulatory intentions of the new Trump administration.

Only one sector declined last year, with Materials dragged lower by China’s sluggish economic performance. The country accounts for 50% of the demand for most metals and mined products. The authorities have pledged to revive the economy amid threats of a new trade war with the US. The head of the world’s largest miner by market capitalisation, BHP, now sees ‘green shoots’ in the depressed property market after Beijing unveiled a stimulus package.

Overall, the defensive bond proxies lagged in 2024 as forecasts for interest rate cuts in the US diminished. Consumer Staples and Healthcare companies offer high dividend yields, which become more appealing as bond yields fall. In the event of market drawdowns, food and beverage manufacturers, and pharmaceutical companies can potentially outperform.

The case for equities

(1) Big tech won in 2024 because the companies delivered high earnings growth. Looking at the true tech stocks in US mega-cap – the ‘Magnificent 7’ excluding Tesla – we get the ‘Mag 6’: Microsoft, Apple, Nvidia, Amazon, Alphabet and Meta.

The gap between earnings growth for the ‘Mag 6’ and the rest of the S&P500 peaked at an enormous 60% but it is set to shrink to a 5% gap by the fourth quarter of this year according to UBS. That’s due to a forecast recovery in manufacturing, which has been in the doldrums, and easier year-on-year comparisons for stocks outside the technology sector.

Broader earnings growth should be healthier for the market, it would mean less stock-specific fragility. The king of AI, Nvidia, was up 171% in 2024, and it accounts for over 6% of the US market. Is Nvidia expensive? Well, Nvidia trades on 30x sales. The overall US market is on 3x sales. Options trading tells us that Nvidia’s earnings have been a very big deal for the overall US stock market. In the run-up to quarterly results, the day’s implied move for the S&P 500 tracked Nvidia’s own implied move, suggesting more risk from one company’s earnings than for the next labour market release, inflation print, or US Federal Reserve meeting (Source: Bank of America). That is the definition of single-stock fragility.

(2) Corporate balance sheets are in decent shape - it is governments that are indebted. For example, US corporates have a record US$7.7 trillion in cash, providing them with the flexibility to deal with uncertainties and the capacity to take advantage of opportunities.

Merger and acquisition (M&A) activity picked up in 2024, rising 16% to US$2.3 trillion in the first nine months as reported by LSEG. It’s notable that the largest agreed deal involved a well-regarded, privately held acquirer in a somewhat out-of-favour sector. Family-owned Mars will pay almost US$36 billion to take over Kellogg’s successor Kellanova, adding Pringles crisps and Special K to a portfolio of brands that includes M&Ms and Pedigree dog food. A more permissive approach by competition authorities would encourage further corporate consolidation in 2025.

(3) There’s plenty of cash on the sidelines with US$6.6 trillion sitting in money market funds. And there’s a big buyer of stock – the companies themselves. In the US, share buybacks have exceeded share issuance for the last three years. It’s interesting that the supply of equities is shrinking at a time when the supply of government bonds is expected to rise to fund deficits.

(4) Activists see value. Campaigns by activist investors increased last year, with demands focused on M&A, board change, and capital return (Source: Barclays). Honeywell became a target after its shares underperformed for several years. Being a diversified industrial conglomerate is less fashionable than it used to be. Activist investor, Elliott, took a 5% stake and called for a separation of Honeywell’s aerospace and automation businesses. It’s a ‘sum of the parts’ thesis and Elliott argued for 50% to 75% upside over two years.

(5) Equities provide a hedge against moderate inflation. This is the most basic reason for investing in real assets – we seek returns that will beat inflation and maintain the true value of our portfolio. The US stock market has the longest history, and S&P 500 earnings per share growth has kept pace with inflation in data going back to 1900 (Source: Bank of America).

Quality compounds over time

There are lots of things to worry about from market concentration to geopolitics. We know equities can be volatile over the short term. Investing requires time - it’s about the long term. You need to diversify to spread risk and while AI is an important theme, it’s not the only one. Expectations for AI are high; positions are crowded and there’s surely an element of hype. There are lots of other growth themes including automation, electrification, increasing longevity, and the rising middle class in developing and emerging markets.

Momentum was a major factor last year. Shares didn’t rise in unison and many stocks were left behind in the narrow rally of 2024. Looking below the overall index level, there are lots of individual stock opportunities, where investors can take advantage of attractive valuations and low expectations.