Narrow markets, wider opportunities

Global equities have delivered strong returns year to date, with the threat of inflation subsiding and faith in the ‘soft landing’ narrative spreading. The first half of the year was dominated by mega-cap tech and the artificial intelligence (AI) theme. A few securities drove indices up, while many stocks were left behind in the rally. According to Citi, companies with high exposure to AI accounted for 14% of the global market by capitalisation but had an outsized impact on performance, driving almost half the market’s return in the six months to the end of June.

Narrow performance led to increased concentration, particularly in the largest and most important region, the United States. The US accounts for two-thirds of the global equity universe and concentration is unusually high. Mid-summer, the top five stocks in the S&P500 - Microsoft, Apple, Nvidia, Alphabet and Amazon - peaked at almost 30% of the index. That compares to 18% for the top five stocks at the height of the tech bubble in 2000, remembered as an exclusively one-track market.

In the third quarter, we saw some rotation from tech to other sectors. Broader performance corresponds to an expected broadening of earnings growth. It also reflects some concerns about the heavy spending on AI infrastructure by the tech giants, the high weighting in the AI theme, and the valuation gap that emerged between the market leaders and laggards. Year-to-date, tech is still in the lead, although the Nasdaq remains shy of its July peak.

AI and the race to create a ‘Digital God’

If last year was about the ‘Magnificent 7’ stocks, this year, Nvidia played top gunslinger. The company designs the semiconductor chips that are powering AI, and it’s enjoying huge demand for its leading-edge products. By the summer, Nvidia’s market value had soared above US$3 trillion.

Some 10% off its peak, the shares have still returned 145% year-to-date (in USD terms), accounting for over a fifth of the increase in the US stock market. In the most recently reported quarter, sales more than doubled and operating margins were over 60%.

Nvidia’s biggest customers - the large data centre operators – generate 40% of its revenues, and therein lies the risk. On the quest to create a ‘Digital God’, Microsoft, Amazon, Meta and Alphabet have ramped up capital expenditure. Notwithstanding the opportunities, at some point the AI infrastructure arms race will slow.

When growth is scarce, the market pays up for growth

Large-cap technology outperformed for a reason – it has generated most of the earnings growth. Excluding the Magnificent 7 stocks, the S&P 500 spent 18 months in an earnings recession. The second quarter marked the first period of collective earnings growth for the ‘other 493’.

So, while the US economy didn’t contract, corporate earnings (ex-mega-cap tech) did. The explanation for this apparent paradox lies in composition: the services sector accounts for 80% of the US economy but it only generates 50% of earnings. The pandemic shut down services and drove higher consumption of goods. Normalisation of demand post-pandemic, together with the destocking of inventory, led to a downturn in manufacturing. Now, with the support of lower interest rates, profits for the remaining S&P 493 are forecast to pick up.

Industrials – secular trends combat cyclical contraction

The Industrials sector is one of the most diversified, with end markets ranging from aerospace to agriculture. Exposure to secular growth themes has propelled some of the top performers.

Electrical equipment maker Eaton is benefitting from several ‘megatrends’ including reindustrialisation, energy transition and the boom in AI infrastructure. Globally, over US$200 billion will be spent building and kitting out datacentres this year. Electrical equipment accounts for around 7% of that bill. Such are the power demands of large language models; Microsoft made the headlines with an agreement to reopen the Three Mile Island nuclear plant in Pennsylvania. In 1979, it was the scene of the most serious nuclear accident in US history. Microsoft aims to be carbon-negative by 2030, and nuclear power is carbon-free.

Seeming to straddle two different worlds, if you look at the operating results of German industrial giant Siemens, you’ll see both secular growth and cyclical contraction. Its smart infrastructure business is benefitting from the high demand for electrification. For its digital industries division, the market for industrial automation, particularly in China, remains challenging.

With the rise in global great power competition, the war in eastern Europe and conflict in the Middle East, defence contractors are in demand. Munitions reserves are low, requiring replenishment. Lockheed Martin has risen to record highs. Of course, there are always risks associated with government funding and execution issues delaying programmes.

Consumers - adapting to the cost of living

Consumer-focused companies from PepsiCo to McDonalds have seen lower income households rein in spending as they cope with the higher cost of living. These businesses have the scale to drive efficiencies while investing in marketing. An above-market dividend yield adds to the appeal of the consumer staples sector as interest rates are on the decline.

International brands with exposure to China have spoken about the depressed sentiment in the region. The Chinese authorities were slow to stimulate the economy, but they’ve finally announced both fiscal and monetary support to boost activity. Has the sleeping dragon awoken? As the quarter ended European luxury goods stocks leapt on the news. Chinese consumers account for around a third of the sector’s sales.

A string of profit warnings hit the European auto sector. Trading at very low valuations, it’s an industry that struggles to make its cost of capital. The transition to electric vehicles has evolved into a survival test. Volkswagen, Stellantis, BMW and Mercedes are caught between weak local demand, and low-cost competition from China’s electric vehicle makers. For the first time in its history, Volkswagen plans to close factories, bringing it into conflict with unions.

There have been several changes at the top of consumer companies as boards aim to invigorate sales: Nestle, the world’s largest food company, replaced its CEO of eight years with a long-time corporate insider, Starbucks shares jumped 25% on the news that Brian Niccol had been lured from Chipotle Mexican Grill to fire up sales, and Nike rehired a formerly retired executive to lead the business.

Healthcare - ample profits from weight-loss drugs

As a fairly defensive sector, healthcare has lower sensitivity to the economic cycle. People still fall ill in recessions, but they may put off elective surgeries. The GLP-1 (Glucagon-like peptide-1) weight-loss plays, Eli Lilly and Novo Nordisk have significantly outperformed their pharmaceutical peers. These are growth stories with elevated valuations to match.

Healthcare is a broad industry ranging from pharma to medical technology - the hip and knee implant makers - to medical insurance providers. Drug makers require productive research and development to populate their pipelines and generate future growth. There’s been a steady stream of deal activity, with companies supplementing their pipelines from external sources. Large-cap pharmaceutical companies have the funding to bring the discoveries of small and innovative biotechnologies to market.

The tech sector has been the epicentre of enthusiasm for AI but in terms of applications, drug discovery through simulating models is one of the more plausible uses of AI. That could be a positive for the sector long term.

The enduring appeal of capital discipline

As investors, we want companies to be disciplined in their use of capital.

(1) Don’t waste money on redundant capital expenditure. The AI datacentre splurge will surely involve some overspend.

(2) Return value to shareholders through steady dividends. It’s not just about rising share prices, dividends are an important part of total return, accounting for 40% of S&P 500 returns from 1936 to 2010 but only 15% since 2010. Lower rates mean less competition for the dividend yielders.

(3) Only engage in acquisitions that will add value. On that front, recent moves in the Eurozone banking sector could be an important step toward a long hoped for financial union in Europe.

In September, Italian bank UniCredit built a 21% stake in its German counterpart Commerzbank but its plans for a full takeover were met with intense government resistance. In the same week, another prominent Italian, former European Central Bank President Mario Draghi, delivered a 400 page competitiveness report to the European Commission. Strengthening funding for industry and infrastructure was a critical component of his review.

Draghi noted that Europeans have more savings than Americans, but cash is stuck in bank accounts within national boundaries. Americans invest far more in large and deep capital markets. At almost US$600 billion, JPMorgan’s market capitalisation is greater than the top-10 EU-based banks combined because Europeans do less with their money, market activity is weaker, and banks earn far fewer fees.

Could consolidation close the valuation gap between US and European banks? In shaping the future, corporates may have the vision but governments have the power.

Invest don’t speculate

Overall stock market valuations are above the historical average – reflecting the high weighting in large-cap tech. Adjusting for this market concentration, valuations are closer to the long-term average. And there are plenty of share prices that have gone nowhere for years - stocks that derated as interest rates rose, valuations that adapted to the higher rate environment.

Now we’re in a new phase, central bankers are loosening monetary policy, and a lower discount rate is positive for valuations. Are there risks for equities? Yes, but there always are. Whether it’s monetary policy error, geopolitical manoeuvres, or disruptive technologies.

We’ve been through an unusual cycle since the pandemic, and it’s been difficult to read economic signals, whether as an investor or a central banker.

At the beginning of 2023, there was a general consensus that the US economy would enter a recession. It didn’t happen, although we did see an earnings recession across several sectors, while growth in Europe has been sluggish, and China has struggled.

40Companies and individuals emerged from the forced recession of the pandemic with sound balance sheets and high savings, which is unusual after a downturn - the debt grew at government level. Supply chain issues and high demand for reopening drove inflation, leading to the fastest pace of interest rate increases in 40 years. Then CHATGPT exploded onto the scene and the AI theme became the focus for markets.