Simon Webber, Head of Global Equities, Schroders, looks at the ways that increased market breadth and volatility against a resilient economic backdrop should create opportunities for active fund managers.
A soft landing for the US economy remains our central scenario and we expect equity markets to be well-supported in the medium term by modest growth in corporate earnings. In Europe, inflation has remained on a clear downward path as the eurozone and UK have emerged from shallow recessions.
This has allowed the European Central Bank and Bank of England to begin cutting interest rates. Economies such as the UK and Spain have a high percentage of floating rate mortgages and a decline in interest rates will provide some immediate support to the consumer. We are also seeing higher real wage growth in Europe and the UK, which combined with excess savings, should further support consumption growth.
The August market correction saw a de-rating in equities to reflect a more uncertain outlook for the US economy, but they have quickly recovered losses, supported by good earnings growth and the outlook for easier monetary conditions. Equity markets were vulnerable to a correction after a very strong nine months, but company fundamentals are decent and heightened volatility creates opportunities for repositioning where dislocations occur.
1. Headline valuations continue to favour markets outside of the US
Based on commonly used metrics, the UK remains one of the most attractively valued markets globally relative to its long-term history. In global equity markets, valuations continue to favour ex-US markets, particularly the UK, Japan, and emerging markets (EM) (see table, below).
However, valuations in the US market looks less demanding when you look beyond the “Big Tech” mega-cap growth stocks, which are dragging up the overall P/E multiple of the S&P 500. The Big Tech stocks have, in aggregate, benefitted from both relevant thematic exposures and strong fundamentals. In contrast, the reminder of the market has been contending with a still tough operating environment, which has dampened top- and bottom-line growth for much of this time.
2. Scope for market drivers to broaden, creating opportunities for active investors
Market breadth has remained at extremely low levels over the past year as a narrow set of stocks has accounted for the vast majority of market gains. The narrowness in markets to date has been a function of both top-down drivers – the AI thematic – and bottom-up fundamentals, represented by divergent revenue and earnings growth.
Consensus is now anticipating this gap to close somewhat, with expectations of an acceleration in earnings growth for the broader market, and a significant deceleration for the Big Tech cohort (see chart, below). The mega-cap US tech companies have demonstrated very strong earnings growth in the last 18 months, driven by renewed cost discipline and sustained revenue growth.
The benefits of that cost discipline are expected to wane in coming quarters though, bringing earnings growth down closer towards the rest of the market. In aggregate, these companies remain underpinned by great businesses and strong fundamentals, but they are vulnerable to downside asymmetry on revenue and earnings delivery relative to the rest of the market.
There is also a case for a broadening of equity market returns regionally. European economies will be more sensitive to interest rate cuts than the US economy, and in Japan real wages have turned positive after many months of contraction. Europe and the UK for example both saw a return to positive GDP growth earlier this year following a period of weaker growth and a more protracted earnings slowdown.
These regions should be further supported by interest rate cuts. European consumers in particular have higher exposure to variable interest rate mortgages (relative to the US) and companies are more dependent on bank lending. In contrast, the narrative in the US has shifted from bringing inflation under control to avoiding a recession. While a US recession isn’t our base case, there is the potential for catch-up in some regions.
3. Japanese companies remain well positioned to return cash to shareholders
We continue to see an underappreciated earnings improvement story underway that should continue to support Japanese equities. Three decades of deflation has led to corporations and individuals stock-piling their cash.
We are now seeing ongoing reforms, led by the Tokyo Stock Exchange and various government institutions, aimed at improving governance and capital efficiency. These reforms are being introduced alongside incentives such as the NISA tax free investment scheme for individuals. Such initiatives should help to put excess cash to work and raise what are exceptionally low rates of equity ownership relative to other developed markets.
As a result, we are seeing greater focus on shareholder returns as well as increased investment and capital spending. This renewed focus on productivity and profitability is further supported by a more normal inflationary backdrop that is leading to the Bank of Japan’s pivot away from yield curve control at a time when most central banks are biased towards easing.
We believe that this should provide greater support for the currency, which has eroded the returns of foreign investors for most of the last decade. As a consequence, we should see an increased number of attractive opportunities in domestically focused businesses.
4. US election: potential for increased volatility but fundamentals take precedence
The political calendar has been particularly busy in 2024. More than 40 countries representing three quarters of the global investable universe have held, or are scheduled to hold, national elections. The US election in November remains one of the most closely anticipated, with an outcome that has the potential to significantly impact geopolitical relationships.
In general, policies and policy differences of the Democrat and Republican candidates are still lacking in key areas, while greater clarity could perhaps serve to increase short-term volatility rather than reduce it. That said, where differences are apparent – trade tariffs, energy policy, deregulation of banks, drug pricing – we think the implications are clear. In either scenario, we expect to see trade policies that realign US relations away from rivals and prioritise advancing US leadership in high-tech industries.
History has shown that positioning portfolios around who you think is going to win an election is almost always a losing strategy, and it is always important to have a diversification of risk. Of course, this is not to say that we ignore the potential policy risks, but we believe it is more important to remain focused on the outlook for the economy, the direction of interest rates, the forecast for earnings growth and the relative attractiveness of valuations.
Within our portfolios we prefer to find companies that are in control of their own destiny. To this end we have tried as best we can to minimise our exposure to some of the sharp edges that are firmly in the crosshairs of policy risk.
5. Increased scrutiny around AI monetisation
The euphoria around generative AI has been a major driver of share price growth in markets over the past year. Investors have flocked to some of the clear beneficiaries in the semiconductor and data centre segments of technology.
However, revenue from AI is running near a level that is estimated at 10x less than the amount of capital expenditure currently being spent. As a result, there are questions about whether there is enough near-term future revenue to justify the current level of infrastructure buildout. These uncertainties contributed to the Big Tech stocks bearing the brunt of the de-rating in the US equity market during the August market correction. The ability of these tech companies to monetise their AI spending will remain an important theme.
We are fully aware that generative AI remains early in its innings and that the development of this technology holds huge potential to transform businesses and productivity. However, it is now facing greater scrutiny around the level of power consumption, supply constraints and the pace of revenue growth. There are also questions around whether we are seeing an overbuild that will require a consolidation phase for AI infrastructure related stocks.
