Better tech than oil
Equity market returns have been solid but there is a focus on why the US market has been so buoyant ahead of an expected recession. There is also concern that the majority of the positive returns have been driven by a small group of technology stocks. Come on everyone, technology is good. Future growth depends on technology, not on war-driven, super-normal profits boosting the share prices of fossil fuel extractors. Equity markets have been strong elsewhere, in markets where technology stocks do not make up such a huge share. Of course, we need to be sensitive to what happens to US growth, and growth elsewhere, and what this means for earnings. The resilience of the major economies is consistent with earnings expectations not being much worse than flat for 2023 - and recovering again in 2024. If you have a bearish view, then volatility is at its lowest levels of the year – meaning it is cheaper to hedge than it has been for ages.
I received a broker research email the other day entitled: “The calm before the storm”. Sometimes there are elements of the investment community – those that profit from higher trading volumes, wider bid-offer spreads, and volatility – that seem to actively try and encourage a feeling of impending doom. I tend to be more in the Corporal Jones camp – “don’t panic Captain Mainwaring” (a reference to Dad’s Army, a 1970s British television comedy based on the Home Guard). Volatility is part of the business, and higher volatility tends to be triggered by unforeseen news, or the actualisation of an unwelcome scenario. I discussed the threat of a US default last week – an event that might cause panic – but a softish US economic landing, the continued easing of inflation, and a peak and plateau for global policy rates close to their current levels is a well-established scenario, not one that should herald a tumult. For what it is worth, measures of implied volatility in both the equity and rates markets are close to their lows of the year. If one is worried about a market crash, it is cheap to hedge against it now.
Most of the total return from the S&P 500 this year has come from a handful of technology stocks. Information Technology (IT) stocks account for 26.7% of the market capitalisation of the index. They have had a total return so far this year of 28%, generating 7.5% of the 10% total return of the S&P index. IT hardware, semiconductor and software companies led the way. By contrast, last year’s best-performing sector – Energy – is down 8.5% and Banks are down over 10%. Instead of thinking there is something wrong with the overall market being led by dynamic, technology-focused growth stocks, I would argue it is a cause for optimism. It is surely better for the longer-term growth outlook for equity returns to be concentrated in companies that have the capacity to add to economy-wide productivity gains and advances in healthcare – such as artificial intelligence (AI) – than for them to merely represent an economic rent to fossil fuel extraction and distribution activities.
Oil and banks down
The rest of the US market might be struggling (Financials and Energy account for about 18% of total market cap) but performance has not been as bad as broadly expected. A passive exposure to the US market would have served global equity investors well so far in 2023, and a bias towards technology would have made the outturn even better. Industrial stocks show a modest positive return while the communications services sector is up 30% in total return terms. Reflecting the resilience of the labour market and the finances of the household sector, consumer discretionary stocks are also up almost 20%.
I noted recently that large-cap stocks have outperformed, being better able to benefit from the nominal growth effect and maintain strong margins even with rising costs. This is not just a US story. European equity returns have been strong. The Euro Stoxx Index returned 14.5% to 18 May. Leadership in European equities has been broader based with sectors like Travel & Leisure, Construction, Retail, and Industrial Goods & Services in the top 10 performing groups. It has paid to be overweight equities this year. Japan and other Asian markets have also been at the party.
The earnings picture
Can it continue? Away from the big technology stocks in the US, valuations are not extreme. They are certainly not extreme in Europe. On the earnings side, outcomes have been better than expected. European earnings have continued to grow, whereas earnings for the S&P 500 peaked a year ago. For the current calendar year, consensus forecasts are for US large-cap earnings to be down slightly compared to 2022’s level, while European earnings are expected to show a modest rise. For 2024, earnings are forecast to grow again with the consensus-implied growth rates for next year at 11% for the US and 8% for European large-cap stocks. Interestingly, the last three months have seen more upgrades to European 12-month earnings forecasts than downgrades, and for the first month since May last year, revisions also turned positive in the US in the most recent data.
But top-down negativism could still prevail
All of this optimism may be totally misguided. Economists are forecasting a recession in the US. Weaker demand will make it more difficult for companies to sustain pricing power so margins could come under pressure, leading to a renewed set of downward revisions to earnings forecasts. Small and mid-cap stocks have already underperformed, suggesting that there are problems in the US economy resulting from higher costs and wages, higher interest rates and the tightening of credit conditions. These problems could filter up at some stage. Or technology might have reduced its beta to GDP given the structural tailwinds coming from drivers like the energy transition, reshoring, and spending along the entire AI value chain (hardware, software development, user applications). I am reading a book on Artificial Intelligence (Human Compatible by Stuart Russell) which considers the longer-term prospects for AI and some of the moral issues around developing machines that could eventually usurp human decision-making. However, he makes the point that we have not even perfected self-driving cars yet. There is a long way to go in terms of introducing and exploiting machine learning and AI in multiple sectors across the global economy. It has the potential to boost productivity and will generate growth and investment. It is hard not to be bullish on technology over the long-term as a result. Indeed, I believe AI – together with the energy transition and huge strides being made in biotechnology – provide lots for growth-focused equity investors to be excited about.
UK exceptionalism (not a good thing)
One market or economy that is lagging is the UK. UK equity indices are underperforming global averages and returns from the gilt market have been lower than from the US Treasury or European government bonds markets. Sterling investment-grade credit has also delivered slightly weaker total returns than the dollar and euro markets, although the UK corporate bond market is delivering a higher spread than its rivals across the maturity curve. Some Brexit-supporting political commentators have made comments, mostly on social media, about sterling not becoming a basket-case currency (hurrah). However, the pound, on a trade-weighted basis, is still 10% lower than at the time of the Brexit referendum. After nearly touching parity versus the US dollar when then-Prime Minister Liz Truss tried to bend the laws of economics last September, the pound has recovered to $1.24. Yet it was trading at $1.45 in June 2016. So the UK has not been a great place to invest this year relative to other developed markets. Any returns have come from the currency bouncing from a near-catastrophe-driven oversold position last autumn.
From abroad, the UK is not attractive
Bloomberg consensus forecasts have UK GDP growth at -0.2% this year compared to +0.6% for the Euro Area and +1.1% for the US. The UK economy has been flat since the beginning of 2020 (to be fair, so have some other European economies) while the US has expanded by 5% in real terms since then. Let us not forget that the UK equity market was one of the best performing in 2022 – driven by the large exposure to oil and other commodities. Yet I cannot help wondering whether investors have become structurally bearish on the outlook for the UK – politics are messy, there is a risk of a recession coming from the Bank of England’s aggressive monetary tightening and there appears to be a constant stream of complaints from companies about the difficulty of doing business, especially exporting. There are good businesses in the UK and good returns to be had, but it is hard to see any global investors overweighting either UK stocks or gilts given the outlook.
I said I would not write about Manchester United for the remainder of the season. I am not going to. Instead, I just wanted to say congratulations to my other team – Sheffield Wednesday – for pulling off a record victory in the League One promotion play-off semi-final. They were 4-0 down from the first leg. They dragged it back to 4-4 on aggregate with a last-minute equaliser. Extra time saw the score go to 5-5 and then Sheffield Wednesday won in the penalty shoot-out. The whole drama played out in front of 32,000 fans and a television audience. This is the third tier of English football. If the current suitors of Manchester United fail in their bid to buy the club, they are welcome over the Pennines to help reawaken the sleeping giant!
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