Diversify Beyond Mega-cap Stocks

Resilient earnings and solid economic data continue to support the global equities rally that began last November. But the manufacturing recovery and continued strength in consumer spending have put upward pressure on inflation, reducing the number of expected rate cuts by the Federal Reserve (Fed). At the May Federal Open Market Committee (FOMC) press conference, Chairman Powell all but eliminated the probability of additional rate hikes but didn’t signal when the Fed would begin cutting.

So, despite solid economic growth and encouraging corporate fundamentals, sticky inflation and the Fed’s data-dependent approach mean continued uncertainty on the rate path will impact rate sensitive equities. And, the longer the Fed delays rate cuts, the more relevant downside risks become.

In a higher-for-longer interest rate environment, for example, we remain cautious about the downside risks to US large-cap earnings growth beyond big tech — even though S&P 500 companies have exceeded earnings expectations by a large margin in Q1 and positive revisions are at a year-to-date high.¹

On the other hand, if cooling inflation allows the Fed to cut rates aggressively in the second half of 2024 without a looming recession, small caps’ low single-digit growth projection looks achievable given significant downgrades in their 2024 earnings over the past six months. And small caps’ near decade-low valuations relative to large caps certainly provide a better risk/reward trade-off.

Despite this monetary policy uncertainty, the US is still expected to lead growth in developed countries. But the eurozone economy has shown positive development, with faster-than-expected Q1 GDP growth and continued disinflation. Additionally, the European Central Bank (ECB) has clearly signaled rate cuts will begin in June with more coming by year end. Along with positive earnings sentiment and attractive valuations, this supports our constructive view of eurozone equities.

To prepare for the wide range of economic outcomes from the Fed’s inflation battle and divergence between the US and eurozone monetary policy, consider diversifying portfolios with:

• Equal-weighted exposure to Tech leaders for resilient growth without concentration
• US small caps at attractive valuations to position for rate cuts
• Eurozone equities that may benefit from rate cuts and potential economic revival

Tech Leaders: High Quality to Sustain Resilient Growth

Today’s extreme market concentration — driven by a few mega-cap, AI-related stocks — rivals levels seen during the Dotcom era. And it’s caused investors to question whether the AI hype over the past 18 months has created a valuation bubble.

Magnificent Seven (Mag 7) stocks’ price-to-earnings multiple (P/E), based on the next 12 months’ earnings, has expanded 44% since the end of 2022 compared to 14% for the rest of the S&P 500. Yet, Mag 7 valuations are 35% below their pandemic peak and 9% below where they were before the Fed signaled the start of the rate hike cycle.² More importantly, the Mag 7’s rally has been driven more by stronger growth than by multiple expansions. Changes to their forward P/E accounted for 29% of their total return since 2022 compared to nearly 60% for the rest of the S&P 500.³

There’s no question that growth momentum in AI applications and infrastructure remains strong, despite the current economic uncertainty. Q1 earnings results from Microsoft, Amazon, Alphabet, and Meta show both higher AI spending through 2024 and gains in AI-aided revenue.⁴ As organizations transition from early experimentation to aggressive data infrastructure-building to broadening adoption, worldwide spending on traditional and generative AI is projected to grow by 31% and 86%, respectively, on an annualized basis — surpassing a total of $300 billion in 2027.⁵

The resulting industry and geographic concentration of the Mag 7 will further reduce the diversification in investors’ equity portfolios. That’s why we favor an equal-weighted exposure to Tech leaders across multiple sectors and countries (the NYSE Technology Index) to capture companies most likely to benefit from the broadening of AI applications and monetization. This includes software development, online consumer platforms, social media, and AI infrastructure (e.g., advanced chip makers and cloud computing) companies.

Due to their high quality characteristics and strong earnings growth, these Tech leaders offer quality growth exposure. In fact, their aggregated earnings grew by 22% in 2023, compared to 1% for the S&P 500.⁶ Based on consensus earnings estimates, this less concentrated Tech leader exposure is expected to outpace the broad market again this year with above 20% growth.⁷

While this growth advantage will likely narrow in the next few quarters as the broad market plays catch up, the near-term earnings growth visibility of these Tech leaders is better, given the increases in AI-related monetization and capital expenditure spending revealed in Q1 earnings releases. As a result, their earnings growth estimates for the next three quarters were raised by large margins since the start of the year, compared to negative revisions for the rest of the market (Figure 1).⁸

Tech leaders’ strong profitability and healthy balance sheets are also attractive, particularly in a higher-for-longer interest rate environment. After having focused on growth efficiency and cost cutting over the past two years, Tech leaders’ profitability has improved significantly. Their return on equity is at record highs on an absolute and relative basis.⁹

Strong balance sheets, where long-term debt to capital ratio is near its lowest since 2018, should help Tech leaders continue to invest for future growth, even with high financing costs.

US Small Caps: Fed Cuts Support Growth and Valuations

Though recent inflation trends posed some risks to the soft landing, progress on goods inflation and cooling wage inflation warrant less restrictive monetary policy in the coming months if the Fed is to achieve its dual mandate of maximum employment and stable prices. Solid economic growth, coupled with potential rate cuts not driven by a looming recession, provide a positive backdrop for US small caps, especially given their attractive valuations.

Thanks to a solid labor market and continued strength in consumer spending, the US economy remains resilient, despite expanding at a much slower pace than it did the second half of 2023 due to the drag from trade and inventories. Positive real income growth, alongside a $37 trillion increase in household wealth since the pandemic, should support consumption in the coming months.¹⁰

Weaker-than-expected April payrolls and a 0.1% increase in the unemployment rate drove negative headlines. But given how payrolls surprised to the upside in Q1, we view the recent slowdown in payroll gains plus moderating wage inflation as a positive step toward a better supply-demand balance in the labor market, not a threat to consumer demand.

Since the beginning of the year, the consensus US GDP forecast for 2024 has been upgraded to 2.4% from 1.3%.¹¹ The Atlanta Fed GDPNow estimate for Q2 real GDP growth has been above 3% since late April, signaling solid growth in the first half of 2024. But even against this solid economic backdrop, earnings sentiment in small caps has been gloomy this year as Treasury yields rose to above 4%. Small caps’ earnings per share (EPS) estimates have been slashed by more than 5% since the start of the year, with growth expectations falling to low single digits, compared to their 12% estimate from six months ago and the 11% estimate for their large-cap peers.¹²

Rising Treasury yields definitely burden small caps more than they do large caps, mainly because small caps issue more short-term debt and are more sensitive to the current high interest rates. Indeed, small-cap current valuations are pricing in a significant level of financial stress for companies, with small caps’ forward P/E 13% below the long-term average and at a 30% discount to US large caps (Figure 2).

But we believe peak interest rates are behind us.

And rate cuts in the second half of this year amid a solid economic environment would ease pressure on small-cap valuations. Given their bearish earnings sentiment so far this year, a resilient US economy may support small caps to deliver upside surprises in the second half, potentially outperforming large caps as US earnings growth broadens out.

Eurozone Equities: Strengthened by a Dovish ECB and Economic Momentum

Green shoots of an economic rebound in the eurozone have appeared in macroeconomic surveys and earnings fundamentals after the region’s annual growth decelerated sharply last year to 0.4%.

In April, the Eurozone Composite PMI (Purchasing Managers Index) indicated overall business activity had expanded at the fastest pace over the past 11 months, driven by above-trend growth in the service sector.¹³ Although manufacturing PMI took a breather from its recent rebound, a shallower decline in output and a two-year high in business confidence support positive development.

Record low unemployment, strong nominal wage growth, and steep disinflation provide a powerful boost to consumer income, potentially supporting domestic consumption and continued expansion in the service sector. A stabilizing Chinese economy may help pull Germany, the largest economy in the eurozone, out of the manufacturing downturn.

Historically, increasing Composite PMI bodes well for positive earnings sentiment (Figure 3). At the beginning of May, earnings upgrades outpaced downgrades for the first time in 10 months as the region’s economic recovery progressed.¹⁴ Despite lower growth estimates compared to the beginning of the year, Q1 earnings beats came in stronger than Q4 and above the historical average thanks to resilient profit margins. This suggests room for greater upside surprises in the coming quarters if positive economic momentum continues.¹⁵

Meanwhile, steep disinflation and weak economic growth have opened the door for the ECB to dial back policy restrictions. While eurozone inflation peaked at a higher level and later than in the US, it’s made greater progress toward the ECB’s target. Core inflation has fallen from its peak of 7.5% in March 2023 to 2.8% in April. The replacement of Russian gas suppliers with American ones, warm weather, and prudent energy consumption all resulted in eurozone headline inflation declining even more steeply to 2.4% in April.

As a result, the central bank has strongly signaled rate cuts would begin in June. Our economists project a total of 100 basis points of cuts this year as their baseline view. With a dovish ECB and steady global demand, a meaningful economic rebound is achievable for the second half of the year, supporting an earnings recovery.

Eurozone equity valuations have become more expensive compared to last year due to the equity market having reached all-time-highs, even outperforming the S&P 500 year to date. But the market’s forward P/E ratio (13.8x) is still below its 10-year average (14.8x).¹⁶

Relative to US equities, eurozone equities are trading at a 15% greater discount than the historical average — around the bottom decile of the past 10 years.¹⁷ Given the prospect of monetary easing and continued positive economic momentum, these valuations may have room for further expansion.