Monthly Equity Market Topics

In brief

• Politics to the fore as elections dominate the headlines. What are investors to do?
• Growth reclaims the market narrative from inflation.
• Heuristic of the month: Recency Bias.
  

Politics to the fore

In recent weeks, major political events have caused uncertainty in several key economies. After the US presidential debate, former President Donald Trump is the betting favorite, but much can change before November. Here in the United Kingdom, Labour’s landslide victory has ushered in a new government. However, its immediate impact seems likely to be limited, with attention shifting to how Keir Starmer will tackle significant economic challenges and stimulate growth in a post-Brexit environment. 

In France, the left-wing New Popular Front coalition’s surprise win in the second round defied expectations. Marine Le Pen’s National Rally came third, despite success in the first round, with Macron’s centrist Ensemble in second. With no clear majority, a coalition that excluded both the extreme left and right would likely be welcomed by markets, while one led by hard-left France Unbowed could negatively affect equities due to its fiscal stance. If the parties are unable to reach an agreement, President Emmanuel Macron could appoint a technocrat as Prime Minister, one who he believed could promote stability, although Macron’s political standing has been severely damaged. France represents 20% of the eurozone, so it’s important, and the political drama is causing uncertainty in how a new government tackles the challenges ahead and any departure from Macron’s business friendly policies. C’est la vie. 

What to do amid political uncertainty? We believe that altering your investment strategy based on election outcomes is unwise, as markets may respond unexpectedly. For instance, betting on clean energy and shorting fossil fuels after Joe Biden’s election would have proved disastrous. We expect that the economy’s overall direction will prevail, so consider remaining diversified and seek to capitalize on the opportunities that volatility provides.

Growth reclaims the market narrative from inflation 

As US macro data softens and growth slows, the more economically sensitive sectors of the market have lagged, and investors seems increasingly focused on the growth outlook and more sanguine on rates and inflation. To illustrate, copper, with its tendency to be a health check on the economy, has rolled over. Other barometers of economic activity like housing, transport and small caps, have all recently underperformed. 

The US and global equity markets continue to be dominated by a narrow cohort of AI-related companies. Nvidia and other semiconductor stocks lead this trend, along with  utilities and industrials, which also benefit from increased power demand from AI data  centers and decarbonizing.

In this environment, the big are getting bigger and the rest are being left behind, confining most market gains to a few large companies. Through the end of Q2 2024, the S&P 500 delivered a 15% return while its equal-weighted counterpart only delivered 5%. Focusing in on the second quarter, the cap-weighted index returned 4% versus -2.5% for the equal-weighted index.^₁ Even within the large caps, it has been difficult to outperform the index as breadth narrowed, with only about 26% of S&P 500 large caps outperforming the index year to date,^₂ while small caps are feeling the pain of higher rates and a slowing economy far more than their large cap brethren. Consequently, concentration continues to increase on the back of increasing earnings expectations for mega-cap stocks. However, beware of the flaw of averages: the S&P 500 is now heavily concentrated in a few names. To make a call on the S&P 500 index is to effectively make a call on a handful of stocks and not a call on the “market”, which it no longer represents. 

Morgan Stanley recently pointed out the that the spread between the market cap of the top five stocks and their net income contribution to the index is wide and continues to widen.^₃ The momentum behind the AI trade has been increasing but it also getting more crowded, and the lofty valuations of these names reflect that. The question is not whether these are good and profitable companies? They typically are. But can they keep beating the earnings estimates that are reflected in their price as economic growth slows and uncertainty abounds over the ability of some of these companies to monetize AI to the extent that investors expect? Multiples can’t expand forever, and while we have little doubt some are justified, these companies will need to deliver on earnings, because the higher the multiple, the lower the margin for error, and any disappointments will likely be met with aggressive mark downs. 

Many large-cap tech companies have reported they intend to increase capital spending by approximately $150 billion to $200 billion for 2025. Clearly, AI compute is capital intensive and absorbs a lot of cash to fund the construction and operation of data centers to handle these new workloads. The impact on earnings will come over the next few years as they depreciate and monetize these assets.

While FactSet has consensus growth for the S&P 500 at 11% for 2024, what is evident is that the growth rate for the mega-cap tech earnings is slowing after a stellar year and the rest of the market is recovering after a poor 2023. In short, the gap in earnings growth rates between the Mag 7 and the rest is closing. According to ASR, earnings growth as reported by IBES for the Mag 7 is expected to fall from 54% over the past 12 months to 27% for the next 12 months, while earnings growth for the rest of the market is seen accelerating from 3% to 9%. If correct, improving earnings breadth should support improved price breadth. 

Recency bias 

Investment choices are often distorted by your beliefs and experiences. The more recent and dramatic the experience, the more likely you are to be influenced by and attach outsized importance to it. Beware of recency bias. As our global investment strategist Rob Almedia eloquently points out, the environment has materially changed. You may be disappointed if you keep following the same strategy and expect the same outcome when many of the conditions that supported that outcome have changed.  

Endnotes

_¹ Bloomberg as at 28 June 2024.
_² Piper Sandler.
_³ Morgan Stanley – US Equity Strategy July 5, 2024, Strategy Data Pack – July 2024.

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The views expressed are those of the MFS Investment Solutions Group within the MFS distribution unit and may differ from those of MFS portfolio managers and research analysts. These views are subject to change at any time and should not be construed as the Advisor's investment advice, as securities recommendations, or as an indication of trading intent on behalf of MFS.