This year the S&P 500 Index and the MSCI All-Country World are posting double-digit returns, which is spectacular no matter how you look at it, especially in a year overshadowed by conflicts in Ukraine and the Middle East, as well as turmoil. politics in other regions of the world. The driving factors behind the strength of equity markets have been profit-taking (particularly in the US), along with investor optimism that this scenario will continue into 2025. At the moment, we believe that Global equities, despite high valuations, can continue to perform quite well in a relatively favorable economic context. However, looking ahead, the outlook is more uncertain, for the reasons we will explain below.
Predominance of the technology sector: dark clouds on the horizon?
In the first half of the year, six stocks (Meta, Alphabet, Microsoft, Nvidia, Amazon, Apple), or the “Mega-Tech”, represented more than half of the total return of the US equity market. As expected, these six values are related to Artificial Intelligence (AI).
Shares of Nvidia (the main maker of the chips that power AI) have risen more than 600% since the launch of ChatGPT in November 2022 (see chart below). Investor enthusiasm has been bolstered by strong revenue and profit growth across all sectors, driving US equity market concentration to record levels, as shown in the chart to the right. .
The outlook for these companies, and for the technology sector in general, remains generally positive. The largest companies are not homogeneous, but they share a common denominator. They often have specific characteristics that allow them to dominate their respective industries and generate exceptional growth, margins and profits.
Unless there is significant regulatory intervention that breaks up these “franchises,” they are likely to remain extraordinarily profitable companies and important components of global portfolios.
However, a growing problem for this group is the enormous volume of spending that is being allocated to AI. As the chart below shows, the big three AI infrastructure providers, Microsoft, Alphabet-owned Google, and Amazon, known as the “hyperscalers,” are investing gargantuan sums in an “arms race” in AI, and the pace Spending shows no signs of slowing down.
In part, this is because they can afford to invest large amounts of money thanks to the strength of their balance sheets and the strength of their cash flows. But the graph on the right shows that the forecasts for increased sales from these investments – at least in the next two years – are quite modest. The market is not sure that the monetization of these investments will be positive for shareholders.
This comes at a time when, at least for the largest technology companies, profit growth is beginning to slow. If the AI payback period turns out to be very long, investors have reason to question the sustainability of technological dominance, at least for the most exposed companies, such as Nvidia.
Equities are expensive, but high valuations can be maintained (for now)
One consequence of the current equity bull market is that it has become more expensive. Using a number of different and commonly used valuation measures, and comparing them to their long-term (15-year) medians, the US market appears to display extremely high valuations, and no other market can be called cheap. Even the least appreciated markets, such as the United Kingdom and Japan, are not cheap at all.
In this context, equity markets are quite vulnerable to some type of negative catalyst (for example, an external problem arising from the escalation of a conflict).
However, these valuations are likely to prove quite strong in the near term. From a macroeconomic point of view, global inflation remains on a downward trajectory, allowing central banks to embark on a relatively synchronized cycle of interest rate cuts.
Historically, as the chart below shows, falling rates have almost always supported equity markets. Given the current strength of the US economy, a recession appears unlikely and business confidence is likely to strengthen in some of the most interest rate-sensitive parts of the global economy.
From a bottom-up perspective, the current strength of the US economy and gradual stabilization in the rest of the developed and developing world should provide room for sales and profit growth in 2025.
Consensus earnings estimates for the next two years in major world regions are strong: average growth of 8-12% annually (source: LSEG Datastream, Schroders Strategic Research Unit, as of November 2024). Assuming stock markets do not depreciate, the return opportunities for global equities would be reasonable, if not spectacular.
Implicit in these figures and linked to the previous debate around big technology companies is the idea of a “broadening” of the markets: that is, hitherto forgotten areas, such as smaller capitalization/size companies, begin to benefit from flows of positive funds. As the chart below shows, small and medium-sized companies are cheap both against large caps and against their own historical record.
Equities are not cheap, especially in the US.
Will the technological cycle continue until 2025?
We have moved through the technological cycle, led by AI. Tech company valuations are higher and there is uncertainty over the sustainability of AI-related capex, given delayed earnings realization.
We see momentum continuing in the near term, given the potential of the technology and the reluctance of any “hyperscalers” – the big US AI infrastructure providers – to lag behind their peers.
Other areas of the technology sector remain weak and are in a prolonged down cycle. In this case, we may see an improvement from a low level until 2025, in some cases supported by improving production cycles.
Valuations are broadly favorable, but uncertainty reigns in the short term
There are three key areas of near-term uncertainty: the impact of a Trump administration, the AI push, and Chinese policy support. But valuations in many markets are generally cheap, as are emerging market currencies. Much of this is already priced in, and a stressed or uncertain environment may offer opportunities to add exposures in the coming months.