In brief

  • The significant gains seen in many stock markets over the last few months have made our portfolio managers a little more cautious on the outlook. Many of the best stocks are now rather expensive, and we see signs of risk  in the level of expectations for AI. Fading prospects for interest rate cuts, such an important driver of the market rally, also give us further pause for thought.
  • But fundamentals of corporate profits still look good. Profits growth has reaccelerated and broadened in the U.S., Europe appears to be improving too, and in Asia, profits are strong in both Japan and India. Globally, this looks like a much better year for profit growth after a lackluster period post COVID.
  • After a stellar performance from the best (and largest) growth stocks in recent months, many of our portfolio managers are turning their attention to less expensive choices in the more cyclical, industrial areas of the market. There is still a strong preference to invest in better quality, more predictable companies, however. Outside the U. S., we see gradually improving fundamentals in Europe, high prices in India and continued fundamental woes in China at least partially offset by low valuations for investors.

Taking stock

2024 still looks like a very respectable year for corporate earnings growth around the world. U.S. companies are leading, helped by a resilient domestic economy, strong pricing power and of course leadership positions in the all-important technology sector. Our expectations have actually risen slightly in recent months and the long-awaited broadening of profits growth appears to be underway. 

We see a favorable outlook for earnings. But after remarkable gains across many markets over the last six months, our portfolio managers are a little less excited about the outlook, with very few expecting above average market returns from this starting point. High valuations in the most fashionable areas of the market (again) and lingering worries over the macroeconomic outlook restrain our enthusiasm a little. Equally, though, only a few of our investors expect unusually poor returns ahead. 

We do see plenty of opportunities for stock selection, with the spread between cheap and expensive stocks still historically wide across global equity markets. From a quantitative standpoint, the financial, healthcare and energy sectors both look low priced by past standards. Of course, technology looks expensive. 

Our portfolio managers’ new ideas have taken on a more contrarian flavor of late, with value themes again more popular. The best companies may still be great long-term investments. But many look more fully priced where the leaders in technology and luxury goods sport very lofty multiples. 

Many portfolio managers are willing to add to stocks with a greater degree of economic sensitivity, but quality remains a sought-after attribute. Commodity stocks vulnerable to continued economic struggles in China and high-priced momentum plays in India top the list of areas to de-emphasize.

A decent year for profit growth 

Our expectations for corporate profits have been generally very stable in recent quarters, and we continue to see 2024 as a much better year for earnings growth across global markets after two years of stagnation (Exhibit 1). American companies continue to lead, with double digit gains expected against a backdrop of sustained economic growth. 

Consumer spending remains strong, if more value focused, the corporate sector is investing heavily in data centers and government spending is providing additional strength. This year we see earnings growth broadening out beyond the mega cap technology names that drove most of the aggregate profit gains last year. Perhaps ominously for bond market bulls, company pricing power remains generally strong. 

We have also seen positive earnings revisions in Japan. In Europe, the weaker local economy is leading to some mild downward revisions in near-term expectations, but there are signs that the outlook is improving. The euro area economy appears to be stabilizing, input prices are down significantly, and pricing is resilient. European companies are paying more attention to their (often long suffering) shareholders too, in the form of dividends and stock buybacks. Unsurprisingly, the less fashionable banks and industrial sectors look especially cheap in our work. 

China remains a particularly weak spot for profits for both shorter- and longer-term reasons, and our earnings forecasts remain under pressure as we reassess the outlook company by company. Much of this is well known and discounted, but uncertainty about government policy towards business remains a headache for forecasters.

Artificial intelligence: Revolutionary, but some warning signs appear 

Inevitably the theme of artificial intelligence took up plenty of time again at our Investors Quarterly. Technology stocks, especially in the U.S., have now led equity markets for more than a decade, with the S&P 500 technology compounding gains of more than 20% for the last 15 years. 

We returned to the topic of AI again and again drew some-what mixed conclusions. Yes, the surge in spending on data centers is impressive, showing no signs of slowing and with broad implications for overall electricity demand across the economy. But most end user companies of AI are still in the experimental stage; our analysts do not think that AI is fully “enterprise ready” just yet. 

The longer-term potential appears vast, but there is a risk of a disconnect in both fundamentals and market expectations between the vast scale of investment to build the data centers and the pace of final demand for those data centers. Returns are uncertain. 

So what to do? We have maintained plenty of investment in the most likely AI winners but trimmed these holdings back in recent weeks, looking more actively for opportunities in related areas such as the electricity grid. 

From a quantitative point of view, we are watching closely for rising signs of risk in the names with the best price momentum. Price momentum has been a powerful force in markets and now matches what we saw in the late 1990s, although today’s winners are fundamentally much stronger. We now see a closer relationship between momentum and high-risk stocks, but it remains well short of the danger levels that we saw at the end of the 1990s and again in early 2022 (Exhibit 2). 

Since 2020, the weighting of Indian equities in the MSCI Emerging Markets index has risen by 10 percentage points to 18%, almost mirroring the decline in the weighting of Chinese stocks over the same time frame (Exhibit 3). The big picture does look very favorable, with India boasting both faster economic growth and much less debt. Our research team sees continued growth in profits, up a projected 17% this year, driven equally by revenue growth and margin expansion. 

Despite the obvious fundamental attractions, India’s high valuations pose a clear risk for investors. This is especially the case in the small/mid-cap space, where multiples now exceed 35x on average. Real estate stocks, for example, often now trade at over 60x earnings, and consumer staples at over 50x. We can identify plenty of attractive secular trends (increased power demand, renewables and green energy, infrastructure, and construction) but finding stocks at attractive prices is another matter altogether. We will look for better opportunities to make additional investments in India.

Exhibit 4 shows the views of our team members. Many prefer quality stocks and find less expensive choices among cyclicals.

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