Examining the peaks and troughs of the global economy can often offer a valuable perspective for investors. However, for some time now, we’ve seen a de-coupling in these business cycles across different industries and countries, largely influenced by the impact of the Covid-19 pandemic. We think this de-coupling has created a complex investment landscape that lends itself to careful stock selection.
Exploring the economic divergence
During the lockdowns, there was a surge in goods markets as consumers rushed to accumulate ‘stuff’ but once they were lifted, people turned their attention to capturing experiences, causing a recovery in the services sector. This de-coupling is still evidenced in today’s economic data, where the manufacturing sector is lagging, while the services sector steams on ahead.
The de-coupling also exists on a country level. The US economy has strengthened its leadership position, having been the first economy to rebound back to 2019 levels and has since returned to impressive GDP growth. Europe has lagged post its re-opening recovery and continues to slip behind the US, while China has seen weak housing and consumer sentiment cause a slowdown in economic growth.
How de-coupling is playing out in equity markets
In the long term, equity prices are driven by fundamental earnings power. The de-syncing of industry cycles and income demographics presents an attractive opportunity to deliver returns in excess of the market and we are positioning the Global Focus Strategy to where we believe the most attractive cyclical and structural growth opportunities present themselves.
While the market will look towards the broadening out of earnings growth across the S&P 500, the reality is that the Magnificent 7 stocks delivered earnings-per-share (EPS) growth of 38% in the second quarter, compared to 7.6% for the rest of the S&P 500. As of around 5 quarters ago, we saw the Mag7 earnings de-couple from the rest of the market as the Mag7 started to improve profitability, something the market believes they can continue to do.
While we may disagree with who among the Mag7 will end up best positioned to profit from artificial intelligence (AI) and the magnitude of future earnings growth, we don’t disagree with the direction of travel. The Mag7 are well positioned within AI to drive growth into the future.
Considering AI in the broader market
Outside of the Mag7, we disagree with the assumption that the rest of the market can return to historical peak profitability and beyond. We see Covid as an exceptional period rather than causing a structural change in profitability. This issue is most prevalent in the low growth, cyclical part of the market, where we have our largest underweight.
For many parts of this segment, companies will need to adopt AI to remain competitive. However, without barriers to entry and pricing power, it's not clear how AI will improve margins for many businesses. UK supermarkets are a great example of how self-checkout services installed back in the early 2000s successfully took out costs, but were unsuccessful in capturing better economics for the companies themselves, as the ultimate beneficiaries were consumers.
It’s easy to draw parallels with how AI may be used by many sectors to offer chatbots at the expense of call centres, but it is likely that customers will again reap the benefits. As such, we believe there is over-optimism in the cyclical part of the market.
Challenges in the automotive sector
Autos is another example of a sector with overexuberant margin estimates. Excluding Tesla, the operating margins of OEMs (original equipment manufacturers) have gone from 5.5% pre-covid to a peak of 9.5% in 2023 and we are still early in the normalisation stage, with current margins around 7%. Consensus estimates forecast margins to begin trending higher again, but we would argue that there are very few fundamental drivers that would support higher levels of profitability. In fact, we can point to three areas where competitive forces have worsened since 2019:
- China can produce cars 30% cheaper than Europeans makers can. Even when building those cars in Europe, Chinese manufacturers are able to build cars 15% cheaper than European peers.
- EVs lower the barriers to entry. Building a combustion engine is difficult, billions of dollars have been spent on R&D to generate efficient diesel and petrol engines but an electric motor is significantly less complex.
- EVs require manufacturers to run dual platforms, one for the EV and one for combustion engines. We know that OEMs require scale advantage to deliver operating leverage and therefore doubling up on production platform, all else equal, is a headwind to profitability.
Conclusion
The de-coupling of business cycles across industries and regions, accelerated by the Covid-19 pandemic, has created a complex investment landscape. While the Magnificent 7 stocks have demonstrated robust earnings growth, driven by their strategic positioning in AI, the broader market faces challenges in returning to historical profitability levels. Spotting the cyclical risks and opportunities and separating them from the structural ones such as AI, is how we believe the Global Focus Strategy can deliver alpha for clients in future years.