The past two years have seen remarkable resilience in equity markets, driven largely by the dominance of the “Magnificent-7”
Image: Nicola Mawson / Independent Newspapers
By David Philpotts
We consider some of the potential beneficiaries of a change in market leadership should the giant US technology stocks struggle to extend their outperformance.
The past two years have seen remarkable resilience in equity markets, driven largely by the dominance of the “Magnificent-7” (Mag-7).
These tech giants have all capitalised on the artificial intelligence (AI) wave to some extent, contributing significantly to the S&P 500's impressive 25% gain in 2024, with Nvidia alone accounting for nearly a quarter of this advance.
Back-to-back annual equity gains of more than 20% are rare, seen only three times in the past century, but strategists remain optimistic that the coming year will deliver more of the same, albeit with less vigour.
Combining quantitative analysis with fundamental insights to navigate the disruption and volatility of equity markets
As we look ahead, the investment environment is likely to become more nuanced and volatile. Given that much of the US market’s potential is already priced in, it should be a better market for stockpicking as investors shift their focus to regional diversification and seizing opportunities beyond the big stocks.
We outline below some of the key themes to ponder as 2025 unfolds. It goes without saying that many of these themes are interrelated but the big question to address is whether US exceptionalism will continue and what this means for the Mag-7, market breadth and opportunities elsewhere.
Certainly we believe that a combined quantitative and fundamentals approach to equity investing is well suited to today’s markets. It offers a middle ground between “hands-off” passive and more traditional active investment management approaches. The objective of such investment strategies is to capture the equity risk premium in a way that avoids high relative volatility, whilst offering the potential for a more consistent return outcome over the market cycle.
US exceptionalism is largely driven by the Mag-7
Next 12-month earnings (indexed to 100)
. Data to December 2024. The Magnificent-7 is the name given to Nvidia, Meta Platforms, Amazon, Apple, Alphabet, Microsoft, Tesla. US earnings in USD, Europe ex UK in EUR. Any reference to regions/countries/sectors/stocks/securities is for illustrative purposes only and not a recommendation to buy or sell any financial instruments or adopt a specific investment strategy.
Image: Source: LSEG Datastream and Schroders
We should not be too sanguine about the resilience of most equity markets in the past two years. Plenty of good news is priced in and there are some signs of exuberance. This increases the risks of greater turbulence ahead with several potential catalysts, not least the prospect of a global trade war and the return of the bond vigilantes after their decades long slumber.
Whilst the current macro and geopolitical outlook is unusually uncertain and almost impossible to call, a more pressing issue for us as bottom-up stockpickers is the scope for a rotation in market leadership away from the dominant themes of 2023 and 2024.
2. US market concentration is here to stay which is not necessarily a bad thing
The current high level of market concentration in the US is not unusual by either long run historical standards or when assessed next to global comparisons. Whilst portfolios can be excessively concentrated from a risk perspective, the same is not necessarily true for indices. What should matter most to investors is mispricing rather than concentration.
On this basis, we don’t see strong evidence that a bubble has formed in the big index stocks. Whilst it will be increasingly difficult for the outperformance of the big stocks to continue at the same pace, a concentrated market seems likely to persist for the time being. However, this does not preclude a rotation in market leadership.
AI has entered the mainstream in recent years and the promise of generative AI leading to significant productivity gains has led companies to spend an estimated $1 trillion on capex in the coming years. The jury is still very much out as to whether this will pay off, with a wide range of opinions that are still based on highly uncertain assumptions.
Comparisons with other inventions such as the internet may be overplayed. The internet facilitated lower cost alternatives to more expensive solutions from the outset. In contrast, AI is very capital intensive to date, and the associated costs may not decline enough over time to make the automation of tasks cost-effective. Whilst long run productivity (and earnings) will undoubtably be higher than the counterfactual without AI, we just don’t know yet by how much and over what period this will manifest.
We will need to see more concrete case studies of productivity enhancing AI applications before estimates of its beneficial impact become more certain. In the meantime, we suspect that we may be close to the peak of inflated expectations.
US equities expected to remain dominant but the pay-off from global diversification is becoming more attractive
Strong productivity growth in the US is often cited as the key driver of American exceptionalism. The evidence is clear that it has stood apart from the rest of the world over the past couple of decades and forecasts suggest that this will continue.
US productivity has soared relative to the rest of the world
Output per worker, rebased to 100 in 2008
Data from 2024-2050 are forecasts. G7 covers Canada, France, Germany, Italy, Japan, the UK and the US.
Image: Source: LSEG Datastream, Schroders and Oxford Economics.
The strongest argument for a reversal in US dominance is valuation based as the US equity market looks expensive both relative to other regions and its own history, regardless of the impact of the Mag-7 stocks.
However, the elevated earnings power of US companies does appear to justify the valuation premium, although that does not mean that the market is cheap. Regardless, much of the good news is already in the price and the prospects for attractive opportunities elsewhere have risen, boosting the case for regional diversification.
We still like the US from a bottom-up perspective but are increasingly finding opportunities in Continental Europe and Japan.
Unloved areas I: value
Value investors had another difficult year in 2024, although this was almost entirely driven by the dominance of the big US stocks. There was certainly a tendency to pay up for quality, particularly structural growth, but value was an important discriminator and worked much better outside of the US. Importantly, cheaper stocks do not appear to be fundamentally challenged.
A reversion to their longer run discount to the market would imply strong gains for value, particularly if this is overlaid with a dual focus on both value and quality. We will continue to focus on the long run sweet spot of identifying affordable quality on a bottom-up basis. This also has the advantage of offering diversification benefits if the market tips back into risk aversion mode, due to the more defensive nature of quality.
Unloved areas II: small caps are cheap for a reason but there are diamonds in the rough
It used to be the case that investors liked smaller stocks for structural reasons, because they were dynamic and represented the next cohort of large cap, or for cyclical motivations such as economic sensitivity. Both these arguments appear to be weaker today than in the past. Small caps are often cited as being “cheap” but the evidence that they are fundamentally attractive is not compelling.
When we consider the financial strength of smaller stocks, around three quarters of the US small cap universe can be considered “at risk” from a balance sheet perspective compared to less than 10% for mega caps and 17% for large caps (as at December 2024, based on proprietary indicators, source: Schroders). Moreover, the proportion of at risk US small stocks has been trending higher over time. Leverage in European smaller stocks is not as extended as in the US but they face broader economic uncertainty irrespective of balance sheet risk.
Smaller companies in Japan are more attractive as they exhibit much lower leverage and, arguably, a more stable outlook. There are certainly diamonds in the rough across regions, but this does not feel like we are on the precipice of another small cap rally along the lines of the early 2000s.
Unloved areas III: emerging markets
Emerging markets (EM) continued to lag the MSCI World index in 2024, with the MSCI Emerging Markets Index underperforming by 11.2%, despite a strong rebound in China (Source: LSEG Datastream, Schroders). We don’t find a compelling valuation case for China whilst the risk of a disorderly handling of its economy should not be discounted.
The key issues to navigate for EM investors are threefold: the extent of Trump’s tariffs, how the Federal Reserve (Fed) reacts to the incoming inflation data (and what this means for the US dollar) and China’s success in boosting domestic consumption.
It is difficult to determine how much has already been discounted but we suspect that China’s policies will disappoint, at least in the short term. Tariffs, however, may be less of a negative than was originally feared. The jury is still out on the Fed and the dollar. This all points to a more volatile year but potentially wide dispersion between countries with those supported by stronger domestic demand more likely to be favoured (e.g. India). Last year also taught us that politics and economics does matter in EM.
We doubt that anyone has the skill to predict political and economic developments with a high degree of consistency. As a result, we would recommend instead to adopt a more risk management based mindset, particularly if attractive stock opportunities lead to a notable overweight in a particular market.
King dollar in the balance with short-term momentum offset by longer term concerns
The main beneficiary of the Fed’s likely inability to ease rates significantly is once again the US dollar. Most market commentators expect that Donald Trump’s policies will drive the dollar even higher next year, even though he has frequently called for the opposite.
Perhaps the biggest argument for the dollar to fall back is that the market has already priced in a high degree of confidence that Trump will follow through. One lesson from Trump 1.0 was that actions speak louder than words. We don’t fully accept this argument but in reality, no one knows how this will play out. There is perhaps greater clarity on the longer-term headwinds facing the greenback, not least the prospect that tax cuts in the US erode confidence in the country’s fiscal position.
Real world progress on sustainability despite mixed investor outcomes
Sustainability focused investors experienced a mixed year in 2024. The performance of ESG portfolios, when measured against the standard benchmarks, was again hampered by the dominance of the big stocks.
The backlash against ESG in the US is well known and looks set to continue under a Trump administration. Europe maintains its dominant position as by far the largest market for sustainable funds. But even supporters of sustainability have been forced to clarify their investment processes due to the greater regulatory scrutiny and the potential of greenwashing.
On a more positive note, there is evidence of ongoing progress in terms of corporates setting carbon emission targets. We have noted an increase in client interest in climate solutions, as opposed to encouraging company target setting. We also expect to see an increase in the demand for nature related strategies in the wake of the recently adopted TNFD disclosures. Nature and climate are closely intertwined but the absence of a unifying metric for biodiversity (unlike carbon emissions) increases the implementation and monitoring challenges for investors.
We don’t believe that there needs to be a trade-off between sustainability and longer-term investment performance, but implementation choices are critical.
The main longer-term theme aside from deglobalisation, decarbonisation and demographics is likely to be the prospect of lower investment returns to investors. Equity investors will need to get used to sub-5% nominal returns primarily due to the high starting point of current valuations, particularly in the US market.
Global equity returns outside of the US are more attractive on a forward basis due to their more appealing valuations and the potential currency tailwind if the US dollar reverses. However, it seems highly probable that the return to a higher interest rate environment post Covid after years of ultra loose monetary policy is here to stay.
This backdrop is likely to challenge poorly managed companies and necessitate strategic adjustments by investors, which is why we maintain a firm eye on balance sheet strength across our investments.
The key investment implication is not dissimilar to last year in that equity investors have had a relatively easy ride of late but there are plenty of sources of potential risks to navigate ahead.
Whilst valuations are not extreme, they leave little room for disappointment. We would suggest that there is scope for the market to broaden without necessitating a reversal in the recent dominance of large cap growth style in the US.
We do suspect, however, there will be greater interest in diversification, particularly stocks with more defensive properties. Remaining diversified across the quality spectrum will be key.
Finally, we always resist making sweeping assertions but would flag the strong probability of higher volatility.
BUSINESS REPORT
David Philpotts, Head of QEP Strategy and Equity Solutions, QEP Investment Team for global investment manager, Schroders
Image: supplied.