A strongly performing equity market, aside from the 2022 bust in growth stocks, has seen Nvidia, headquartered in Santa Clara, California, on course to gain superstock status. Its market capitalisation was hovering around the $1trillion mark at the end of May. The world’s most highly valued semiconductor/chip maker has become synonymous with Artificial Intelligence (AI) and as the tentacles of AI reach, with accelerated momentum, into everything from the interpretation of hospital X-rays to writing music, the company is fast becoming a household name.
It joins an elite cohort with Meta, Apple, Alphabet, Microsoft and Amazon. These equities, aligned to global businesses, are driving a wedge between their market leading performance and the more moderate gains of the rest of the market. For an investor that has a remit which allows for a focused portfolio, this may be a dream scenario if this collection of stocks was put in place before prices took off, but for managers tasked with building diversified investment portfolios that spread risk and balance returns, it creates a conundrum. Indeed, the top 5 largest companies in the US now account for almost a quarter of the index exposure, with the top two stocks (Apple and Microsoft) accounting for greater than 7% each. We have never seen such concentration in the US market for the greater than 40 years for which data exists.
A backdrop of extended valuations
Our portfolio was well diversified in 2022 and, in a tough year for market returns, that stance was positive in relative terms. We held large cap US stocks but were light against benchmarks, wary of extended valuations in that area and the impact of rising interest rates. We kept an eye on the shifting dynamics between value and growth stocks, trimming the former earlier this year as we expected that the economic and earnings cycle would turn down. We anticipated an economic slowdown and considered the possibility of a recession.
We divested some of our value exposure, particularly in the US, and reinvested the proceeds into Europe and the emerging markets (EM), at the start of this year, expecting a widening in performance beyond the leading US market. We also topped up some of our exposure to large technology names through an increase in US growth exposure. Coming into 2023, China was opening up again after the Covid lockdowns and EM markets were enjoying relatively faster growth than developed markets. But EM has not performed as well as we might have expected. Europe performed much better as the absorption of energy price spikes were eased by a milder than usual winter. We took profits on our European equities in late May, leaving proceeds in cash and reducing gearing further.
A rapid and sharp adjustment in valuations
US equities should perform well but with performance so highly concentrated in just a small number of stocks and valuations at an extreme relative to history, the prospects for longer-term returns are subdued. The Nasdaq has rapidly moved into a bull market and, while the long-term implications of AI could be profound, the rapid and sharp adjustment in valuations suggests that much of the prospective good news is already in the price. European equities may well have moved out of a sweet spot and, with the European Central Bank still intent on rate hikes, and after a pronounced period of outperformance, near term return prospects are less exciting.
We have a small but overweight position in UK equities based on our view that this long unloved area represents a very interesting valuation opportunity for longer-term investors. The market is also defensive, although it may be exposed to a wider economic slowdown if it unduly impacts on commodity prices. Japan is interesting. It has performed well but is trading at a discount to global peers and is benefiting from an increased focus on delivery of shareholder value. Monetary policy remains loose, and inflation is finally beginning to pick up which may encourage domestic investors from their significant holdings in cash deposits.
Interest rates and the economy
We are not expecting a pivot to interest rate cuts as quickly as many investors are hoping, either in Europe or the US. The economies of the UK, Europe and the US are proving more resilient than widely expected to the rises in rates thus far. But monetary policy works with a long and variable lag and credit conditions are tightening. Inflation generally remains stickier than hoped and growth is slowing though labour markets remain unusually tight. Robust growth has been a boon for corporate earnings, which have held up better then feared but it also means that interest rates will be higher for longer than investors had assumed. Nonetheless, with the peak in inflation rates likely soon and with global growth set to slow in coming quarters, we can expect some respite from rising government bond yields. Indeed, for the first time in many years, both fixed income and cash deposits are providing healthy competition to equity markets in terms of return prospects.
Wide adoption of AI expected in the years to come
At the same time as leading technology disruptors take an ever-larger share of the market, AI could yet be a saviour. Its commercialisation will have profound longer-term implications for companies, workers, and economies. And the market will broaden its perspective over how wide the group of stocks which benefit can be. Stocks in the orbit around Nvidia will be the first tier to be pulled but AI could also assist the capital sector, unlocking efficiencies, loosening vulnerabilities to labour shortages (skilled and otherwise) and pressure from higher wage demands. Indeed, in time, AI could be a saviour for corporate margins and for productivity more widely.
While we await a clearer view on the direction of interest rate rates and more analysis on the implications of AI, we are holding cash ready for deployment and a smaller allocation to equities with a greater balance, than previously, to the opposing forces of value and growth.
