Investment Outlook: Getting through market Summertime Blues

If American singer Eddie Cochran were alive today, he could use the title of one of his famous tracks, “Summertime Blues”, to describe how markets are currently behaving. Essentially, global markets have been affected over the past few weeks by growing fears about several risks materialising at the same time.

These include: i) the Artificial Intelligence (AI) theme not living up to lofty expectations as investors were underwhelmed by the latest financials from the mega cap* companies; ii) the risk of a US recession after July’s employment data surprised on the downside; iii) market volatility as Japan normalises its monetary policy; and iv) escalating geopolitical tensions in the Middle East following the recent assassination of top Hezbollah and Hamas leaders.

These risks have been compounded by thin trading as market participants take breaks over the summer period.

While investors are understandably concerned by these developments, it’s important for long-term investors to focus on the fundamentals, specifically the economy and the ability of companies to generate earnings.

In this edition, we focus on these drivers and conclude that, despite the risks, robust company earnings, interest rate cuts and investor-friendly election results can support equity markets over the coming quarters.

As we discussed in last month’s Investment Outlook, US market breadth remains narrow, with roughly two-thirds of returns in the first half of the year produced by mega cap stocks connected to AI. This has left the market highly exposed the performance of these companies.

Much of their performance has been driven by profit growth. The consensus currently expects net income for these companies to grow by 49% over the next 12 months. This contrasts to a small contraction in net income for AI-related mega caps in October 2022, the month before the launch of Chat GPT (the computer software credited with starting the AI boom).¹

For the rest of the market, investors will be looking for evidence that businesses are using generative AI technologies to raise productivity, rather than just growing computing power. One bellwether to monitor in relation to AI mass adoption is the proliferation of Microsoft’s Copilot. Strong growth in this product would indicate that firms are integrating AI into their processes, and this could help boost profits.

Encouragingly, annual net income for the rest of the US stock market is starting to pick up. Excluding the mega caps, net income is forecast to increase by 7% over the next year - the fastest rate in nearly two years.¹

There remain pockets of the stock market – including stocks connected to the AI theme - where valuations look stretched. Take AI chip designer, Nvidia. The stock trades on a price-to-earnings (PE) ratio of 40 times. However, if Nvidia delivers on projected consensus Earnings Per Share from AI spending growing strongly, then its PE ratio falls to a less demanding 28 times by 2026.¹

Importantly, there is room for the valuations of companies in the broader market to expand, as global output growth holds up and inflation and interest rates come down. The one-year forward PE ratio for the MSCI All Country World, a global equity index, is currently on 18 times earnings, lower than its last peak of 20 times in August 2020 and a record high of 25 times in February 2000.¹

After July’s employment data surprised on the downside, market participants became increasingly worried about the health of the US economy. But despite these concerns, US employment is still increasing, while other barometers of activity, such as the Federal Reserve Bank of Atlanta’s real-time GDP estimate, remain resilient.

Meanwhile, lower inflation and a decelerating labour market increases the likelihood that the US Federal Reserve (Fed) will follow the European Central Bank and cut interest rates over the coming months. In the US, June annual core (excluding food and energy) Consumer Price Index (CPI) inflation was 3.3%, half the post-pandemic peak reached in September 2022.¹ Inflation could slow further over the coming months as disruption caused by the pandemic continues to unwind.

Given concerns about growth, the Fed could cut interest rates by 25 or 50 basis points at its 18 September Federal Open Market Committee meeting, as indicated by the Fed Futures market. Irrespective of the timing, the Fed is about to embark on an interest rate cutting cycle that will lower financing costs and should give a liquidity boost to the stock market.

Market uncertainty around US President Joe Biden’s withdrawal from the presidential race and the shocking attempted assassination of Republican nominee Donald Trump in Pennsylvania last month are reminders of US election-related risks. This highlights the importance of owning some downside portfolio protection, like gold, in the run-up to the 5 November vote.

However, investors were probably relieved that Marine Le Pen’s National Rally party did not get a majority in July’s French parliamentary election. Bond investors had been worried that this scenario would lead to higher public spending and debt levels, although these fears have lessened since the election.

In the UK general election, the Labour Party secured its biggest majority in parliament since Tony Blair’s landslide victory in 1997. Despite the win, Labour will be mindful of the voting data as the new government moves forward with its policy agenda. Labour won just 34% of the vote, the lowest for a single-party majority post-war government, and below the 40% share won by its then leader Jeremy Corbyn in 2017.²

On balance, there are four reasons to be positive on UK stocks following the election. First, political stability derived from Labour’s large majority adds a layer of support that has not been there in recent years. Second, Labour has placed market-friendly economic growth and wealth creation at the heart of its priorities as it embarks on a “decade of renewal”. Third, British multinationals, which dominate UK benchmark indices, should benefit from a benign global macro environment. Fourth, UK stocks look historically cheap.

To deliver on their policies and with limited fiscal space, the government must rely on cutting red tape and persuading companies to invest to boost the economy. There are some positive signs. In her first speech as Chancellor, Rachel Reeves said she would overhaul planning rules to build more homes. And luckily for Labour, after three years of review, the Financial Conduct Authority made its biggest changes of listing rules for three decades in July. The regulator’s streamlined rules will make it easier for firms to list on the London Stock Exchange and could attract much needed investment into the UK. While it is too early to know if Labour will succeed in convincing firms to raise capital investment, it is possible that the UK economy and stock market can shrug off the current Summertime Blues.

[1] LSEG Datastream/Evelyn Partners

[2] BBC, Sir John Curtice: The dramatic Tory decline behind Labour’s landslide, 04 Jul 2024

*Includes Microsoft, Apple, Alphabet, Meta, Amazon, Tesla and Nvidia