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Weekly Market Analysis - Why We Expect Equity Performance to Broaden in 2024
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Equity Performance Likely to Broaden Next Year
As we look to 2024, equity investors are asking: should they continue to favor big tech or add exposure more broadly? While momentum trading into year-end may exacerbate the narrow tech rally in the near-term, we find reasons to expect the broadening story to gain traction.
Fed Easing Could Benefit Catch-Up Trade
While not a precondition for our market broadening view, modest US Federal Reserve easing could be icing on the cake for the 2024 catch-up trade. Falling rates in the absence of a profit collapse would be supportive for a pick-up in M&A and IPO deal flow. Value created over the past two years is ripe to get scooped up by public and private firms sitting on significant deployable capital.
US Equities Stand to Gain in 2024
Healthcare is a sector that never experienced an annual profit decline before 2023. The pandemic distortions and tech challenges from a new class of weight-loss drugs has dimmed performance. This portends a rebound in 2024. AI-dominant tech firms have led equity performance in 2023, but their spending should help the chip-equipment industry, in particular.
Summary
The winning trade of 2023 appears simple: buy big tech and ignore everything else. While each of the largest 7 American tech darlings have idiosyncratic growth drivers and risks, this group – which comprises 17% of the MSCI AC World benchmark – was a clear beneficiary of AI-related fever. While momentum trading into year-end may exacerbate the narrow rally in the near-term, we find reasons to expect the broadening story will gain traction.
To get this call right, earnings will need to recover and expand beyond tech next year. How will this happen? We expect the recessions “rolling through industries” to “roll out” within 2024. Higher output and more stable input costs will help profit margins of many firms. US corporate earnings are more reliant on global production than is obvious. Nearly 40% of S&P 500 revenues are earned abroad. Therefore, drivers of international growth, like global consumption and trade, will matter nearly as much as American economic activity to determine their profitability.
Portfolio considerations
We believe international indices mask significant potential opportunity present within regional equity markets. The small but vibrant tech sectors in Europe and Japan, or international consumer names tied to a rising Asian middle class, are two examples of secular themes that continue to drive outperformance. Strategies that focus on quality or consistent dividend growth have also performed better than passive non-US benchmarks. We therefore continue to believe that non-US equities have a place in portfolios, but we prefer an active or thematic lens during allocation.
Source: Haver Analytics, Nov 16, 2023
Equity Performance Likely To Broaden Next Year
Two of the most cyclical industries, semiconductors and chemicals, tell the story for 2023. While hype around AI has drove the price of a handful of semiconductor stocks higher, profits for the broad semi group are actually on track to fall nearly 7%. Chemicals stocks within the Materials sector also saw earnings decline over 20% this year.
As we look to 2024, both segments should experience recovery as electronics, industrial, and automotive manufacturing recovers globally. In the world of travel and trade, 2023 was a story of significant divergence. Passenger airline profits rose 135% this year amid a surge in travel demand while a glut of goods saw earnings for air freight & logistics firms drop by 26%. As both travel and goods trade normalize in the absence of recession next year, Transportation profits are expected to rise by 8%. 2024 Mega-cap tech outperformance is understandable. Earnings growth for big tech has been far superior to the broad market for much of the past five years.
While we don’t expect the S&P 500 in aggregate to deliver an earnings recovery as strong as 2021, we believe that index-level profit growth for 2024 will power a catch-up across several sectors that underperformed in 2023. US corporate earnings are more reliant on global production than is obvious. Nearly 40% of S&P 500 revenues are earned abroad. Therefore, drivers of international growth, like global consumption and trade, will matter nearly as much as American economic activity to determine their profitability. This also explains 2023 performance, where manufacturing and trade experienced the most challenging backdrop relative to soaring tech and consumer activity. Earnings breadth is the most important ingredient for market broadening. In 2Q 2023, profits fell 6% year-over-year. Less than half of the 11 US sectors delivered positive growth in the first half of 2023. As we look to 2024, most sectors should return to profitability. Major beneficiaries include manufacturing, trade, and health care sectors that saw their businesses take part in rolling recessions in 2023.
Fed Easing To Benefit Catch-Up Trades
While not a necessary precondition for our market broadening view, modest Fed easing could be icing on the cake for the 2024 catch-up trade. Inflation normalization could create room for the Fed to move rates from moderately restrictive to neutral, taking some pressure off of financing costs for highly levered projects. Falling rates in the absence of recession would also be supportive for a pick-up in M&A and IPO deal flow, as value created over the past two years is ripe to get scooped up by public and private firms sitting on significant deployable capital.
Two Standouts: Healthcare & AI Tech Firms
Not all of the 2024 catch-up opportunities are cyclical. The health care sector is a notoriously defensive sector that has for decades delivered consistent, positive earnings and sales growth. That was until the distortions of COVID and some other factors that hit 2023. Yet we also expect health care earnings to return to growth next year. Much like the release of Chat-GPT initially impacted the shares of education companies, call centers, and other staff-heavy services firms, excitement around GLP-1s, a grouping of anti-obesity drugs, has driven declines in companies with exposures to heart medication and sleep apnea equipment. While the use cases for deployment of GLP-1s continue to grow and manufacturing is ramping up, we also see an opportunity to invest in other forms of health care innovation which have meaningfully lagged for the past 2 years. Life sciences tools companies which help administer and facilitate drug trials remain well off their highs. An easing of rate pressures and a recovery in venture financing would be especially supportive for early-stage biotech firms.
In our upcoming Outlook 2024, we also highlight the opportunity to invest in the buildout of AI capacity next year. While mega-cap chipmakers have a clear lead in the development and design of GPUs required for AI applications, these companies don’t actually make the chips themselves. A complex, global supply chain is vital to the delivery of AI-optimized CPU and GPU chips into data centers and supercomputers. Indeed, as we see the global semi cycle forming a bottom, the alignment of both cyclical and secular tailwinds is poised to support semiconductor equipment firms in particular in 2024.
