Rise of the Megacaps
Chris ZEE Head of Equity Advisory, Asia, BNP Paribas Wealth Management & Godfrey OYENIRAN, Senior Adviser, Equity Advisory Asia, BNP Paribas Wealth Management & Maggie YEO, Adviser, Equity Advisory Asia, BNP Paribas Wealth Management
The US Federal Reserve (Fed) increased its interest rate by 25bps to the 5.00%-5.25% range in May 2023 as widely expected. Our house view expects this to be the last Fed rate hike and that the Fed will likely not cut rates until 2024.
Markets seem to think otherwise though, as interest rate futures imply an expectation for the Fed to start cutting rates by the end of 2023. This possibly takes into account US regional bank risks, but could also change quickly if there is policy support.
Additionally, April 2023's US inflation data was lower than the figure recorded the previous month, and our house view is for US inflation rates to dip below 3% by the end of 2023.
Off to a good start
US first quarter (Q1) 2023 earnings season was off to a good start, with no signs yet of the feared earnings cliff. Both Q1 2023 Earnings-per-share (EPS) beat rate (mid-single digit range) and quarterly guidance also came in better than what the market was expecting.
However, it remains to be seen whether this is a function of earnings durability or already lowered expectations heading into the reporting season, thus setting a lower bar for corporates.
During the recent results briefing, most corporates guided for a sustained earnings recovery throughout the rest of 2023, albeit this is contingent on the macro backdrop.
In terms of market-wide earnings revisions momentum, after a 13% downward revision from the peak level in June 2022, FY2023’s  consensus EPS revision appears to be trying to find a bottom. Market consensus is now expecting FY2023 EPS to be largely flat (+0.2% YoY ), with the bulk of the earnings recovery to occur in Q3/Q4 2023 (Chart 1).
Thus, this suggests that whether a recession is coming in the US or not, is key for the second half of (H2) 2023 earnings outlook, in our view.
What is the market telling us?
It is remarkable to see a disconnect between the rates and equities market. US equity indices have exhibited resiliency, but market expectations for rate cuts in H2 2023 is telling a somewhat different story of concerns relating to an economic slowdown and growth downside risk.
Although S&P 500 showed resiliency with stable price and volume, it is important to note that the year-to-date performance is narrow in terms of the market breadth.
The top 10 S&P 500 constituents (making up 28% of the index’s market cap), and largely AI-related names have contributed >80% of the year-to-date total return for S&P 500 (Chart 2). Additionally, we highlight the relative underperformance of small caps, as reflected in the Russell 2000 Index.
Recently, the resolution of the debt ceiling issue removed critical overhang in the US market after it injected volatility in US one-year Credit Default Swaps.
Going forward, if history is any guide, markets generally rise post the final Fed hike, but this also depends on if inflation remains elevated or not, and is based on the premise that the economy does not go into a recession.
Read US Equity Perspectives April-may, 2023: When the Tide Goes Out
The value of large banks
US big banks generally reported healthy Q1 2023 results, with strength in net interest income, and providing positive forward guidance. The big banks also benefited from significant deposit inflows in the regional banking crisis’ aftermath.
Going forward, the macro picture is still a dominant consideration for these banks, reflected in higher provisioning levels. However, the net interest income outlook remains supportive, even if higher expenses and more competitive deposit pricing, particularly driven by regional banks, become more of a challenge.
Bigger banks are better placed to navigate any near-term volatility and, more broadly, should benefit from the challenges facing regional banks over the longer term. As such, we maintain our preference for these bigger US banks.
We view JPMorgan’s acquisition of First Republic as a positive for sentiment around bank stocks. For JPMorgan, First Republic accelerates wealth management growth plans by adding branches in affluent markets on the US West and East coasts, while from a sector perspective, the sale should lessen the chance of additional forced sales of banks due to deposit flight and likely ends the panic phase of the banking crisis.
The deal has calmed the market for now, though it is too early to assume that sector concerns have entirely disappeared.
Showing signs of resilience
US tech megacaps’ Q1 2023 results came in better-than-expected, albeit with a somewhat mixed guidance, which can largely be attributed to optimisation headwinds due to the macro situation.
Notably, we saw that the tech megacaps’ cloud business remains resilient in Q1 2023 as the shift toward business digitalisation continues with AI now an additional driver.
Moving into the second half of the year, we see margins supported by increased cost discipline after the tech industry’s massive growth during the pandemic years, while a favorable year-on-year base effect should also help an inflexion in earnings.
We expect investors to focus on the execution of cost initiatives in a year dubbed as “efficiency”, along with commentary on AI strategy. We believe the AI opportunity for the tech megacaps is largely in enterprise infrastructure & operational software, cloud, and search engines.
Although an uncertain macro backdrop presents downside risk to IT and ad spending in the near-term, we remain positive about long-term structural opportunities tied to cloud and AI.
Further more, most of the tech megacaps importantly have strong balance sheets with net cash. This basically allows them to self-fund their working capital and/or support cash return to shareholders. This is a high quality attribute especially in the current operating environment of tightening credit conditions.
1. FY: Fiscal Year
2. YoY: Year-on-year
3. YTD: Year-to-date
4. E: Expected, Q: Quarter