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Equity Focus - March 2024

How passive investments benefit index heavyweights?


Are European Earnings finally turning the corner?


Key Points

Earnings Season Update: Over 80% of S&P 500 companies and 55% of STOXX 600 companies have now reported Q4 results. EPS growth for the quarter is tracking at +7% y/y in the US, and -11% y/y in Europe. On aggregate, US companies strongly beat expectations with EPS surprises being 8%. European companies have disappointed vs consensus expectations by 2%. More importantly though, while still in negative territory, the levels of forecast Sales and Earnings revisions breadth continue to improve. This increases our confidence that European earnings revisions are likely to trough near-term (if not forming a trough already) which supports our positive stance on the region.

Markets start to look at the 2024 US Presidential Election. 2024 is a super election year. Roughly 50% of the global population will head to the polls with the US presidential election being the primus inter pares. While the election will only take place in early November and the candidates have not been officially chosen, markets start to look for the potential impact on companies. With betting odds of Mr. Trump winning rising, (recall, there are still legal cases pending which could prevent him from running at all) so are stocks which are expected to benefit from this victory, while potential losers start to fall behind. We will provide more detailed information of which sectors may benefit / suffer from a given outcome in the month ahead.


Main recommendations

Upgraded US Mid/Small Caps to positive. We see the stars aligned for a period of outperformance of US mid/small caps as valuations, historical market patterns and economic growth point to future relative and absolute strength. We prefer the S&P 400 and 600.

We stick to our positive view on EU Tech despite the good run recently and continue to like a barbell approach of selected growth and value (e.g. financials) sectors.

Country-wise, we maintain our positive stance on the eurozone, UK, Japan and Latin America

Be cautious/selective with expensive market segments, such as some large-cap US tech stocks and some Consumer Staples.

We downgrade Chemicals to negative due to ongoing earnings risk and too high valuations

We see increasing risks for battery metals, especially lithium, as the market is likely to stay in surplus due to weaker demand

The key risks are that the US Federal Reserve or the ECB could be forced to further push out rate cuts or even shift back to a hawkish rhetoric should inflation surprisingly pick up again.


The impact of passive investments

ETF Flows are pro size & pro momentum

Passive investment products now command more assets than active managed mutual funds. This evolution has several consequences for market dynamics, which investors should be aware of.  Active managed funds usually deviate from their benchmark, be it due to an active decision by the portfolio manager or some diversification rules. Mutual funds that register with the Securities and Exchange Commission as “diversified” cannot put more than 25% of their assets into large holdings — with a large holding defined as a stock that represents more than 5% of the fund’s portfolio at the time of investment. Those restrictions do not apply for passive funds which simply track their underlying index.

As a consequence, flows into ETFs are by nature pro momentum and pro large cap. This is becoming increasingly concerning as the weight of growth increases in major benchmarks like the S&P 500. The same is true for the growing weight of US stocks in global indices such as the MSCI World where US stocks now represent roughly 70% of the index.

The five largest stocks represent 26% of the S&P 500 market cap, the highest concentration on record. If you allocate $1 passively to that index, 26 cents goes into the top 5 companies. The issue is even more extreme in the Nasdaq 100. Here, the largest 5 companies  represent 32.6%. If you allocate $1 passively, 33 cents goes into the top 5 companies. Allocating into the MSCI does provide little more diversification effects. US equities represent 70% of MSCI World equities, the largest country weight on record. If you allocate $1 passively, 70 cents goes into US equities and 18 cents into the top 5 US stocks.

As passive funds just track their reference index, the trend in flows creates a self-feeding effect. The more money flows into ETFs, the more money goes into the index heavyweights, increasing their weight further. Thus, those indices became far less defensive than usual with almost  record low weightings on utilities, consumer staples or healthcare. This provides investors with an inflated exposure to any downside in tech stocks by having both a greater weighting to that sector and smaller weighting to defensive sectors. On top of that this creates a smaller weight (~ 30%) than usual to cyclicals like energy, materials, industrials or financials. For reference: The MSCI World ex US has a weight of over 50% in traditional cyclicals.

ETF Flows are benefitting expensive areas of the market

The aforementioned dynamics create another issue. Not only are those flows amplifying concentration risk, but investors are as well increasing their exposure to one of the most expensive parts of the market. The “Magnificent 7” are still trading close to record valuation premiums compared to the rest of the market. However, those names have also shown superior earnings growth over the last couple of quarters. One might thus be forgiven for thinking that the valuation premium is warranted. If, and that looks like a big “if” to us, big tech can continue to deliver at least the outstanding earnings growth which is currently priced into valuations, those valuations should be less of an issue. Bulls may take further comfort from the fact that valuations are still well below the extremes we observed during the dotcom bubble.

This being said, we are still worried by the simple fact that valuations do have an impact on returns. While there is basically no relationship between valuations and the subsequent one-year returns, the picture changes completely if we look at the subsequent five-year returns. Apparently, valuations do matter in the long run. This makes intuitively sense as high valuations require outstanding earnings growth which can be easily achieved (or expected) for a short period of time. Do keep the pace in the long run is a totally different venture which is much harder to realize.

Where does this take us? Given the strength of flows into passive products, the observed trends may have some room run. Having said that we do think that investors should be aware of the concentrations risks which arise from the current weights in American und global indices. With manufacturing purchase manager indices both in Europe and the US looking to rebound, the more cyclical parts of the market could start to question big techs leadership in the near-term future.  We thus see increasing value in diversifying into areas of the market which offer better long term return prospects due to more attractive valuations. Those areas include US Mid/Small Caps as well as European and Japanese equities.


Europe has its own magnificient crowd

The leading EU stocks have many Mag 7-like features but are trading on lower multiples

Like the US, Europe’s equity market is dominated by a small group of internationally exposed quality growth companies.  They benefit from strong earnings growth, low volatility, high & stable margins and strong balance sheets. While trading with a justifiable (but not cheap) 60% P/E premium to the European market, the GRANOLAS offer a 30% discount vs the Mag 7. This comes despite certain similar characteristics, a superior sharp ratio and a more diversified sector allocation.