By Julian Howard, lead investment director, multi-asset solutions, GAM Investments
Halfway through 2023, equity investors have reason to cheer. World stocks, measured by the MSCI AC World Index in local currency terms, are up nearly 16% (to 17 July), led by the S&P 500 Index, up 19% in USD terms.
These gains hinge on the artificial intelligence (AI) revolution. A handful of names – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – have driven markets higher. They were almost entirely responsible for the US stock market’s gains from the beginning of the year until the end of May. The rally’s sustainability is contested, depending on how one views AI’s impact on the economy and the few firms enabling it.
Inflation and interest rates remain a source of investor unease. Stubborn core inflation in developed markets has forced central banks into an unenviable ‘policy corridor’. This entails smashing down on the economy via tighter monetary policy, to adhere to targets set when inflation was deemed vanquished.
This has made the rally feel vulnerable, with earnings’ yields offering little over and above risk-free rates and valuations stretched. The S&P 500 equity risk premium (ERP) is barely 1%. This is hardly adequate compensation for the ‘giddy ride’ characteristic of holding stocks.
Similarly, valuations, measured by Shiller’s Cyclically-Adjusted Price-to-Earnings (CAPE) ratio, are at over 30 times, meaningfully higher than the long-term average. Understandably, serious investors remain cautious in a market driven by speculative sentiment and underpinned by uninspiring financial metrics.
Why the rally may hold
Against this, it is hard to imagine the equity rally powering ahead. But recent developments may turn the rally from one enjoyed by structural holders of stocks—pension funds and wealthy individuals—to one more widely shared.
The first is that the rally is broadening out. From the end of May to mid-July, over 140 stocks in the S&P 500 hit fresh 52-week highs, with all sectors making progress. Driving this are more benign conditions, from an economy demonstrating unexpected resilience against tighter monetary policy.
It could be argued that tightening has not yet worked. The US labour market has remained firm, with June’s figures showing unemployment at 3.6% and wages rising at 4.4% on the previous year, a real-terms gain of nearly 1.5%. This has increased optimism across all sectors and contributed to broader market success. Breadth is important, as an indicator of an equity rally’s viability. Lopsided progress overexposes investors to one theme, leaving them vulnerable to idiosyncratic risk.
Sustained disinflation would boost equities
Another new tailwind has emerged. Nothing lifts the price of a financial asset over time like lower cost of capital. Following unexpected global price spikes in 2022, US inflation appears to be on a definitive cooling pathway.
It is often said that three datapoints make a trend. US headline CPI fits that bill, falling from 9% in June 2022 to under 3% in June 2023. Even core inflation has eased off, from a near-seven-per-cent peak in September 2022 to under 5% in June.
This does not mean monetary policy will be unwound overnight. The Federal Reserve (Fed) is haunted by its premature dismissal of 2022’s ‘transitory’ inflation and committed to bringing it down to 2%. If inflation data continues to cool, one or two more rate rises may be sufficient to push down yields across the maturity spectrum and make stocks’ earnings yields relatively attractive.
A drop in the 10-year US Treasury yield from 3.8% to say, 2.5%, would see the ERP on the S&P 500 rise to 2.3%. In other words, equity investors would have a meaningful earnings advantage over the risk-free rate.
Positive sentiment and fundamentals could align
In recent years, stock markets have skipped between ‘mini eras’. From pandemic panic to stimulus in 2020-21, followed by 2022’s inflation and interest rates shock, then 2023’s uneasy rally. The AI revolution has ignited wider risk appetite, as evidenced by retail inflows into equity exchange-traded funds (ETFs). Longer-term sustainability was always going to be an issue, given the fiercely-debated impact of technological paradigm shifts and poor state of market fundamentals.
Investors have reassurance from two sources: a resilient US economy and an end in sight to tightening. Given the dominance of US stocks within the MSCI AC World Index (around two-thirds), these positive developments cannot be ignored by global equities investors.
Risks remain. Inflation could surprise to the upside again, while the Fed may overtighten in the name of credibility and hurt the economy unnecessarily. Should the positive developments continue, investors may need to consider increased strategic engagement in stocks. Markets are typically driven by sentiment in the short term and fundamentals in the long term. The next few months may see the two positively align.
