Pursue resilient growth amid rate uncertainty. Prepare for different economic outcomes by diversifying portfolios to balance quality growth with cyclical value. (State Street Global Advisors)
Resilient earnings and solid economic data continue to support the global equities rally that began last November. But the manufacturing recovery and continued strength in consumer spending have put upward pressure on inflation, reducing the number of expected rate cuts by the Federal Reserve (Fed). At the May Federal Open Market Committee (FOMC) press conference, Chairman Powell all but eliminated the probability of additional rate hikes but didn’t signal when the Fed would begin cutting.
So, despite solid economic growth and encouraging corporate fundamentals, sticky inflation and the Fed’s data-dependent approach mean continued uncertainty on the rate path will impact rate sensitive equities. And, the longer the Fed delays rate cuts, the more relevant downside risks become.
In a higher-for-longer interest rate environment, for example, we remain cautious about the downside risks to US large-cap earnings growth beyond big tech — even though S&P 500 companies have exceeded earnings expectations by a large margin in Q1 and positive revisions are at a year-to-date high.1
On the other hand, if cooling inflation allows the Fed to cut rates aggressively in the second half of 2024 without a looming recession, small caps’ low single-digit growth projection looks achievable given significant downgrades in their 2024 earnings over the past six months. And small caps’ near decade-low valuations relative to large caps certainly provide a better risk/reward trade-off.
Despite this monetary policy uncertainty, the US is still expected to lead growth in developed countries. But the eurozone economy has shown positive development, with faster-than-expected Q1 GDP growth and continued disinflation. Additionally, the European Central Bank (ECB) has clearly signaled rate cuts will begin in June with more coming by year end. Along with positive earnings sentiment and attractive valuations, this supports our constructive view of eurozone equities.
To prepare for the wide range of economic outcomes from the Fed’s inflation battle and divergence between the US and eurozone monetary policy, consider diversifying portfolios with:
Equal-weighted exposure to Tech leaders for resilient growth without concentration
US small caps at attractive valuations to position for rate cuts
Eurozone equities that may benefit from rate cuts and potential economic revival
Tech Leaders: High Quality to Sustain Resilient Growth
Today’s extreme market concentration — driven by a few mega-cap, AI-related stocks — rivals levels seen during the Dotcom era. And it’s caused investors to question whether the AI hype over the past 18 months has created a valuation bubble.
Magnificent Seven (Mag 7) stocks’ price-to-earnings multiple (P/E), based on the next 12 months’ earnings, has expanded 44% since the end of 2022 compared to 14% for the rest of the S&P 500. Yet, Mag 7 valuations are 35% below their pandemic peak and 9% below where they were before the Fed signaled the start of the rate hike cycle.2 More importantly, the Mag 7’s rally has been driven more by stronger growth than by multiple expansions. Changes to their forward P/E accounted for 29% of their total return since 2022 compared to nearly 60% for the rest of the S&P 500.3
There’s no question that growth momentum in AI applications and infrastructure remains strong, despite the current economic uncertainty. Q1 earnings results from Microsoft, Amazon, Alphabet, and Meta show both higher AI spending through 2024 and gains in AI-aided revenue.4 As organizations transition from early experimentation to aggressive data infrastructure-building to broadening adoption, worldwide spending on traditional and generative AI is projected to grow by 31% and 86%, respectively, on an annualized basis — surpassing a total of $300 billion in 2027.5
The resulting industry and geographic concentration of the Mag 7 will further reduce the diversification in investors’ equity portfolios. That’s why we favor an equal-weighted exposure to Tech leaders across multiple sectors and countries (the NYSE Technology Index) to capture companies most likely to benefit from the broadening of AI applications and monetization. This includes software development, online consumer platforms, social media, and AI infrastructure (e.g., advanced chip makers and cloud computing) companies.
Due to their high quality characteristics and strong earnings growth, these Tech leaders offer quality growth exposure. In fact, their aggregated earnings grew by 22% in 2023, compared to 1% for the S&P 500.6 Based on consensus earnings estimates, this less concentrated Tech leader exposure is expected to outpace the broad market again this year with above 20% growth.7
While this growth advantage will likely narrow in the next few quarters as the broad market plays catch up, the near-term earnings growth visibility of these Tech leaders is better, given the increases in AI-related monetization and capital expenditure spending revealed in Q1 earnings releases. As a result, their earnings growth estimates for the next three quarters were raised by large margins since the start of the year, compared to negative revisions for the rest of the market (Figure 1).8
Tech leaders’ strong profitability and healthy balance sheets are also attractive, particularly in a higher-for-longer interest rate environment. After having focused on growth efficiency and cost cutting over the past two years, Tech leaders’ profitability has improved significantly. Their return on equity is at record highs on an absolute and relative basis.9
Strong balance sheets, where long-term debt to capital ratio is near its lowest since 2018, should help Tech leaders continue to invest for future growth, even with high financing costs.
US Small Caps: Fed Cuts Support Growth and Valuations
Though recent inflation trends posed some risks to the soft landing, progress on goods inflation and cooling wage inflation warrant less restrictive monetary policy in the coming months if the Fed is to achieve its dual mandate of maximum employment and stable prices. Solid economic growth, coupled with potential rate cuts not driven by a looming recession, provide a positive backdrop for US small caps, especially given their attractive valuations.
Thanks to a solid labor market and continued strength in consumer spending, the US economy remains resilient, despite expanding at a much slower pace than it did the second half of 2023 due to the drag from trade and inventories. Positive real income growth, alongside a $37 trillion increase in household wealth since the pandemic, should support consumption in the coming months.10
Weaker-than-expected April payrolls and a 0.1% increase in the unemployment rate drove negative headlines. But given how payrolls surprised to the upside in Q1, we view the recent slowdown in payroll gains plus moderating wage inflation as a positive step toward a better supply-demand balance in the labor market, not a threat to consumer demand.
Since the beginning of the year, the consensus US GDP forecast for 2024 has been upgraded to 2.4% from 1.3%.11 The Atlanta Fed GDPNow estimate for Q2 real GDP growth has been above 3% since late April, signaling solid growth in the first half of 2024. But even against this solid economic backdrop, earnings sentiment in small caps has been gloomy this year as Treasury yields rose to above 4%. Small caps’ earnings per share (EPS) estimates have been slashed by more than 5% since the start of the year, with growth expectations falling to low single digits, compared to their 12% estimate from six months ago and the 11% estimate for their large-cap peers.12
Rising Treasury yields definitely burden small caps more than they do large caps, mainly because small caps issue more short-term debt and are more sensitive to the current high interest rates. Indeed, small-cap current valuations are pricing in a significant level of financial stress for companies, with small caps’ forward P/E 13% below the long-term average and at a 30% discount to US large caps (Figure 2).
But we believe peak interest rates are behind us.
And rate cuts in the second half of this year amid a solid economic environment would ease pressure on small-cap valuations. Given their bearish earnings sentiment so far this year, a resilient US economy may support small caps to deliver upside surprises in the second half, potentially outperforming large caps as US earnings growth broadens out.
Eurozone Equities: Strengthened by a Dovish ECB and Economic Momentum
Green shoots of an economic rebound in the eurozone have appeared in macroeconomic surveys and earnings fundamentals after the region’s annual growth decelerated sharply last year to 0.4%.
In April, the Eurozone Composite PMI (Purchasing Managers Index) indicated overall business activity had expanded at the fastest pace over the past 11 months, driven by above-trend growth in the service sector.13 Although manufacturing PMI took a breather from its recent rebound, a shallower decline in output and a two-year high in business confidence support positive development.
Record low unemployment, strong nominal wage growth, and steep disinflation provide a powerful boost to consumer income, potentially supporting domestic consumption and continued expansion in the service sector. A stabilizing Chinese economy may help pull Germany, the largest economy in the eurozone, out of the manufacturing downturn.
Historically, increasing Composite PMI bodes well for positive earnings sentiment (Figure 3). At the beginning of May, earnings upgrades outpaced downgrades for the first time in 10 months as the region’s economic recovery progressed.14 Despite lower growth estimates compared to the beginning of the year, Q1 earnings beats came in stronger than Q4 and above the historical average thanks to resilient profit margins. This suggests room for greater upside surprises in the coming quarters if positive economic momentum continues.15
Meanwhile, steep disinflation and weak economic growth have opened the door for the ECB to dial back policy restrictions. While eurozone inflation peaked at a higher level and later than in the US, it’s made greater progress toward the ECB’s target. Core inflation has fallen from its peak of 7.5% in March 2023 to 2.8% in April. The replacement of Russian gas suppliers with American ones, warm weather, and prudent energy consumption all resulted in eurozone headline inflation declining even more steeply to 2.4% in April.
As a result, the central bank has strongly signaled rate cuts would begin in June. Our economists project a total of 100 basis points of cuts this year as their baseline view. With a dovish ECB and steady global demand, a meaningful economic rebound is achievable for the second half of the year, supporting an earnings recovery.
Eurozone equity valuations have become more expensive compared to last year due to the equity market having reached all-time-highs, even outperforming the S&P 500 year to date. But the market’s forward P/E ratio (13.8x) is still below its 10-year average (14.8x).16
Relative to US equities, eurozone equities are trading at a 15% greater discount than the historical average — around the bottom decile of the past 10 years.17 Given the prospect of monetary easing and continued positive economic momentum, these valuations may have room for further expansion.
Authors
Michael W Arone, CFA Chief Investment Strategist
Matthew J Bartolini, CFA, CAIA Head of SPDR Americas Research
Contributors
Anqi Dong, CFA, CAIA Senior Research Strategist
Footnotes
1 FactSet, as of May 8, 2024. 2 Bloomberg Finance, L.P., as of May 9, 2024. 3 Bloomberg Finance, L.P., as of May 9, 2024. Bloomberg Magnificent Seven Index and Bloomberg Large and Mid Cap Index ex Magnificent Seven. 4 Forbes, Big Tech Q1 Earnings: AI Capex Increases As AI-Related Gains Continue, May 9, 2024. 5 IDC, IDC Forecasts Spending on GenAI Solutions Will Double in 2024 and Grow to $151.1 Billion in 2027, December 2024. 6 FactSet, as of May 9, 2024. Tech leaders are represented by the NYSE Technology Index. 7 FactSet, as of May 9, 2024. 8 FactSet, as of May 9, 2024. Tech leaders are represented by the NYSE Technology Index. The rest of the market is represented by the S&P 500 excluding AAPL, AMZN, GOOGL, META, MSFT and NVDA. 9 FactSet, as of April 30, 2024. For the period since September 2000. 10 Federal Reserve Bank of St. Louis, as of May 13, 2024. 11Bloomberg Finance, L.P., as of May 14, 2024. 12 FactSet, as of May 13, 2024. Used S&P 600 SmallCap Index to represent small caps and S&P 500 Index to represent large caps. 13 S&P Global, as of May 6, 2024. 14 FactSet, as of May 8, 2024. 15 Barclays, Earnings optimism Prevails, as of May 3, 2024. 16 Bloomberg Finance, L.P., as of May 8, 2024. 17 FactSet, based on forward P/E, as of May 8, 2024.
Glossary
Dotcom Era-The speculative stock-market run-up of the late 1990s that grew out of excitement about the potential of the Internet. While companies such as eBay and Amazon were born in this period, countless other start-ups with vague business plans and no profits were funded by investors dreaming of winning big. The fervor peaked on March 10, 2000, and a nearly three-year bear market followed.
Earnings Per Share (EPS)-A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
European Central Bank (ECB)-The European Union’s central bank, which is responsible for monetary policy within the EU. The ECB was founded in 1998.
Eurozone-The eurozone, also sometimes referred to as “euroland,” is the geographic and economic region that consists of all the European Union countries that have incorporated the euro as their national currency since the currency’s launch in 1999. This area comprises 27 countries currently.
Forward Price-to-earnings (P/E)-The price of a security per share at a given time divided by its projected earnings per share over the coming year. A forward P/E ratio is a way to help determine a security’s stock valuation — that is, the fair value of a stock in a perfect market. It is also a measure of expected, but not realized, growth.
Gross Domestic Product (GDP)-The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
Magnificent Seven (Mag 7)-The Magnificent Seven refers to the group of 7 stocks that currently dominate most major indexes: Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms and Tesla. Due to their outsized market capitalizations, Magnificent Seven stocks hold a disproportionate influence on the market-cap weighted Nasdaq composite and S&P 500 indexes.
NYSE Technology Index-An equal-dollar weighted index designed to objectively represent the technology sector by holding 35 of the leading U.S. technology-related companies.
Purchasing Managers Index (PMI)-An indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
Quality Companies-The term refers to companies with a consistent track record of strong earnings and stable balance sheets.
Return on Equity (ROE)-The amount of net income returned as a percentage of common shareholders’ equity. ROE shows how well a company uses investment funds to generate earnings growth.
S&P 500® Index-A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Risk Disclosure
The views expressed in this material are the views of Michael Arone, Matthew Bartolini, and Anqi Dong through the period ended May 14, 2024, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.The S&P 500® Index is a product of S&P Dow Jones Indices LLC or its affiliates (“S&P DJI”) and have been licensed for use by State Street Global Advisors. S&P®, SPDR®, S&P 500®,US 500 and the 500 are trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”) and has been licensed for use by S&P Dow Jones Indices; and these trademarks have been licensed for use by S&P DJI and sublicensed for certain purposes by State Street Global Advisors. The fund is not sponsored, endorsed, sold or promoted by S&P DJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of these indices.Past performance is not a reliable indicator of future performance.The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent. Investing involves risk including the risk of loss of principal. Diversification does not ensure a profit or guarantee against loss. Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress. Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. A “value” style of investing emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market. A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market. Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions. The fund is classified as “diversified” under the Investment Company Act of 1940, as amended (the “1940 Act”); however, the Fund may become “non-diversified,” as defined under the 1940 Act, solely as a result of tracking the Index (e.g., changes in weightings of one or more component securities). When the Fund is non-diversified, it may invest a relatively high percentage of its assets in a limited number of issuers. Because of their narrow focus, sector funds tend to be more volatile than funds that diversify across many sectors and companies. Foreign (non-U.S.) Securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets. Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole. Dividend paying securities can fall out of favor causing securities to underperform companies that do not pay dividends. Changes in dividend policies of companies may adversely affect fund performance. The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data. There can be no assurance that a liquid market will be maintained for ETF shares. The funds or securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities or any index on which such funds or securities are based. The Prospectus contains a more detailed description of the limited relationship MSCI has with SSGA Funds Management, Inc and any related funds.
Most women are comfortable taking risk in their investments and cite patience and discipline as their top investing strengths, a Schwab survey reveals.
