Opportunities broaden outside cash and U.S. stocks

U.S. stocks face a broadening, not a rotation

In recent years, the U.S. stock market has been dominated by the “Magnificent Seven” technology stocks, but there are signs this once‑monolithic group of large‑cap growth firms is beginning to fragment. The outperformance of the Magnificent Seven propelled the S&P 500 to new highs earlier this year and resulted in the index becoming concentrated to an unprecedented degree.

Performance within the group is now diverging, however— as of late May, NVIDIA, Meta, Microsoft, and Amazon have continued to outpace the market, while Apple, Alphabet, and Tesla have begun to lag. As the benefits of AI technology are unlikely to be evenly spread among the members of the Magnificent Seven, further dispersion within the group can be expected.

Fewer cuts should favor value stocks

Meanwhile, value stocks could be primed for a comeback as investors seek to diversify their exposure beyond the Magnificent Seven, particularly given growing expectations that the higher rate environment will persist. If the Fed only makes a few cuts or does not cut at all, value companies should benefit as they have tended to be more rate‑sensitive and have typically fared better in a world where interest rates remained higher for longer. And while value stocks have begun to perform better in recent months, they continue to trade at a significant discount to growth stocks. If conditions continue to favor value stocks—as we believe they will—the dominance of growth stocks may start to fade.

Small‑cap stocks are trading at a major discount to larger companies after struggling for several years against high inflation and a steep rise in borrowing costs. While the persistence of a higher rate environment could limit the upside of small‑cap stocks, the earnings of smaller firms should improve if rates come down.

A widening opportunity set

Although we believe that value—and possibly small‑cap—stocks may begin to challenge the dominance of large‑cap growth stocks, it is important to stress the difference between a broadening of the market’s opportunity set and a rotation between market styles, sectors, or capitalization. We are not predicting the imminent demise of the Magnificent Seven—rather, we anticipate a continued broadening of opportunities to include more companies and sectors across the market that may have lagged in recent years.

“...we anticipate a continued broadening of opportunities to include more companies and sectors across the market that may have lagged in recent years.”
Peter Bates, CFA, Portfolio Manager, Global Equities

International stocks still appear to be good value

Fueled by the outperformance of growth technology stocks, U.S. equities reached all‑time highs earlier this year, pushing their premium versus international (i.e., non‑U.S.) stocks to 20‑year wide levels. International stocks remain favorably valued but are fundamentally more attractive in the post‑COVID environment, as demonstrated by improved earnings growth in recent years. This is because, in contrast to the U.S. market’s heavy exposure to growth stocks, the international market is more exposed to value‑oriented sectors such as financials, materials, industrials, and energy, where we see secular support in the years ahead. The S&P 500 Index, for example, has a very different sector composition from the MSCI EAFE Index.

Supply chain diversification, infrastructure rebuild, defense spending, and the likelihood of higher energy prices should favor traditional value sectors as capital spending accelerates. As these sectors are currently cheaper and, in some cases, have a lower earnings bar than their U.S. counterparts, investors seeking diversification from large‑cap tech growth stocks may seek to increase their exposure to select international markets.

Improving corporate governance is driving Japanese stock performance

Of the international markets, we continue to favor Japan. Improved corporate governance standards continue to have a tangible—and considerable—impact on company performance. Shareholders are now a much higher priority in Japan than they were in the past. While the BoJ recently ended its negative interest rate policy, it is not expected to embark on a hiking cycle that brings Japanese rates in line with those of other developed markets. This should keep the yen relatively weak and Japanese exports competitive. Valuations are reasonably attractive, too—although the Nikkei 225 has climbed to within reach of its record high, Japanese stocks continue to trade at a low price‑to‑book value. However, investors outside of Japan will need to consider how yen weakness relative to other currencies will impact the value of their returns.

South Korea and Vietnam the pick of emerging economies

South Korea has sought to emulate Japan’s success in boosting stock valuations with a corporate governance drive. Tax incentives have been offered to businesses that prioritize shareholder returns, while the new “Korea Value‑up Index” will list firms that have improved capital efficiency. Vietnamese stocks also appear cheap despite a cyclical recovery, an expanding consumer economy, and a looming upgrade to emerging market status. With corporations seeking to diversify their supply chains beyond China, Vietnam appears well placed to attract manufacturing capacity.

Key takeaway

Of the international equity markets, we continue to favor Japan, South Korea, and Vietnam.

Investors moving out of cash may favor equities and short duration bonds

A vast amount of money is hanging over U.S. financial markets in money market funds and other short‑term liquid instruments. Evidence from past economic cycles suggests that this strong liquidity preference will ease at some point, especially if the U.S. avoids a deep recession.

“Evidence from past economic cycles suggests that this strong liquidity preference will ease at some point, especially if the U.S. avoids a deep recession.”
Tim Murray, CFA, Capital Markets Strategist, Multi‑Asset Division

As concerns over a hard landing for the U.S. economy have receded, focus has shifted from recession risk to inflation risk. This will impact where investors seek to allocate their money. Historically, bonds—particularly longer‑dated bonds—have been an excellent hedge against recession but a poor hedge against inflation. During rare periods when inflation has turned negative due to sharp economic downturns, bonds have outperformed stocks.

Energy stocks may offer best hedge against inflation

Stocks have tended to perform best during periods of low, moderate, or even slightly elevated inflation. But they have typically dipped sharply during recessions and have also weakened when inflation has moved to very high levels. However, energy sector stocks have historically performed quite well during periods of very high inflation. These patterns suggest that one way to hedge against inflation risk would be to tilt portfolios to stocks, with an emphasis on the energy sector and other commodity‑oriented equities.

Investors are also likely to turn to shorter‑term bonds given attractive yield levels available and the potential for price appreciation if yields move lower. Short‑term bonds are highly valued during uncertain periods—such as the present—as they are less exposed to interest rate changes than longer‑dated bonds. They also provide the potential for higher returns than cash while being almost as flexible. This flexibility may be useful given uncertain economic and market conditions.

Key takeaway

Commodity-oriented equities may offer an effective hedge against inflation risk.

Shifting market conditions will favor active management

The investment environment is changing. The post‑GFC era of low rates and abundant liquidity is being replaced by one of higher rates, greater divergence of returns, and more volatile markets. We believe this period of transition will continue in the second half of 2024 and underpin conditions for active managers to outperform.

Challenging market conditions will require investors to be more valuation‑sensitive than in recent times, when a rising tide lifted all boats. Traditional skills, such as identifying stock drivers and idiosyncratic risk, will continue to be essential, but investors will need to take into account wider macroeconomic, social, and geopolitical factors along with company fundamentals.

Active managers have performed well following periods of index concentration

Active managers tend to go beyond benchmarks and into factors that can be cyclical, such as small‑cap and value stocks—both of which we believe may perform well in the period ahead. Top performing active managers have also historically performed well following periods of heavy index concentration—and markets recently have been concentrated to an unprecedented degree.¹ Although it is difficult to predict when the current period of index concentration will recede meaningfully, there are already signs that the dominance of the Magnificent Seven is beginning to fade.

The end of the period of very low rates will also, we believe, lead to greater dispersion and heightened volatility in bond markets. Active investing can help with duration management, as well as managing country selection, curve positioning, and security selection.

These developments do not mean we expect passive investing to undergo a major retreat. However, we believe that active management will be the better option for the period ahead, as it can offer better outcomes during periods of greater volatility and dispersion.

Key takeaway

We believe the likelihood of continued asset price dispersion and heightened volatility will suit active management strategies.