By Alex Tedder, Head of Global & Thematic Equities, and Tom Wilson, Head of Emerging Market Equities, at Schroders
In 2024 uncertainties will persist and equity markets are likely to remain volatile. As always, however, the old adage that “there is always a bull market somewhere” may prove accurate. In fact, we think there are a number of areas that may prove highly profitable for global equity investors next year.
The 3D Reset and the end of the free money era
Perhaps the most striking feature of financial markets in the last decade was the steady decline in the cost of risk. With post-Global Financial Crisis (GFC) central bank policy driving down interest rates to zero, the effect on asset prices was dramatic; they went up, a lot.
Then came the pandemic, closely followed by the war in Ukraine, events which served to crystallise pressures that had been building for some time.
There are many different factors at play, but we think they can be usefully grouped into three categories, namely 1) Demographic constraints; 2) Decarbonisation imperatives; and 3) Deglobalisation initiatives. Together, they form what we’ve called the 3D Reset.
Combined with high sovereign debt levels, these factors have created supply bottlenecks, driven up wage costs, boosted general price inflation, and underpinned populist politics. Central banks have been forced to act decisively. Interest rates have been raised dramatically and look set to stay that way for some time. No wonder financial markets are jittery.
Time to do the opposite of what you did in the last decade
Hindsight is always 20/20. Looking back over the 10 years to 2021, there were only a few things that investors needed to have done: buy equities; invest in growth (especially technology); invest mainly in the US; not worry about valuations; lever up (finance with debt). Anyone following this approach would have done superbly well, and many investors did.
But the 3D Reset is now ongoing and the implications for investors are substantial across most asset classes. Most obviously, cash is no longer trash: money in the bank can get you respectable returns. For equity investors a change in mindset is needed. This involves:
- more diversification across regions (less US, more of the rest of the world)
- more focus on the implications of structural change
- renewed attention to valuation, quality, and risk.
Look beyond the US; particularly to unloved markets like Japan and the UK
As Warren Buffett regularly reminds us, it’s tough to bet against the S&P500. Since the end of 2010 the S&P has delivered, in US dollar terms, a cumulative return of 340% compared to 95% for European equities and just 20% from emerging markets. China has delivered a negative return over that period.
The US corporate sector remains, in aggregate, better managed and more innovative than pretty much any other. It has a unique constellation. High growth areas such as technology, communications, or healthcare account for a far higher proportion of the index than in other regions. The IT sector, for example, now accounts for 28% of the S&P500 compared to just 6% in Europe.
On the basis of the above it is likely that the S&P will continue to trade at a premium to other markets. However, it is notable that the valuation gap between the US and the rest of the world is now at extreme levels. To put this into context, the market capitalisation of the “Super-7” group (responsible for most of the return from global equities this year) is now greater than that of the UK, France, China, and Japan combined. Historically, while such polarisation has often persisted for long periods, inevitably at some point the gap closes.
To be clear: we aren’t negative on the US market. Stripping out the Super-7 and other high growth names, the S&P500 is trading only slightly above its long-term average. Indeed, small- and mid-cap US stocks look compellingly valued in many cases.
Think about long-term, structural themes
It is striking that so far in 2023 the MSCI Global Alternative Energy Index is down 40% (source Bloomberg, end October 2023). Investor sentiment has been hit by a combination of poor results (not helped by extended valuations in some cases), and a political backlash against environmental initiatives.
And yet, even the most hardened eco-sceptic would struggle to deny that extreme climate effects are becoming ever more apparent. The case for decarbonisation is over-whelming. Given that many of the post-pandemic cost pressures and over-capacity in parts of the renewable energy space have now been worked through, now would seem to be an excellent time for investors to consider the energy transition theme.
It seems clear that technology is key to addressing many of the structural challenges we currently face. Solar and carbon capture are central to the energy transition theme, for example. In a similar vein, the challenge of demographics is one that will largely be met by medical discovery, automation, and Artificial Intelligence (AI).
AI has captured the imagination of investors and of course there is a substantial risk of it getting over-hyped. Nevertheless, the logic behind the market’s excitement is irrefutable. Automation is a long-standing trend that has rapidly expanded from narrow industrial processes to whole swathes of the service sector. Generative AI, based on language models, raises the stakes materially.
Globally, there are more than one billion knowledge workers – that is, workers applying theoretical or analytical knowledge to specific tasks. Augmenting, enhancing, and perhaps replacing a portion of this work will result in immense changes and create significant opportunities for investors not just in the technology sector but in almost every part of the economy. PWC put the potential economic value of AI at $17 trillion annually by 2030. Compared to current global GDP of around $110 trillion that is an extraordinary sum and the opportunities in the automation space are likely to prove immense.
Price is what you pay, value is what you get
In a higher interest rate environment, valuations matter much more than when interest rates are close to zero. Equities have been wonderful long-term investments, with the S&P500 delivering a real return (after inflation) of more than 7% per annum over the last 150 years, compared to just 2% from US Treasuries. And yet, as we all know, equities are also highly volatile; there have been drawdowns of more than 10% in 29 of the past 50 years. Equity markets are fickle and can be quite unforgiving.
All the more reason, in our view, to focus on valuations. Or more precisely, on value for money. Whereas the last decade was all about growth (especially revenue growth), the next decade is likely to be much more about finding companies that offer genuine value.
By this we do not simply mean companies that are cheap. Cheap stocks are usually cheap for a reason. Companies in traditional sectors such as energy, financials, or industrials are not only highly cyclical, but also face major disruption from the transition to new technologies. In contrast, a company trading expensively on current metrics may turn out to be anything but if it delivers sustained growth and cashflows in the future.
We think it will pay investors to focus on the longer-term, identify the areas with structural, under-appreciated growth, and commit strongly to those companies with sustained competitive advantage. Like anything, the price you pay for a security is the price you pay. Value is what you get. There is plenty of value in global equity markets, especially for the patient investor.
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