August
2024
Market Update

EXECUTIVE SUMMARY

  • US small caps outperformed in July as investors welcomed the prospect of lower US interest rates.
  • US big tech earnings failed to generate much excitement. Investors will have to wait 1-2 years for the payoff of their massive AI-related spending to become visible.
  • US banks are performing well, supported by a surge in investment banking income.
  • Consumer-facing businesses continue to struggle as low-income US consumers curtail spending.
  • Global equity markets have sold off in early August as US growth concerns resurfaced.
  • With equity markets priced for growth well into the future, we remain cautious and focused on diversification.

MARKET SUMMARY

All major asset classes recorded a positive performance in July as expectations of US interest rate cuts grew.

There was a notable shift in equity market leadership from mega-cap technology stocks to smaller companies

trading on cheaper valuations. These companies are expected to benefit more from declining rates.

Despite their name, “US small caps” are still meaningful companies. Equivalent Australian-sized companies include Computershare, ASX, Sonic Healthcare, Qantas, Amcor and South32.

Sustained positive sentiment towards small caps is contingent upon the US/global economy remaining resilient.

July also marked the start of the US Q2 earnings season.

As always, big tech was the main focus. There is a lot of hype surrounding artificial intelligence (AI), which has driven up the valuations of technology companies. Investors are now asking when they will start reaping the benefits of their substantial investments in AI.

The short answer is not for another year or two, as most companies are still in the piloting phase. But sooner or later, big techwill have to show that AI can make real money.

In the meantime, investment in AI-related infrastructure (e.g. data centres and servers) continues at pace. Figures from recent quarterlies show that tens of billions of dollars are spent each quarter.

The fear of missing out or losing market share appears to be a big driver of their decisions. Tactically, this makes some sense.

Alphabet CEO Sundar Pichai sums it up neatly, “not investing to be at the front” of the AI race “definitely has much moresignificant downsides” for Alphabet.

Meta CEO Mark Zuckerburg concurs, “I’d rather build capacity before it is needed rather than too late”.

After rallying strongly into reporting season, big tech results did not generate much excitement.

Outside of tech, US banks benefited from a surge in investment banking income.

According to Dealogic, global merger and acquisition volumes increased by 20% to US$1.6 trillion in the first half of 2024. This is a significant tailwind for investment banks such as Goldman Sachs and JP Morgan, who earn substantial fees from advising on M&A transactions (and debt and stock underwriting).

This boost helped offset lower net interest income, as banks paid more on customer deposits (higher interest rates).

Banks warned of stress amongst the lower-income consumer segment and set aside more funds for future loan losses.

Global banks have performed strongly on the stock market over the past 10 months. They trade on much cheaper valuations (9x forward earnings) than their Australian counterparts (average 17x).

Many consumer-facing businesses commented similarly that higher prices and slowing wage growth are curtailing spending, particularly among lower-income consumers.

Kraft Heinz noted “consumer sentiment remains cautious” after reporting lower-than-expected sales growth. Consumer goods leader Procter & Gamble is seeing a more discerning US shopper.

McDonald’s reported its first drop in global sales since the pandemic. It suggested that in many cases, the lower- income consumer was “dropping out of the market, eating at home, and finding other ways to economise.”

Starbucks said the “challenging consumer environment” is weighing on cafe sales.

PepsiCo trimmed its full-year revenue outlook, stating it was “related specifically to the consumer in the US”.

The early August sell-off on the equity markets reflects renewed concerns about US economic growth and the possibilitythat the Fed may be too late in cutting interest rates. Expensive valuations provide a good excuse for investors to reduce risk until the outlook becomes clearer.

We note with interest Warren Buffett-led Berkshire Hathaway’s recent financial report, which showed it had sold almost half of its Apple stake and boosted its cash (and short-term US Treasury holdings) to a record US$277 billion.

Berkshire’s equity holdings represented about 52% of the total porfolio value as of 30 June 2024, down from about 67% on 31 December 2023.

Investor confidence is all that matters.

  • The US S&P500 Index gained +22.6% over the 12 months ending 30 Jun24.
  • One could easily assume economies are booming, CEOs are optimistic and consumers are confident.
  • Our takeaway however is that investors are the most confident.
  • Why do we say this?
  • Corporate profits grew by a modest +5.5% over the last 12 months, which tells us a lot about corporations andconsumers.
  • Investors however are willing to pay +15.4% more for the same profits. All this when the starting point was already elevated (equities were expensive a year ago).
  • The primary driver of returns over the last 12 months has been “multiple expansion”.
 

So, what got investors so excited?

  • The US equity market climbed the proverbial “wall of worry” over the last 12 months.
  • What was the worry?
  • Interest rates.
  • How high will they go and what damage will this cause?
  • These questions have now been answered.
  • The 10Yr US Treasury yield reached 5% in October, pressuring equities along the way. A second move higher failed at 4.7%. This time, equities started rallying before rates even peaked
  • Today, it is clear that a stimulus-fuelled economy with much momentum proved enough to save jobs and consumer spending while central bankers fought inflation.

Where to from here is the big question.

  • The key to looking to the future is to fully appreciate the past.
  • Two important ingredients investors brought to equity markets over the last 12 months are:
    • Liquidity
    • Earnings Achievability
  • Will investors continue this journey?
  • The prospect for liquidity remains good.
  • Rate cuts and future earnings hopes may keep investors complacent, which is good for liquidity.
  • Earnings achievability is perhaps more debatable.
  • For the past 24 months, investors have had high hopes of robust earnings growth. Those same growth expectations have never materialised.
  • Growth expectations have just been pushed out to future quarters. To date, their achievability has never been doubted.
  • There is no need to look further than current market pricing to illustrate earnings confidence.
  • Paying 20 times current earnings is fair for the US market and has been for some time.
  • Earnings expectations for the last 12 months are $218…multiplied by 20 gives an index fair value of 4360.
  • Earnings expectations for the next 12 months are $258…multiplied by 20 gives an index fair value of 5160.
  • Current market levels of 5500 highlight investor confidence in 2025 earnings achievability.
  • Not only are index earnings at a record level, but investors also endorse a 12-month growth rate of +18.2% as a given.
  • If that is not enough, investors are already buying further growth…be cautious.

Volatility is not your friend.

  • We may be exiting a period of lower volatility, which started in Nov 23.
  • This was driven by a consensus belief that interest rates had peaked globally.
  • This 8-month period (1Nov 23-30Jun 24) of low volatility saw investors enjoy a +28.8% gain in the US S&P500 Index.
  • Will this continue?
  • The US election is about 3 months away and brings uncertainty at a time when market valuations are stretched.
  • Should the recent spike in volatility stick around we would look to similar periods of higher volatility for guidance.
  • The preceding 7-month period (1Apr 23-31Oct 23) saw a modest +2.1% gain in the US S&P500 Index.
  • We don’t assume the past to be the future and for previous winners to be persistent winners.
  • Diversification is key in this market.
  • Areas of interest are Japan, Europe, equal weight US stocks, Mid/Small Global Stocks, Infrastructure and Gold.
 

ASSET CLASS PERFORMANCE

Australian Equities

  • The S&P/ASX200 Index gained +4.19% in July, the best monthly performance since December 2023.
  • At a sector level, Consumer Discretionary +9.08%, A-REITs +6.78% and Financials +6.26% performed best as investors became more comfortable that Australian interest rates had peaked.
  • Wesfarmers stock surged +13% to reach a record high. It trades on a high multiple of 30x forward earnings.
  • Commonwealth Bank also hit a record high, gaining +7.94% for the month. Its elevated valuation (23x forward earnings) has many investors scratching their heads.
  • Utilities -2.85% performed worst, weighed down by Origin Energy – 3.41% and AGL Energy -4.16%.
 

International Equities

  • The MSCI All-World Index added +1.76% in July and has gained +18.34% in the past 12 months.
  • There was a wide dispersion in US equity market returns. The Dow Jones Industrials Average gained +4.51%,

the S&P 500 added +1.22%, whilst the technology-heavy Nasdaq eased –0.73%.

  • European stocks bounced back from June’s losses, with the S&P Europe 350 Index gaining +2.29%.
  • European equity market valuations continue to look more attractive than US markets.
  • The S&P Japan500 Index surged +4.76 in July. At its July policy meeting, the Bank of Japan unexpectedly raised rates to 0.25% (still a very low level), supporting the yen and reducing the risk of higher import prices.
  • The Dow Jones Emerging Market Index added +0.42% in July, whilst the S&P China500 Index eased –0.14%.
 

Property and Infrastructure

  • Higher conviction of upcoming US interest rate cuts boosted Property and Infrastructure prices in July.
  • These asset classes have defensive characteristics and provide diversification benefits to porfolios.
  • Australian and International Property increased by +6.83% and +6.01%.
  • Global Listed Infrastructure (Hedged) added +4.48%.

 Fixed Income

  • The Bloomberg Australian Bond Index gained +1.48% in July.
  • The 10-year Australian government bond yield eased to 4.14% from 4.35% a month earlier.
  • June quarter inflation came in at 3.8% over the year, meeting market expectations and suggesting no change in the RBA cash rate at its upcoming (6th August) policy meeting.