After recession concerns drove investors to seek cash as a safe haven for much of 2023, a shifting outlook towards lower short-term interest rates and reduced cash earnings is prompting investors to reallocate capital into riskier assets, according to Lazard’s chief market strategist, Ronald Temple.
However, with current market levels near record highs, investors are reconsidering where to allocate their capital in global markets.
In his latest midyear outlook, Temple noted the S&P 500 Index and the MSCI EAFE Index, which focus on developed markets excluding the United States, both delivered a total return of around 55 per cent from mid-October 2022 through to mid-June 2024.
Importantly, the drivers of performance for the two indices were very different, he said. Eight of the 10 biggest contributors to the S&P 500 gains were technology and communication services stocks while only 30 per cent of the MSCI EAFE Index return was generated by the top 10 stocks and 35 per cent was from the top 20.
Instead, the MSCI EAFE Index return was driven by a much broader range of industries, including healthcare, technology, financial, and industrial companies. Temple noted that while the US market’s advance has been narrow and at or near record levels, non-US markets have delivered a healthier, broad-based advance.
“From my perspective, the only way the mega-cap tech companies can continue to deliver market-beating earnings growth is if their customers realise a return on investment from buying their goods and services,” Temple said.
“To date, we have seen strong growth in earnings from the top six stocks but no meaningful earnings growth from the rest of the S&P 500 stocks in aggregate since the end of 2021 when the market hit its previous peak.”
He believes that executives of large companies will hesitate to invest in AI unless there is clear evidence that the capital deployment is yielding returns, given the prominence of the AI rally in US markets. Moreover, Temple added that while it may be too early to see these returns in earnings or profit margins in 2024, he anticipates that this will not be the case in 2025.
“I expect to see a broadening of the equity market rally driven by better earnings growth outside of the technology sector,” he said.
This broadening, he noted, does not imply that some tech leaders won’t continue to perform solidly. However, the gap between tech leaders and the rest of the market could narrow or even reverse, as investors recognise that the broader market has largely stagnated for over two years and now presents more attractive return potential.
Looking ahead, the market strategist said the best approach to deploying capital will stem from identifying risky assets that are less correlated to the most expensive parts of global equity markets, like tech and AI leaders.
Instead, he proposed investing in areas that have “more unrecognised upside” moving forward.
“These include emerging markets, Japan, small cap, and infrastructure-related equities,” Temple said.
“Another option for gaining equity exposure with less downside risk is to consider convertible bonds, which offer a bond floor (assuming you have done the proper credit analysis) while also offering equity upside participation through the embedded call option.”
Looking at non-US markets, they are trading at much less demanding valuation multiples, Temple said, and are likely to benefit from accelerating growth.
“Moreover, non-US companies typically are more exposed to floating-rate debt, which should benefit them disproportionately as the European Central Bank (ECB) and other non-US central banks ease before the Fed,” he said.
He projected the ECB, which began cutting rates in June, could ease by 100 bps by the end of 2024, while the US Federal Reserve will initiate an easing cycle in September, cutting by 50 to 75 bps in 2024.
In Japan, where markets have been pricing 30 bps of tightening from the central bank throughout the year, he expects any additional hikes to be limited to 10 to 20 bps.
Non-US companies could also see a more pronounced uplift in earnings and revenue from current levels, given their economies were “less resilient” after the pandemic than the US economy, which benefited from much larger fiscal and monetary stimulus, he suggested.
“Outside of the United States, there is still room for upside both in terms of valuation multiples and earnings recovery given less-resilient economic conditions since the pandemic,” he said.
In determining allocations, the investment executive also highlighted recent analysis of investor behaviour that suggests those who missed the 10 strongest up-days in the US equity market forfeited over half of the total return generated from 2003 to 2022.
“This anecdote applies similarly, though to different degrees, to global equity markets, where trying to time entry and exit points is a very risky proposition.
“While no one likes to buy at the peak, it’s also important to recognise that five years from now, such a purchase, if targeted based on the quality of the investment and the valuation thereof, will often be seen as a wise decision,” Temple said.
