Macro: Sandcastle economics
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Equities: Are we blowing bubbles again
Peter Garnry
Chief Investment Strategist
Summary: Explore key trends and opportunities in European equities and electrification theme as market dynamics echo 2021's rally.
The sandcastle of extreme index concentration
In our last Outlook we highlighted how the rally in AI and obesity drugs was defying financial gravity, offsetting many of the headwinds from higher interest rates. As a result, we leaned against the rally in technology stocks. Throughout April, it looked like the right call as markets priced in a higher-for-longer narrative on US policy rates. In May, sentiment came back, and animal spirits were unleased by Nvidia’s demand outlook convincing the market that the boom in AI and US economy will continue.
As we enter the third quarter of 2024, it all feels like an echo from 2021, as many of the same dynamics are underpinning the current rally: simple extrapolation of recent growth, a belief that technology growth has no limits, speculation in crypto and meme stocks, strong buy-the-dip patterns, extreme index concentration (the 10 largest stocks are now 35% of the S&P 500 Index) and strong momentum in a narrow group of the market. To top it off, the US equity market has now entered the same equity valuation levels as in 2021, which is higher than we saw during the dot-com bubble.
Four of our thematic baskets are showing signs of being in a short-term bubble, as they are up more than 50% over the past year, double that of the MSCI World. These themes are AI/semiconductors, defence, nuclear, and obesity/oncology.
ECB rate cut, robust economy, and inflation dynamics
The third quarter of 2024 will be marked by the ECB’s rate cut in June and whether it will do another cut in September. The market is also split on whether the Fed cuts in September or November. Regardless of these central bank decisions, the outlook for equities and earnings both remain stable.
On regions, our view is to overweight Europe, as we believe European equities will be repriced higher relative to other markets on the ECB rate cut in June and a growth rebound in the third quarter. We remain negative on emerging market equities until we see concrete evidence that China is making the necessary market reforms to restore confidence in its equity market.
On a sector level, we are the most positive on energy, health care, financials, and information technology, while negative on industrials, consumer discretionary, utilities, and real estate.
Conviction: Electrification is a game changer
When we look back 10 years from now, it will be clear that the electrification of our economy was a profound game changer. It has transformative implications for energy markets, geopolitics, and industrial production. The region that stands to win the most from this change is Europe with its large, interconnected electricity market, which is sometimes called “the world’s largest machine”. This allows Europe’s electricity market to be more efficient than the US grid, allowing a higher degree of stability and diversification in addition to reducing its previous reliance on Russian energy, increasing Europe’s geopolitical strength.
Before AI, the key drivers of electrification were electric vehicles (transportation), data centres (digitalisation), and conversion of oil and gas boilers to air-to-water heat pumps (heating). With the explosion in demand for AI workloads, data centres related to training and running AI models are now the key marginal driver of electricity demand. One year ago, most utility companies in the US projected almost no growth, while recent estimates now suggest a 160% increase in power consumption from these data centres over the next 6.5 years . Investors are facing the choice of how to invest in the electrification boom. With the surge in power consumption, one would think utilities are a sure winner. We view this bet as risky and prefer investing in companies building the electricity grid infrastructure.
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