Midyear Equity Outlook: Investing Beyond the Megacaps

Nelson Yu:

If you told me at the beginning of the year that we were going to go from starting with six interest-rate cuts to now we’re hoping to get one, I would be shocked to say that the equity markets are up 15%. What’s really happened was the economy underneath has been very, very strong, and that’s really what’s enabled the Fed to actually push out those interest-rate cuts. I think that’s actually really good for the stock market. Clearly, the best performing sector has been technology, of course with all of the AI powering the technology gains. But the second best—you would never guess—it’s actually Japan. And that’s really because of the corporate reform movement that’s going on with Japan, as well as the weaker Yen. So then we’ve also got other economically sensitive sectors—like financials and industrials—doing quite well, underlying the health of the economy, as well as generally the rebuild that’s needed in manufacturing.

Lagging the stock market is consumer, not surprisingly, as well as materials. There is a question in terms of how long the consumer can stay healthy, given the level of inflation that we have right now. Inflation has actually been stickier than the world expected. And higher up for longer means that we actually have to be more selective in the types of companies that we invest in. We have to actually manage the risks to the higher costs of capital. One of the biggest risks we see out there is the concentration in the market. There’s a handful of stocks whose valuations, for deserved reasons, have gone up quite high. What we need to do is we need to turn our attention from what we’ve called the Magnificent Seven to the Magnificent Others. There’s a large valuation gap and a lot of opportunity outside of that pool of largest cap stocks.

Over the last six quarters, what we’ve seen is many, many companies outside of that magnificent group of large-cap stocks has not done well. They’ve beat, and the market just hasn’t reacted. On the other side, if they miss, they get punished just as much as they always have. This asymmetry is actually what opens up a lot of opportunities to us. What’s going to be the catalyst for valuations to reconverge and actually get rewarded for some of the opportunities that we’re seeing? Well, one of the big catalysts is actually AI itself. Rather than just sticking to the largest cap companies who are, right now, the poster child of AI, there’s a lot of other opportunities playing here, both from the providers of AI and the AI enablers to also the AI beneficiaries. On the enablers’ side, just think about what it takes to create some of the large language models: You have data centers. You actually have a lot of power that you need to power those data centers.

Then if you think about the beneficiaries—healthcare. Think about how much efficiency we can get out of the healthcare system if we can actually apply AI to R&D, to connecting with customers, even looking at connecting patients to doctors. In industrials, we actually see a lot of other factors besides just AI that’s powering their profitability. There’s a lot of move towards reshoring of manufacturing capability and building up industrial strength within each country. We see that also in Europe. We’re expecting a manufacturing renaissance in Europe, and that’s where we’re finding a lot of growth opportunities outside of the US. Finally, we’re actually seeing a lot of movement in emerging markets. That’s an area that’s been depressed for a very long time because of the headwinds we’re seeing from China. But we’re also seeing a lot of great companies. And the returns we’ve been able to generate in emerging markets has been fantastic, given the dispersion that’s available in that market.