Half time… much still to play for

Q2: continuation of the narrow U.S. rally

After a pretty weak start in April, U.S. equity markets continued to advance over the remainder of Q2 against the backdrop of a solid Q1 earnings season, moderating inflation and jobs data that added further momentum to the “goldilocks” drumbeat. Moreover, the most recent U.S. CPI release (for May) showed the slowest MoM core CPI rise in almost two years which helped to cement market expectations that Fed rate cuts are still on the cards.

As a result, the S&P 500 rose +4.3% in Q2, reaching a number of fresh all-time highs as well as posting a third consecutive quarterly gain. It is noteworthy, however, that broader U.S. equity market gains were once again characterized by a rather narrow leadership being largely driven by another very strong quarter for the Magnificent Seven (+16.9%). By contrast, the equal-weighted S&P 500 (-2.6%) lost ground in Q2 (see Chart 1). So quite different story depending on one’s angle, and a continuation of the Q1 story of Mega Cap Tech outperformance and weakness elsewhere.

Across the pond, the ECB announced its first interest rate cut since the pandemic, lowering the deposit rate by 25 basis points (bps) to 3.75% at their June meeting. Even so, European markets still experienced challenging closing weeks in Q2 due to the snap legislative elections in France with the CAC 40 (-6.6%) recording its worst quarterly performance in two years and the Franco-German 10-year spread widening by the largest quarterly amount (+29bps) since the Euro sovereign crisis. Nonetheless, the STOXX Europe 600 was able to end Q2 in the green (+1.6%). In Japan, the Nikkei was down -1.9% in Q2, after a very strong over 20% gain in Q1 (see Chart 2).

From a sector perspective, Real Estate and Materials are the only sectors on a MSCI ACWI basis that have delivered a negative price performance YTD, while the Q2 performance shows a very narrow leadership with IT clearly leading the pack. Apart from that only Communication Services and Utilities are in the green (see Chart 3). 

Attractive NTM return prospects

Despite the undeniably-stretched valuations observable in the U.S., where the combination of falling inflation, fading recession fears and AI enthusiasm has shrunk the premium that investors require for taking on the additional risk of owning equites over bonds (equity risk premium) to the lowest levels since the late 1990s (see Chart 4), market performance in the first six months of 2024 has once more underpinned the argument that equities remain the most convenient vehicle to capitalize on the AI- driven technological progress wave.

Backed by an expected NTM EPS (next twelve months earnings per share) growth of 11%, we have lifted our 12-month (June 2025) S&P 500 index target to 5,600, applying an unchanged LTM P/E (last twelve months price/earnings ratio) of 21.5x which is clearly exceeding what a “historically common” equity risk premium would suggest. To account for the valuation stretch as well as the implicit option on AI potential, we have added a temporary growth premium of 15% to our fair S&P 500 P/E estimate of 18.5x to reflect superior expected mid-term earnings growth, because the index may become less vulnerable to cyclical swings – as the proportion of secular growth companies (with a greater share of recurring revenues in revenue streams) increases further. Likewise, ex-U.S. earnings should grow at healthy rates, while we assume that the extreme valuation discounts relative to the U.S. equity market (see Chart 5) will not expand further from here.

Overall, our new June 2025 index targets imply attractive return prospects for most regions, in the mid-single-digits (see Chart 6). Of course, our base case is exposed to an array of risks from internal as well as external factors. With regard to the former we would highlight that an eventual “AI fatigue” could lead to mean-reverting valuation levels. An initial rate cut by the Fed could also trigger some significant sector and style rotation. Moreover, aggregate profit margins are still very high, giving them little scope to widen further. On the external side various elections could cause volatility spikes but with possible corrections expected to be rather short-lived. Global geopolitical risks (from military conflicts as well as tariff disputes) could however spark fresh market uncertainty. Finally, the consumer space might be challenged by the exhaustion of accumulated savings from the Covid period.

Barbell: keep Mega Caps, add Small Caps

Given the unprecedented rally of some U.S. Mega Cap Tech names that has been driving the broader equity market, the question arises: how much upside is still on the cards, now the easy money has been made? It appears likely that the overall trend will persist as long as the macro picture remains stable, the Tech-heavyweights continue to deliver on earnings and they keep launching new, exciting products and services. The latest news flow has been quite encouraging – new product releases and ever more powerful large language models (LLMs) are continuing to fuel AI enthusiasm within the investment community. On top of this, substantial data centre investment announcements may bolster optimism around potentially transformative productivity gains, with the hope being that these could result in higher margins and softer inflationary headwinds, while associated Capex needs could have a meaningful positive macro effect. However, we emphasise that it is premature to assume an imminent AI-driven impact on the economy as a whole.

We believe that the significant underperformance of Small Caps represents an opportunity to engage with this category – particularly in Europe (as discussed below). We believe that Small Cap stocks should benefit from stabilizing bond markets and likely peaking yields in the U.S. and Europe. Re-accelerating economic momentum in Europe may act as a catalyst for Small Caps in the region that show favourable valuations and at the same time are expected to deliver strong earnings growth over coming quarters and years. We believe that European Small Caps provide a cyclical hedge and could complement to Mega Caps (expected to do well owing to strong secular earnings growth, AI exposure, sound balance sheets and superior pricing power) as part of a “Market Cap Barbell Strategy”.

AI is not a bubble (yet), a historical perspective 

Historically, new innovations have often been accompanied by stock market bubbles. A study from 2000 found that, out of a sample of 51 major technology innovations that were introduced between 1825 and 2000, 37 caused distortions in the stock market.

In the 1840s for example speculation built up in railway stocks in the UK amid a rapid expansion of the railway system following the opening of the first locomotive-hauled public railway in 1825. The bubble burst in the 1850s and stocks fell by an average of 85% from their peaks. During the 20th century, several bubbles formed in stocks associated with consumer products. First came the bubble in radio stocks in the 1920s/30s that followed the surge in demand for radios and broadcasting. Between 1923 and 1930, 60% of U.S. households purchased radios and consequently radio stations mushroomed across the country. This increased the scope for advertising and the adoption of other products as they came to market. The valuations of broadcasting shares skyrocketed in the 1920s but soon crashed back to earth. Some stocks lost as much as 98% over a span of less than five years and most radio manufacturers went out of business. Later, during the 1980s, hundreds of companies entered the market for PCs. However, in 1983 several producers announced losses, which led to a broad decline in share prices.
Over the following years many companies left the industry, which became dominated by a few of the surviving firms.
Famously, the pattern repeated itself during the dotcom bubble in the late 1990s as investors flocked to stocks (seemingly) related to the internet. 13 large caps increased in value by over 1,000% in 1999 alone, driving the Nasdaq to increase fivefold from 1995 to 2000. However, as the bubble burst in 2000, the index lost 34% within a month and 80% before it eventually troughed in October 2002.

Given the long history of stock market bubbles associated with technological innovations and the recent rally of the IT sector, particularly of stocks seen as the epicentre of artificial intelligence (AI) revolution, investors understandably wonder whether the sector is currently in a bubble. We think it is not (yet)! Valuations of the largest U.S. technology companies are high. Nevertheless, they are not close to levels reached at the peak of the dotcom bubble. The Magnificent Seven, which many see as the major drivers and beneficiaries of the AI evolution, have traded at a peak NTM P/E of 44.1x which compares to S&P 500 Information Technology NTM P/E of 59.1x at the height of the dotcom bubble (see Chart 7).

Aside from a less stretched valuation, an important difference between the current tech leaders and those from 25 years ago is that the current group is already very profitable. They are also able to invest in their business or acquire smaller companies even in the current interest rate environment, as their cash reserves are higher than their dotcom predecessors.

Furthermore, the aggregate Magnificent Seven 12-month trailing return on equity and net profit margin are standing at 33% and 21%, respectively, both topping the equivalent S&P 500 Information Technology dotcom levels by a substantial extent. Over the last three years they have grown their EPS at an average CAGR of 39%, while revenues grew at a 24% rate. This has made these companies into earnings-generating machines.

However, we caution against projecting similar sales growth and profitability rates into the future. According to research, there have been only 121 S&P 500 companies since 1985 that have been able to maintains a sales growth rate of 20%+ for 5 consecutive years, while only 4 companies managed to have EBIT margins above 50% for 5 years in a row.

European small caps – also beautiful 

European Small Caps (STOXX Europe 200 Small Index) recorded a dismal performance since their peak mid-November 2021 and last trough end October 2023. During this time the sub-index of the STOXX Europe 600 has delivered -29% (total return) in EUR terms, underperforming the STOXX 200 Large Index, the corresponding large cap benchmark – by 26 ppts (see Chart 8). The difference in performance, however, is not surprising in view of the characteristics of these market segments.

European Small Caps have tended to be more cyclical with their relative performance versus Large Caps moving in tandem with the ups and downs of business cycle indicators in the past. More importantly, these two groups on average display some significant balance sheet differences. Excluding Financials and Real Estate companies, as these would impair the comparability of the two indices, the Small Cap index contains more levered companies. Compared to their large peers, Small Caps’ net debt-to-EBITDA ratio is 30% higher at 1.3x.

In addition, approximately half of Small Cap debt is financed at floating rates which is a significantly higher share than for Large Caps. Small Caps' profitability was therefore more severely affected as bond yields began to rise across Europe.

The prospect of declining profitability has meant a double whammy for the Small Cap index that was trading at a NTM P/E-valuation of more than 20x in 2021 – a more than 40% premium compared to its own 10-year median as well as to the Large Cap equivalent. Despite its recent recovery, the STOXX 200 Small Index multiple is currently standing at 12.7x, roughly 20% lower than it had been typically in the past (see Chart 9).

Since then, European Small Caps have gained momentum on the back of the expected ECB cutting cycle which should alleviate rate headwinds and support a re-acceleration of the European economy – based on rising real wages, improving consumer sentiment, normalised energy prices, ongoing fiscal support, and a stabilisation of growth in China – in H2 of this year. The earnings outlook has thus turned the corner and Small Caps could return to superior earnings growth and regain a premium to their large peers. Negative earnings revisions have faded, and consensus estimates point to 10% and 14% YoY EPS growth in 2024 and 2025, which is almost 6 ppts and 4 ppts ahead of Large Caps. Further impetus could come from the merger and acquisitions (M&A) space. According to M&A experts, volumes are expected to pick up further in the second half of 2024 after a period of sluggish activity.

Overall, the improving backdrop has sent the STOXX 200 Small Index on a remarkable rally since its trough at the end of October 2023, thereby outpacing the STOXX 200 Large Index by a small margin. Despite the recent slight outperformance, the NTM P/E discount of Small Caps has however widened, which could mark an attractive entry point for investors.

Q2 2024 earnings season preview

The Q2 2024 earnings season in the U.S. will kick off next week with some major names from the banking universe releasing their numbers. In contrast to Q1, where hurdle rates came down noticeably over the quarter, aggregate Q2 2024 earnings growth estimates for the S&P 500 have been revised up since the beginning of April with companies having overall been much less pessimistic on their Q2 prospects compared to the previous quarter as the number of companies lowering their EPS guidance stands below its 10-year average level. Below the surface one can however observe a quite pronounced sectoral divergence.

Consensus forecasts are currently pointing to a +10.6% YoY increase of S&P 500 earnings in Q2 2024 on +4.2% higher revenues – this would mark the fourth consecutive quarter of positive aggregate earnings growth for the index. It is however worth noting that a bulk of the earnings growth is again attributable to Mega Cap Tech, which continues to benefit from the developments around AI. Since the beginning of the quarter the aggregate Q2 earnings growth forecast has been revised up by 0.2ppt with consensus EPS estimates of six out of eleven sectors having seen upward revisions – Energy (+3ppt), Communication Services (+3ppt) and Consumer Discretionary (+2ppt), Financials (+2ppt), IT (+2ppt) and Utilities (+0.3ppt).

Eight sectors are expected to deliver positive YoY earnings growth figures for Q2 2024.

While Communication Services (+22%), Healthcare (+20%), IT (+17%) and Energy (+13%) are expected to see double-digit YoY advance in earnings, Materials (-9%) and Real Estate (-3%) are assumed to take the lead in terms of YoY earnings declines in Q2 2024 (see Chart 10).

Over in Europe, the aggregate STOXX Europe 600 earnings forecast for Q2 2024 has come down slightly by 0.9ppt since the beginning of April, now suggesting an earnings increase of +1.4% YoY (after four consecutive quarters of negative YoY earnings growth) which is in line with the acceleration in economic activity momentum one could witness over Q2. Utilities (+11ppt) and Financials (+4ppt) are the only sectors that have seen upward revisions to Q2 2024 earnings forecasts. On a YoY basis Utilities (+18%) and Energy (+13%) are expected to experience double-digit YoY earnings growth, while only IT (-25%), Industrials (-8%) and Real Estate (-2%) should report negative earnings growth in Q2 (see Chart 11). Q2 2024 revenues of the STOXX Europe 600 are expected to rise by +1.6% YoY, following four straight quarters of YoY revenue declines.

On a full-year basis, consensus earnings growth estimates have improved over the past three months, now indicating that aggregate FY 2024 earnings per share (EPS) will come in at +11% (S&P 500) and +5% (STOXX Europe 600) YoY. It is worth mentioning that, after having been in positive territory since March (S&P 500) and April (STOXX Europe 600), respectively, 2024 net earnings revision ratios have started to weaken, most recently falling back to negative levels on both sides of the Atlantic indicating that the upward revision momentum is at least slowing (see Chart 12).