What we discussed in
May
Donough Kilmurray
Chief Investment Officer
In April, we debated whether the strength in equity markets could be justified by the optimistic outlook for economic growth and corporate earnings. In May, the discussion focused more on the technology sector, from where the strongest returns came. The first quarter earnings season surpassed expectations again, with US profits growing by roughly 25% from the same time last year. This brought down the valuation ratios of the largest technology companies, the hyperscalers1, and it allayed fears that they were burning all their revenue to build AI (artificial intelligence) capacity.
One source of earnings for the largest technology companies, which was initially over-looked, was the revaluation of their investments in private AI companies such as Anthropic and OpenAI. However, when SpaceX announced their intention to go public2, market attention moved very quickly to these three enormous yet loss-making companies. Concerns have been expressed for years now around the size and concentration of the largest technology stocks in the market, but so far their profitability has justified their size. The new unprofitable market entrants will pose tricky questions for index providers, passive investors and active managers.
Figure 1: The largest stocks in the world index
Source: Bloomberg.
Last month, we outlined our rationale for reducing our position in European equities – the region is more exposed on the downside if the energy crisis worsens and is not participating in the upside of the technology rally. The same is true for parts of Asia. While Korea and Taiwan have energy supply issues, their chip industries are booming, and have lifted the Asian equity index. However, India and Indonesia, which are the largest countries in the Asian high yield bond index, are on the wrong side of both the energy and the technology divides. Given that the spread of Asian bond yields over government bond yields has narrowed so much in recent years, delivering strong returns, the compensation for the higher risk no longer seemed high enough (see figure 2). Therefore, we decided to take profits and remove this long-held position. Please see the next section for more details.
Figure 2: Yield spread for high yield bonds over government bonds
Source: Bloomberg. US and Asian yields quoted in US dollar. European yields priced in euro. The yield spread is the difference in yield between the higher risk bond and the government bond.
Lastly, we spent some time looking at the Japanese stock market, which has delivered the highest returns of any major developed market this year (up 17% in local currency). The economy has emerged from decades of zero or negative interest rates and inflation, and the new Prime Minister Takaichi is ambitious to stimulate more growth. Importantly for investors, regulators have pushed Japanese companies to improve their governance and profitability, and to focus on returns to shareholders, and as a result the market outperformed the US this year and last year.
Figure 3: Return on equity in Japan, US and Europe
Source: MSCI. Return on equity is net income dividend by shareholders' equity, a common measure of profitability.
However, when we dug deeper, the case weakened. First, the economic recovery has stalled recently, partly due to Japan’s dependence on foreign energy and resources. Second, the Bank of Japan has started to intervene in currency markets, to prevent further yen depreciation, which has for years been a boost to the large export economy. As for the stock market, it is no longer cheap. In fact, its price/earnings ratio is in its top quartile of the past 20 years. As for the corporate reforms, they have yet to make any difference to the overall profitability of the index. Therefore, we decided not to make a tactical allocation to the Japanese market. We do still maintain our position in the Japanese yen though.
1 The AI hyperscalers are Amazon, Alphabet (Google), Meta (Facebook), Microsoft and Oracle.
2 At the time of writing, SpaceX is expected to launch their IPO (initial public offering) on Friday June 12th.
Warning: Past performance is not a reliable guide to future returns and future returns are not guaranteed. The value of investments and of any income derived from them may go down as well as up. You may not get back all of your original investment. Returns on investments may increase or decrease as a result of currency fluctuations.
Warning: Forecasts are not a reliable indicator of future performance.
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