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There’s been a significant divergence between the forward earnings trends of the technology sector and the overall market explaining the outperformance of tech-related shares. Technology earnings expectations have risen sharply over the past year, fuelled by companies related to Artificial Intelligence (AI). These companies are expected to grow at more than double the pace of the overall market.
Technology shares have led the way in global markets. NVIDIA accounted for nearly all of the rise in the MSCI World Index of developed market equities in the second quarter. Meanwhile, TSMC, the Taiwan Semiconductor Manufacturing Company Limited accounted for an equally distorted portion of the rise in the MSCI emerging market index. TSMC accounts for over 40 percent of the Taiwan market-weighted index.
The US equity market is expensive relative to other markets and by historical standards, but for good reason, and the relative valuation premium has yet to surpass the dot-com bubble peak and even the post-pandemic peak. Historical precedent alone suggests that US shares have room to get even more expensive. Warranted, the global tech sector is now much more concentrated in the US than it was at the dot-com bubble peak. Almost 80 percent of the world’s combined information technology and communication services sector market capitalization is found in the US, compared with around 50 percent during the dot-com bubble.
Ultimately, it is the trend in earnings that dictates relative performance. Since profits are largely derived from productivity, the equity market generally tracks the productivity cycle, which has been strongly in favour of the US over recent years. The US lead in private AI investment continues to widen, expecting to drive a further acceleration in productivity growth. As a result, the US is likely to maintain this trend of relative equity market outperformance. Profit margins are historically high, and continuously improving in the US.
Inflation, the greatest threat to global financial markets over the past two years, has continued to decline towards central bank targets. Inflation is declining even in the US, where it has been more problematic. The 3.3% shelter inflation – the main culprit in the US – is finally coming down. If shelter inflation continues to soften as expected, then core CPI will decline more swiftly. Declines in regional inflation have enabled the start of central bank interest rate cuts, and as such, the global interest rate cycle has started. Despite solid GDP growth, the Fed is expected to initiate its rate-cutting cycle in September 2024. A peak in interest rates coinciding with solid GDP growth bodes well for financial markets.
The technology investment boom, falling inflation, and the start of interest rate cuts create ripe conditions for a growing AI-driven asset bubble. There are strong similarities between now and the internet revolution of the 1990s, but shares are underpinned by stronger fundamentals now than in the 1990s.
Also, compared with the 1990s, there is an absence of speculative fever and valuations are more competitive. Productivity growth after languishing around one percent for a prolonged period accelerated in line with the internet revolution of the 1990s from 1 percent to 3.5 percent, at the same time boosting GDP and capping inflation. The US economy today is on the cusp of a similar upswing in the long-term productivity cycle.
Global ex-US equity markets trade at a sizable discount to US markets, as we have already seen, but we believe US markets will continue to outperform on a two-year view, led by a new and large-scale AI industry, with a strong possibility that a bubble may develop over the period. As the economic recovery strengthens amid falling interest rates, there is scope for market laggards to catch up. US small-cap shares, especially in technology and AI-related sectors, hold significant upside potential.
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Provided there is not a material global event that negatively impacts markets, we are expecting all the company’s global portfolios to perform well during the second half of 2024, and in 2025.
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By Nick Downing & Damian Johnson All writers’ opinions are their own and do not constitute investment recommendations or financial advice. Speaking to a qualified wealth and investment professional is crucial before making financial decisions.
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