Tech outperformance distorts returns, but may well continue

POLARISED returns, market distortions, and investor short-sightedness – these are the current market dynamics at play.

The S&P 500 has rallied 14.8 per cent this year, up to Jun 14. Taken at face value, it appears markets are doing well.

But if you peel back the headlines, it is evident that returns are extremely polarised across sectors. US technology led the pack with a 40.9 per cent rally while traditional sectors like energy (-7.5 per cent), materials (+4.6 per cent), and industrials (+6.4 per cent) lagged.

This polarised performance explains why the S&P 500 has outperformed S&P 500 equal-weight index by 10 percentage points (ppt) year to date, while the outperformance of technology was even more stark at 36.1 ppt.

Taking this one step further, if one had averaged out the performance of the top five companies based on market capitalisation (Apple, Microsoft, Alphabet, Amazon and Nvidia), the outperformance of this group over the S&P 500 (equal weight) would shoot to 68.8 ppt – propelled no less by the recent surge in enthusiasm over generative artificial intelligence (AI).

The message is clear – US equities have been lacklustre, and the only segment performing well is technology.

This brings me to my next point on investor short-sightedness. Based on the market’s reaction after May’s jobs data, there is rising market chatter that the “Goldilocks” trade is making a comeback. Indeed, despite strong jobs growth, equity markets rallied as wage growth was deemed weaker than expected. Investors are essentially embracing the notion that the US economy will keep chugging along without pushing inflation higher.

We feel that this Goldilocks perspective is overly sanguine and falls prey to the recency effect. The narrative could quickly flip should forthcoming macroeconomic data paint a different picture.

In fact, the recent hawkish pivot by the Fed to consider another one or two hikes for the rest of the year proves this point. Accordingly, we believe a more moderate view is appropriate for the second half of 2023. On a three-month basis, we adopt a neutral weight for both equities and bonds, and instead have an overweight call for the alternatives space.

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For equities, we continue to subscribe to a barbell construct, which focuses on having quality growth-oriented stocks on one end, and income-generating assets on the other. And on the growth end of the barbell, we seek out winners using our Idea (innovator, disruptor, enabler, adapter) framework, which aims to identify beneficiaries of long-term secular trends such as digital transformation and demographic shifts.

For bonds, we maintain our preference for three to five years short duration, investment-grade (IG) developed market credits for their attractive yields of over 5 per cent and a favourable risk-reward.

However, we are also tapering our cautious stance on emerging market (EM) bonds as we see pockets of value emerge due to: (a) the eventuality of a Fed pause in 2024, which will be accompanied by a US dollar peak and tailwinds for EM currencies; and (b) the eventuality of lower yields next year, compelling portfolio allocators to seek yield opportunities beyond the traditional developed markets. Nonetheless, we remain selective and recommend exposure only to quality IG plays from this segment.

On the alternatives front, we believe that the tightening lending conditions – stemming from US regional bank failures and falling commercial real estate valuations – present opportunities for direct lending funds to make loans to companies at higher interest rates and stringent provisions.

Moreover, market dislocation is also a boon for special situations and distressed debt strategies, as companies are faced with the double whammy of an economic slowdown and liquidity tightening. Separately, we favour gold and advocate sufficient exposure to the precious metal as a portfolio hedge on the following grounds: (a) interest rates will peak in the second half of this year before trending lower in 2024; and (b) the risk of recession has risen as high bond yields weigh on the broader economy.

Beyond 2023, we predict the Fed will pause its monetary tightening cycle. But we caution against being overly enthusiastic. Historically, a Fed pause amid yield curve inversion is no panacea for risk assets. In the absence of yield curve inversion, equities and bonds registered average gains of 30.1 per cent and 9.9 per cent, respectively, during periods of rate pause.

However, under inverted yield curve conditions, the average gains for equities and bonds moderated substantially to 3.4 per cent and 4.2 per cent, respectively.

Accordingly, we advocate a long duration bias for equities, but with a quality overlay. This will allow for participation in the rate-pause upside, while providing some protection against further unforeseen hawkishness from the Fed.

From a sectoral perspective, we earlier highlighted technology in driving much of the market’s outperformance. We predict that this trend will continue, backed by the rate pause/duration play as well as resilient earnings and undemanding valuations.

Despite the aggressive sectoral sell-off in 2022, forward tech earnings still managed to grow by 0.9 per cent in 2022. And after a challenging year, the outlook is turning the corner with forward earnings up 4.7 per cent on a year-to-date basis (versus +0.1 per cent for the broader market).

On the valuations front, US tech currently trades at 35 per cent premium to the S&P 500 on a forward price-to-earnings (PE) basis. But on an earnings growth-adjusted basis, valuation remains undemanding. At PE-to-growth (PE/G) of 1.5 times, US technology offers investors compelling upside and the same can also be said for Big Tech, which trades at an even lower PE/G of 1.1 times.

On the thematic front, AI stands out. Markets have been abuzz with excitement lately over great leaps in AI advancement and how they might supercharge the next wave of productivity gains, growth, and of course, market performance. OpenAI’s ChatGPT, in particular, has taken the world by storm with its human-like natural language output, amassing a landmark one million users in just five days after its launch.

While such recent advances in AI are highly significant, successful monetisation of new AI technology is still a race in the making. In search of the next big thing, the key is to discern investable avenues that can truly capture the long-term upside of new AI technology. We believe there are four major themes that would emerge as long-term beneficiaries of AI adoption:

• Big Tech: With billions in cash reserves, ready access to tech talent and a huge repository of user data to train AI models, Big Tech companies (FAAMG – Facebook, Apple, Amazon, Microsoft, and Google) are obvious winners of further technological disruption
• Integrated circuit – chip designers and semiconductor foundries: AI models require advanced chipsets, both in training and production. Further uptake of AI will boost demand for graphics processing units, microprocessors, power management integrated circuits, et cetera
• Cloud platforms: Once AI models are sufficiently trained for commercial purposes, they are likely to be deployed on cloud platforms for ease of access. A proliferation of AI models will give rise to demand for cloud companies to host them
• Cybersecurity: Advancements in AI also invite potential detriment. Widespread misinformation, scams and enabling cybercriminals to identify vulnerabilities in digital networks are just some examples of the malicious misuse of generative AI

The writer is chief investment officer of DBS