The startling possibility of a Megarally

AI sentiment has driven US stocks higher despite poor fundamentals. But US economic resilience is now broadening out equity market leadership and softer US inflation could lead to more attractive equity earnings yields.

24 August 2023

2023 is well over halfway through and equity investors have had plenty of reason to cheer. World stocks, as measured by the MSCI AC World Index in local currency terms, are up nearly 13% this year to 21st August, led in large part by the S&P 500 Index which is up nearly 16% in USD terms over the same period. The explanation for these healthy gains hinges on the artificial intelligence (AI) revolution, with a handful of names - the so-called ‘Magnificent Seven’ consisting of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – driving markets higher. This year to end of May these firms were almost entirely responsible for the US stock market’s gains. As such, the rally’s sustainability was becoming contested, depending on how one views AI’s impact on the economy and in particular the select few firms enabling it. Additionally, the broader inflation and interest rate backdrop remains a significant source of investor unease this year. Stubborn core inflation in the US, eurozone and UK has been forcing central banks into an unenviable ‘policy corridor’ of having to bluntly smash down on the economy via tighter monetary policy in order to adhere to inflation targets originally set when inflation was considered largely vanquished. This has made the rally in stocks feel vulnerable, with earnings yields offering little over and above risk-free rates, and valuations stretched on most measures. For the S&P 500, the equity risk premium (ERP) is just 0.7%, the result of a forward earnings yield of 5.0% minus the 10-year US Treasury yield of 4.3% as at 21st August. This is hardly adequate compensation for the giddy ride characteristic of holding stocks. Similarly, valuations, as measured by Shiller’s Cyclically-Adjusted Price Earnings (CAPE) ratio, are currently trading at over 30x, meaningfully higher than the long-term average. Serious investors remain understandably cautious in the face of a market driven by speculative sentiment and underpinned by uninspiring financial metrics.

Why the rally in global stocks could have staying power

Against this backdrop, and with markets pausing for breath in recent weeks, it feels strange to be raising the possibility of the equity rally powering ahead. But a few developments are worth considering which may turn the rally from a hated one enjoyed mainly by structural holders of stocks, such as pension funds and wealthy individuals, to a more widely shared phenomenon. The first change has been that the market rally has quietly begun to broaden out as the summer has progressed. From the end of May to 21st August, the energy, industrials, consumer discretionary and materials sectors took over market leadership from technology, demonstrating unexpected economic resilience in the face of the tighter monetary policy referenced above. In fact, a case could be made that monetary policy tightening hasn’t worked at all, certainly not yet at least. For example, the US labour market has remained firm, with June’s figures showing unemployment at just 3.6% and wages rising at 4.4% on the previous year, or 1.2% in real terms. This has increased optimism across all sectors of the economy, in turn contributing to the broader market leadership described. This breadth is important because it is a reasonably reliable indicator of an equity rally’s viability. Lopsided progress only exposes investors excessively to one theme and leaves them vulnerable to idiosyncratic risk from a select few sectors, or even one.

Breadth of fresh air - wider S&P 500 sector leadership since end May:

Slaying the dragon – sustained falls in inflation would boost equities

Broader-based market leadership might itself be sufficient for stable market progress into the end of the summer and autumn. But another new potential tailwind has also emerged. Nothing lifts the price of a financial asset over time like the lower cost of capital and, following the unexpected global price spikes of 2022, US inflation finally appears to be on a definitive cooling pathway. It is said in finance that three datapoints make a trend and US headline CPI more than fits that bill, falling from 9% in June 2022 to just over 3% in June this year. Even the more stubborn core inflation, which strips out volatile food and energy components, has now eased off from its near-7% peak in September last year to just under 5% for June this year. Of course, this does not mean that monetary policy will be unwound overnight. The Federal Reserve (Fed) remains haunted by its premature dismissal of early 2022’s ‘transitory’ inflation and is now committed to bringing it down to the 2% target level. Just recently one of the most inflation-focused Fed committee members, Christopher Waller, was at pains to point out to journalists eagerly looking for signs of an about-turn from the Fed that “Inflation briefly slowed in the summer of 2021 before getting much worse.” But if the inflation data continues to cool then one or two more rate rises really may be sufficient to wrap up the current monetary policy cycle, potentially pushing down yields across the maturity spectrum and making stocks’ earnings yields relatively attractive again. A drop in the 10-year US Treasury yield from the present 4.3% to say, 2.5% would see the ERP on the S&P 500 rise to a much healthier 2.5%, i.e. equity investors would be getting a meaningful yield advantage over the risk-free rate.

Core to the floor? Both key measures of US CPI are now on a downtrend:

Positive sentiment and fundamentals could yet align

The last three years have seen stock markets skip between ‘mini-eras’ with bewildering frequency, from pandemic panic to stimulus in 2020-21, followed by 2022’s inflation and rates shock, then onto 2023’s uneasy rally. The AI revolution has started to ignite wider risk appetite, as evidenced by retail inflows into equity exchange-traded funds (ETFs), but longer-term sustainability was always going to be an issue given the fiercely debated impact of technological paradigm shifts and the poor state of market fundamentals. But investors may now have reassurance from two new potential sources; first, a resilient US economy manifesting itself in broader stock market leadership, and second, the very real prospect of an end in sight to the current monetary policy tightening cycle as US inflation naturally normalises. Given the domination of US stocks within the MSCI AC World Index (at around 2/3), these positive developments cannot be ignored by investors with any holdings in global stocks. Risks of course remain. Inflation could surprise to the upside again (see OPEC’s recent moves to support the oil price) while the Fed may yet over-tighten interest rates in the name of credibility, hurting the economy unnecessarily in the process. But should the positive developments previously described persist, investors may need to start considering increased strategic engagement in stocks. It is often said that markets are driven by sentiment in the short term and fundamentals in the long term. The next few months could be the moment when the two start to positively align.