There is never a dull moment in the stock market. While the singular focus a half year ago was a consensus that China’s COVID-19 reopening would pull the global economy up with it despite a tighter G7 monetary policy regime, now the stock market’s primary focus has shifted to artificial intelligence (AI). The poster child has been chipmaker Nvidia, which spent this summer’s early days busting through a $1 trillion market capitalization on the heels of a blowout revenue number.
Corporate chieftains know that what is working in the stock market right now is AI, whether it’s the proverbial chipmakers supplying axes and shovels or the AI-focused companies themselves. According to John Butters at FactSet, 110 companies played the AI card this earnings season, mentioning it on their conference calls, a cool doubling from just two quarters ago. Turns out another 10th of the S&P 500 has in some way entered the AI business since Thanksgiving. No one knows how profits will manifest because of this technology, but such matters are of little concern to many players right now.
We don’t want to give full credit to AI for the tech run that has almost single-handedly pulled the S&P 500 out of its funk since the October 12 low, but it does deserve the lion’s share of the Index attribution. There is one other concept that put a bid into the Silicon Valley giants this spring, though it’s hard to quantify how much force it punched. As spring rolled around and the debt ceiling crisis became more acute, some players started to view 1-Month and 2-Month t-bills as hot potatoes. Better to park capital in the equity of the big behemoths while the saga unfolded, went the theory. Now that the debt ceiling saga appears behind us, this catalyst for mega-cap tech is dissipating.
Q1 S&P 500 earnings were down 9%, according to Zacks. This is no big surprise. Truth be told, it was a generally positive earnings season because the red ink was widely anticipated. One issue that we are respecting because it is disconcerting: the much-awaited revenue pinch is starting to show up in these quarterly numbers. There are several main causes, namely a follow-through of wage inflation in what appears to be a disinflationary goods environment going forward, plus the adverse effect on 2023 profits that comes from the lagging-in of 2022’s USD strength. On the latter matter, the positive for out-quarter earnings, perhaps Q4 2023 or Q1 2024, is the boost to earnings that will stem from this year’s dollar reversal.
We suspect many of our Indexes are positioned to benefit from the wage-induced revenue pinch, as the very concept of return on equity (ROE) has profit margins as an input. The overwhelming majority of our Indexes have either an explicit ROE screen or an implicit one via concepts such as dividend coverage ratios and the like.
Nevertheless, we anticipate that some of the forthcoming earnings seasons may splash more red ink on headline S&P 500 earnings, though sentiment is dour enough that it may not put a fright into many nerves. One look at the New York Fed’s General Business survey indicates that the next couple of earnings seasons are going to need more than AI ebullience to hold the profits picture together (figure 14).
Sources: Refinitiv, NY Fed, as of May 2023. S&P 500 earnings calculated using Datastream P/E tabulations. There is no guarantee that any projection, forecast or opinion will be realized. Actual results may vary.
For now, the consumer is hanging tough, which is a moral victory given the severity of the inflation shock. For evidence, consider that Memorial Day weekend air travel volumes exceeded the 2019 numbers. Also, our in-house alternative inflation calculations, which account for the home price and rent slowdowns, show that the inflation issue may be over for the near term.
However, a sector like Consumer Discretionary must contend with credit card interest rates having spiked above 20%, up from the mid-teens last year. This is happening in tandem with the student loan payment brick wall that will face millions. Additionally, while commercial banks were extending 48-month auto loans at 4.58% at the COVID-19 trough in November 2021, the most recent print on that figure was 7.46%. While on the topic of “7-handles” on important interest rates, the 30-year conforming mortgage briefly flirted with that level a few weeks ago.
We have been favoring Consumer Staples, though valuations there are on the rich side because many companies were rewarded when they showed an ability to pass on inflation in their 2022 numbers.
Thus far, the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) says that credit has been tightening for commercial and industrial (C&I) loans to small firms for “only” four quarters. Historically, when net tightening starts to get into the second year, that’s when the market comes to appreciate the extent of the credit contraction, often causing a bout of relative performance for Staples. Assuming Q3 witnesses more caution at lending institutions, that puts this cycle into that age range. It’s rewarding to defensive value concepts.
The key issue of 2023, in our view, may be the “Bank Walk.” Unlike a bank run, a bank walk is the term we came up with to describe the shift of capital out of bank accounts and into money market funds because of opportunity, not fear.
It’s a simple enough concept: with money markets suddenly paying 4.83% while the national average deposit rate is just 0.57%, money will find a home where it is treated most kindly (figure 15).
Source: FDIC, as of May 2023.
Though this phenomenon may cause a reflexive concern for bank stocks, it may be smart to go a little deeper into the thought process, especially since the headwinds for banks’ profitability are no secret. At this point, in summer 2023, almost everyone who is allocating serious capital has participated in the bank walk themselves, with their own money.
The bigger concept, the critical one, is from Banking 101: fewer deposits, fewer loans. Companies with scant or non-existent earnings, often a condition that goes hand-in-hand with iffy balance sheets, are to be under-weighted as the system contends with a rarity: a retrenchment in bank lending stemming from the Bank Walk. It begs the question: how far deep did the system get when it blew off 2021’s excesses during 2022?
One of the WisdomTree themes is “Value for the 2020s.” Though 2023 has been rough, figure 16 may offer a guide for how far along the market is in the process of the multi-year value rotation. As we march into summer, it is worth remembering that the 2022 action barely skimmed the froth that formed over the post-global financial crisis years. Even after the carnage wrought on high price-to-earnings (P/E) stocks in 2022, the 10-year performance gap between the market’s expensive and cheap stocks is still about as extreme as it was in the final innings of the dot-com bubble. Many companies that couldn’t turn a profit in the go-go days when COVID-19 stimulus programs were pouring in bundles may have a tough go of it if financing remains cold(ish) in 2024.
Source: Ken French Data Library, CRSP database, 7/31/1951–3/31/2023, data for April 2023 sourced from WisdomTree PATH using Russell 3000 Index attribution. Stocks separated into top quintile minus bottom quintile. Past performance does not guarantee future results.
We don’t want to make it sound like the “only” thing running right now is the AI theme, though that largely sums up the scene in U.S. markets this year. We provide more commentary on that below. A market that is catching a bid, a strong one, is international developed equities. Part of it stems from valuations. For example, the largest country in many developed market indexes, Japan, has a 3.9% shareholder yield—the sum of its dividend and buyback yields. It is now higher than the S&P 500’s 3.7%. That condition—Japan paying bigger dividends and buying back more stock than the U.S.—is something that has rarely occurred in WisdomTree’s database, which dates back to 2006.
That country also has several other drivers working for it. Warren Buffett recently upped his holdings there. His investing style—a combination of high profitability and reasonable valuations—provides us with some degree of confidence, as that plays into our quality dividend growth concepts.
Another catalyst to watch, one that is firm-specific but critical when you think of the optics: keep an eye on whether stockholders can drive management out at Toyota. In the unlikely case that it comes to pass, it would be viewed as a big coup for shareholder rights.
Being long on developed markets (DMs) means stepping into the murky waters of British equities, perhaps the most hated of the major stock markets. That country’s weight in the MSCI EAFE Index is 15%, making it the second-largest country in the non-U.S. developed market index. Britain has given off an aura of incompetence as a former world power that struggles to find its way, lumbering from one prime minister to the next. With Brexit having caused a shift of many finance jobs to Paris, the City of London has lost its sense of purpose. The idea of a tech initial public offering in London, to name a common concern, is felt to be a lost cause. Why float equity there when a premium valuation can be garnered in New York? The positive part of this: all of the above is a well-known and -worn quantity.
Britain and its neighbors have positive portents working for them. For one, Spain just reported year-over-year inflation of just 2.9%, while Germany’s May wholesale prices showed outright YoY deflation. These two economic releases flew under the radar, buried under the Nvidia and AI ebullience. The catalyst is clear: the European Central Bank—and maybe the Bank of England—may end its monetary tightening programs. We like the five-point P/E discount on MSCI EAFE relative to the S&P 500 and anticipate the gap will close, shown in figure 17.
Source: WisdomTree PATH, as of April 2023.
Another matter that is critical for H2 2023 sentiment: we do not think the market fully appreciates the anti-trust drums being beaten at the Federal Trade Commission and its overseas equivalents. One of the main rolling headlines is Microsoft’s acquisition of Activision Blizzard, where both American and British regulators are trying to block the deal. There is a feeling in the air that maybe the major techcos got too big for their britches.
Right now, the entire basket of emerging markets stocks is valued at less than the total value of Apple, Microsoft and Amazon. Did these companies get too powerful for the good of society? It’s not for us to answer that question. But if society’s answer is “yes,” it may be catalyst enough for owning asset classes such as emerging markets instead of the S&P 500 top brass.
Source: Refinitiv, as of 5/22/23.
When we run screens on our emerging strategies, many of them show up at multi-year wides to U.S. large caps on metrics such as trailing and forward P/Es, dividend yields and price-to-sales ratios. Much of the cause is the question mark on China. Nevertheless, as we write this, there isn’t a day that goes by inside WisdomTree’s four walls where we aren’t talking amongst ourselves about “8-handle” dividend yields on some of the deeper value emerging market screens that we have been running since before Lehman. An economic picture that has something like a mild slowdown or muddle-through may be enough to give the asset class a bid relative to the top-heavy and FTC-daggered S&P 500.
Summary: We are increasingly constructive on both developed and emerging equities relative to the U.S., especially as a domestic blend has turned into “domestic quasi-growth,” courtesy of the mega caps that dominate the S&P 500. Some markets, namely Japan, have perhaps a dozen catalysts that we can count off the top of our heads. We cannot figure out why Japan bulls are still so few and far between. It’s an opportunity for the rest of us.
Among smart beta factors, we like the quality dividend growth business, as we suspect unprofitable firms or those with scant profits will struggle in a 5% money market regime. Additionally, because we believe credit conditions are tightening and will continue to deteriorate as 2023 continues, defensive value may be poised for outperformance. An ideal situation for that group will be if the S&P 500 chooses to be disagreeable. Anything like 2022’s bearish vibe would fit that bill, but then again, a “sideways chop” could be enough to get it done. Sober markets are where we often find most of our alpha in the dividend-weighted concepts, not the melt-up markets.
A Comment On Artificial Intelligence
Many investors are looking at the broader benchmarks being led higher by the world’s largest companies. Many are associated with “generative AI,” with Nvidia’s chips powering the technology.
A good conceptual framework in our thematics research is that things are rarely as extreme as they seem. We are only about a half year beyond the original release of ChatGPT. We don’t yet know what we don’t know. So far, it looks like the large platforms, like the Android store of Office 365, will be able to deploy certain productivity-enhancing features. The large cloud platforms will be able to provide access to different models too. We don’t yet know what the longer tail of smaller and mid-sized players will look like.
While generative AI brings Nvidia to mind for many, and for good reason, we would remind investors that no company, for an idea as big as this, does everything themselves. For example, Taiwan Semiconductor Manufacturing Company is the only company that can currently fabricate Nvidia’s most advanced chips. Data centers are also critical; these devices need to sit in purpose-built, physical locations. Finally, generative AI search could be three to five times as energy-intensive as classical standard searches. When the world is excessively excited by one or a handful of companies, it may make more sense to look at the companies on which such companies may rely.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, please call 866.909.9473, or visit WisdomTree.com/investments to view or download a prospectus. Investors should read the prospectus carefully before investing.
There are risks associated with investing, including the possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in emerging or offshore markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Funds focusing their investments on certain sectors and/or regions and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility.
Dividends are not guaranteed, and a company currently paying dividends may cease paying dividends at any time.
Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Diversification does not guarantee a profit or eliminate the risk of a loss.
You cannot invest directly in an index. Index performance does not represent actual fund or portfolio performance. A fund or portfolio may differ significantly from the securities included in the index. Index performance assumes reinvestment of dividends but does not reflect any management fees, transaction costs or other expenses that would be incurred by a portfolio or fund, or brokerage commissions on transactions in fund shares. Such fees, expenses and commissions could reduce returns.
This material contains the opinions of the authors, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product, and it should not be relied on as such. There is no guarantee that any strategies discussed will work under all market conditions. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This material should not be relied upon as research or investment advice regarding any security in particular. The user of this information assumes the entire risk of any use made of the information provided herein.
Kevin Flanagan, Rick Harper, Jeremy Schwartz, Scott Welch and Jeff Weniger are registered representatives of Foreside Fund Services, LLC.
WisdomTree Funds are distributed by Foreside Fund Services, LLC, in the U.S.