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Q4 Quarterly Report 2024
America’s Economic Puzzle
Even though some sectors suffered a shallow earnings recession, the strength of others made up for it. If the US economy continues to chug along and fears of a recession don’t resurface, equities can continue to do well. But when we look at this year’s outsized returns, the level investors have been willing to pay for earnings has driven a substantial part of the overall returns. A lot of valuation has been put into the market at this point and there is little room left for further valuation multiple expansion (P/E ratios).
One definition of a bubble is a good idea that has gone too far, and the markets willingness to continue to pay such a premium for the world’s best companies has now likely gone too far. For the rally to continue, earnings will need to broaden out from here. The vast outperformance of the market weighted S&P 500 index over its equal weighted counterpart (where each of the 500 companies represents 0.2%) depicts this dynamic very well. There is a strong argument that the equal weighted index (a good representation for the other 493 stocks) will need to do more of the heavy lifting for the rally to endure this year.
To date, the export nature of Europe’s main firms has provided some protection against domestic economy weakness, but there are now clear and obvious concerns regarding Trumps proposed tariffs. We hope the eventual impact will be less than feared, but some sectors will be more exposed than others if tariffs are implemented. European savings rates are still well above pre-pandemic levels as the region’s typically more sensible citizens did not splurge in the same way as their US counterparts. As ever, we are unlikely to see Europeans go out and spend with any degree of exuberance, but see potential for a pickup in economic activity, from a low base.
There are a lot of great companies listed in Europe that are trading at attractive valuations, so there are lots of good opportunities. Although we recognise the list of structural issues referenced in Mario Draghi’s recent report makes it harder for the continent to produce the next Apple or Amazon, the below chart shows the pure 25% discount for European equities vs US. This chart displays a neutral sector weighting comparison (the US has more growth sectors).
As Howard Marks, one of the great investors of our era said in a recent interview: "That word is music to my ears… China is on the pile of things that people feel ill about, and it's on that pile that you find the bargains”.
Global longer term bond yields moved meaningfully higher over the last few months, even though most major central banks have been cutting rates. The bond vigilantes have been pushing back against governments’ very loose fiscal policies, by demanding an extra return to hold their debt. Investors have been selling debt from big countries such as the UK, France and the US, as they are running large deficits and have large debt burdens. Germany’s debt brake has ensured an entirely different approach, but it led to the recent collapse of its government and a “snap” election this February. The UK’s heavy-borrowing budget in October helped trigger a sell-offs in gilts, pushing the 10-year yield to its highest level since 2008 and 30-year interest costs to the most this century (notably above Liz Truss’ finest hour).
These higher yields are putting government finances under pressure and the US isn’t immune. US bond yields have moved up since the election result, with the 10 year once again surpassing 4.7%. Equity investors have looked through the higher longer term yields for now, but higher yields have traditionally been a headwind. US equities have been the envy of the world for the past fifteen years, with particularly outsized performance returns for the last two. They can continue to move higher, but current valuations suggest much more muted future returns.
We are mindful of the elevated concentration and valuation risks, so we stay focused on fundamentals. Will this finally be the year the equal weighted S&P 500 outperforms the concentrated market cap weighted index? Or will the ever widening gap between US equities and their international peers finally narrow? Given the current starting positions, these are the big themes that we will be looking out for in the year ahead. The general level of market uncertainty has rarely been so high, and wide-ranging, but there is no choice but to embrace it in a responsible way. Every year is challenging for investors, and 2025 won’t be any different.
