Talking Heads – Will US equities run much further, pause or stumble?

This is an edited audio transcript of the Talking Heads podcast episode: Will US equities run much further, pause or stumble?

Andrew Craig: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week Talking Heads will bring you in-depth insights and analysis through lens of sustainability on the topics that really matter to investors. This week, we’re going to be talking about US equities and in particular growth stocks. These are fast growing companies whose businesses are developing rapidly. And that includes a lot of the big tech companies in the US. I’m here with Christian Fay, who’s Senior Portfolio Manager for US and Global Equities in the BNP Paribas Asset Management office in Boston. Welcome, Christian, and thanks for joining me.

Christian Fay: Hi. Thank you. Great to be here.

AC: Now, let’s just pause for a moment to take stock. This is a momentous week. We’ve had the US presidential elections. It’s now clear that President-elect Trump and the Republicans have won control of the US Senate, and it looks like they’re going to maintain their hold on the House of Representatives. Away from politics, a lot has happened. We’re coming to the end of the earnings season. And there have been important developments on the macroeconomic front. Can you talk a little bit about what’s happened to the market running up to the election and which sectors you see as continuing to be most impacted from the win for Donald Trump? What might change after this run-up?

CF: Just to start off, markets have been very strong all year, with the S&P up 22%, the Russell growth 26% and smaller-cap stocks lagging a little bit, up 12%. But in particular, there has been a run-up in the various Trump baskets, including banks, but also insurance, industrials, which includes electrification and machinery, some technology stocks, and Bitcoin. Conversely, renewables that include solar and some consumer goods companies and stocks due to potential China tariffs have been noticeably weak. What we saw post-election, these baskets continued to widen their gains or losses.

The big question is, will this continue? It is really hard for us to see how it would continue for an extended period of time. Trump will take over on 20 January 2025. It will be very interesting to see what he what he tackles first. We think he’s going to focus on tax cuts, deregulation, potential tariff discussions, and immigration reform. The question is we’re pondering is, will these policies lead to potential continued inflation. A lot of economists say there’s the potential for that if the tariffs actually happened.

For this reason, there’s uncertainty still and we’re likely to continue trimming our winners into the strength, and maybe reallocate to our longer-term winners. Prior to the election, we really didn’t take any significant bents. But we are now ready to take advantage of any dislocations on the upside or downside in the near term. We’ve already started doing so.

AC: So, we’re going to go into a period of some uncertainty about to the extent to which policies will actually be enacted. And as you say, these baskets, which reflect stocks that investors believed would benefit or would be disadvantaged by Donald Trump’s victory, are now trading up given the fact that he’s won. But it remains to be seen to what extent that will continue. If we just look back now, 2023 and 2024 have been characterised by very strong market returns and by extreme narrowness. And by that, I mean the fact that it’s a fairly limited number of stocks which are behind the rally. Do you think this is going to continue – this phenomenon of a small number of stocks driving the strong returns of the US stock market?

CF: Let me step back for a second and set the stage. The performance in 2023 of the S&P was up 24% and the Russell 1000 Growth was up 38% – very good years for both of those indexes. But the MAG-7 –  those seven largest tech. consumer and com services companies – were up 78% as an entity. And that really drove those returns of both of those benchmarks. And if you didn’t own those seven stocks in some degree, there’s no way you could beat the benchmark. So, it was very narrow. So far in 2024, the S&P is having another great year. It’s up 24%. The Russell Growth is up 29%. But this time only three of the seven ‘Mag’ stocks are beating the index. So, the question of do we think it can continue, we do not believe it could.

However, the market concentration of these stocks is still significant – 35% of the S&P is the MAG-7 and 55% of the Russell Growth. So, you need to be there in some degree. In terms of contributions to earnings, they’re still going to remain high. Just on another note, the information technology sector itself is huge. It’s almost 50% of the Russell Growth. When you come combine that with the MAG-7 stocks, about 70% of the benchmark is either large mega-tech companies or these MAG-7 stocks. It’s just so amazingly concentrated. But we just don’t see how this narrowness of outperformance can continue. But that does not mean that these stocks will underperform the rest of the market. Rather,  we see allocating overweight positions in certain MAG-7 names and an underweighting to a significant degree the rest of them, making room for what we believe will be stronger outperformers.

AC: The Magnificent 7 have had an incredible run. How do you see the prospects for these companies, given that they’ve come an awful long way in a very short period of time?

CF: That’s a complicated question. The case for investing in these large growth companies is premised on the view that these companies are considered among the best in the world in terms of innovation, in terms of their products and services. They are well established with strong financial foundations, experienced management teams, and they’ve over time consistently delivered robust capital appreciation. Generally speaking, these large growth stocks are less vulnerable to economic downturns and cycles than smaller, mid-sized value stocks, while at the same time offering great global diversification.

Just to put some numbers on it, over the last 10 years, the Russell 1000 Growth has a cumulative return of over 400%. That is a compound annual growth rate of over 16% as of this October. That is just astounding over time. The index has dramatically outperformed the S&P and the Russell 2000. In fact, the Russell 1000 has only underperformed once in the last 10 years and that was in 2022 when there was a 29% drawdown. Now this was more severe for these large growth companies, primarily due to the supply chain issues that came out of the pandemic.

Importantly, the MAG-7 share of the market cap isn’t wildly different from their share of free cash flow. In terms of valuation, these MAG-7 stocks are a bit pricey. But they generate so much cash flow and so much earnings growth that it’s kind of worth that valuation. It’s starting to get up there and we’re getting concerned about that valuation compared to some of the peers. There is one concerning thing to us about some of these companies in that their capex spending is extremely high. The question is, is that going to generate growth and for us maybe it does in the long term, but in the near term it’s less certain.

We believe we can find other growth companies that will outperform the broader markets as we think this concentration in earnings, the higher valuation and significant spending could lead to earnings reductions over time. We believe we’re almost at a peak in earnings at these companies when compared to the rest of the market. So, the rest of the market could catch up to these companies over the next couple of years.

AC: Let’s just talk about putting aside the Magnificent 7stocks. What types of companies are you currently looking at and what sort of themes do you think will work going forward?

CF: Right now, we’re looking at secular growth themes like artificial intelligence, semiconductors, cloud computing and datacentres, infrastructure, innovative healthcare and there are some areas of consumer that we believe are poised to rebound as [interest} rates come back down. We also like some of the smaller companies that could be considered M&A targets, specifically in the information technology sector. As I said, AI will continue to work as a theme in 2025 and beyond, but we believe the leadership will broaden to include companies beyond early winners. We’re looking at networking and storage systems, database software and software applications that embed AI functionality.

It’s not just going to be those few winners. We believe there’s a whole host of companies that could take advantage of the products and services of these large companies. In the consumer sector, we’re looking at companies that are more tied to housing as we expect conditions to improve given lower rates and replacement cycles- a lot of the buying that happened during Covid means that home goods would need to be replaced. We’re also looking at names that are tied to some of the mega trends of healthy living, demographic shifts and the rise of the emerging market consumer.

In healthcare, we like some of the small and mid-cap biotechnology companies, in particular those that focus on rare disease and oncology. Given there’s about USD 200 billion in branded drugs that are going off patent over the next decade, it’ll be huge sales losses for the large companies. We added all the cash up on the balance sheets of all these companies and it does total about USD 200 billion. Now the election is over, companies will start to put some of this cash to work in terms of M&A and we think it could really benefit this sector.

Switching over to financials, we like certain banks. We think there will likely be a less stringent regulatory regime with increased liquidity and more M&A. This should improve profitability and growth for these banks. We also believe loan growth could accelerate, and yield curves could steepen,  which would be a nice tailwind.

Within the industrial sector, we’re looking at those companies leveraged to electrification, but also automation, although near0term manufacturing activity has been somewhat soft. We’re definitely sharpening our pencils on those short-cycle companies that are reflecting the worst.

In general, we’re looking for these growth companies that are innovative, well-run with differentiated products and services and that have idiosyncratic drivers that can work in literally any regime – these ‘go-anywhere companies’.

AC: Well, Christian, thank you very much. That’s a very comprehensive review. We’ve talked about the extraordinary performance from the Magnificent-7 big tech companies which have outperformed and have been behind a large part of the overall US equity markets performance. You’ve explained why investors really cannot afford to neglect these stocks. But having said that, we’re aware that the valuations are now demanding and it’s going to need these companies to continue to generate extraordinary earnings to maintain these levels of valuations. So, you’re looking further afield and finding sectors, businesses which stand to benefit from technological change, from artificial intelligence and from the potential changes under the new US administration. We’ll look forward to seeing how these next few months pan out. Thank you very much for joining me today.

CF: Thank you very much.