investment insights
IT’s about valuations
Key takeaways
- US technology stocks are beating earnings expectations and markets anticipate 2024 revenues and EPS growth of around twice the wider stock market
- Investor enthusiasm has driven valuations up and raised tech stock dispersion and volatility
- We have increased our allocations to US stocks, with a preference for communication services, while keeping our global exposure to the tech sector at strategic levels
- We see the dollar appreciating in the first half of 2024, before political risks and a global economic recovery weaken the currency. For now, we remain overweight the US currency.
A positive earnings season and the prospect of lower interest rates have seen US equities reach a new record over the last week. Valuations are high, especially among technology names, but we see a number of positive dynamics. We look at what lies ahead for US stocks, the tech sector and the dollar.
Fourth-quarter corporate reporting in the US has been strong so far compared with expectations, as earnings per share (EPS) have risen around 2% from a year earlier. Of course 2023’s stock markets were dominated by a handful of US technology stocks, collectively labelled the Magnificent Seven. The start of this earnings season saw tech sector results beating investors’ high expectations. Markets now expect IT sector revenue growth in 2024 of around 10%, and around 22% for EPS, double the levels anticipated for the wider market. That inevitably raises questions about whether the sector can maintain such growth levels, and the pace at which it can deliver on its productivity and promise, monetising its investments.
The US tech sector is supported not only by demand for generative AI semiconductors, but by innovations in digitalisation and cloud computing. It also continues to report strong cash flows and investment levels. Companies are addressing profitability through cost measures including slower hiring, and cutting back on projects. If revenues recover in line with market expectations and cash flow and profitability are maintained, there is, we think, scope for further share price gains. Within tech and its related sectors, we prefer communication services, which include some of the largest American stocks by market capitalisation.
Not ‘cheap as chips’
At the global level, technology valuations are also high. The MSCI World IT index is trading at around 26-times full-year forward earnings, compared with its long-term average of 17-times. High expectations for future growth contribute to making the US tech sector’s valuation levels, at least in part, justifiable. The oversupply of semiconductors continues to normalise, for example, offering a healthier outlook for 2024 and demand for the most sophisticated chips is dominated by AI acceleration and connectivity.
However, high valuations are the main reason that we keep our exposure to the tech sector globally at strategic levels. The wider S&P 500’s valuations are around 21-times 12-month forward earnings, far higher than the index’s 16-times average for the last quarter century, and currently more than 10% above its 200-day moving average. Statistically, such valuation metrics should begin to weigh on the market outlook.
Four factors
Valuations are just one of four factors that we consider in our analytical framework. The other three factors take account of macroeconomic fundamentals, technical signals, and earnings. All three suggest that US markets remain attractive, despite strong recent performance.
Indeed, rather than the usual downgrade to US corporate earnings through the year, markets may maintain or even upgrade them in 2024. This is typically the case when economic environments record a rebound in manufacturing activity, which there are signs of now.
At the macroeconomic level, a broad disinflation trend is in place, even if it is not linear, and we recently upgraded our US GDP growth forecast for 2024 to 1.9% from 1.2%. Retail sales remain resilient, labour markets are normalising and productivity gains suggest non-inflationary growth. Of course, we continue to monitor risks, including the impact of tighter credit and the commercial real estate issues that are again cropping up from the US to Europe and Japan. The eurozone’s corporate outlook looks less promising (see chart 1). For these reasons, we have increased our tactical exposure to the US market to overweight levels compared with our strategic benchmark, while we underweight our eurozone equity exposure. In December 2023, we had already revised our strategic asset allocation to increase exposure to the outperforming US equity market. To date this year, that has benefitted our portfolios and we remain constructive on equities generally, keeping exposures at strategic levels.
Dollar dominance
Our higher exposure to US stocks in portfolios also mechanically implies a higher exposure to the dollar. Fundamentals for the currency remain supportive, even after the dollar’s rise in value in the early months of the year – driven both by US growth upgrades and a pushback in investor expectations for a first US rate cut. The dollar remains one of the highest-yielding currencies in the G10, drawing in foreign investment. It is also likely to retain this yield advantage even once the Federal Reserve starts to cut interest rates. While a resilient US economy continues to support the currency, so does softer growth in the rest of the world. As a defensive, haven currency, the dollar tends to rise in a global growth slowdown.
By some measures the dollar appears overvalued, which suggests a limit on the scope of gains from here. Yet the degree of overvaluation versus history may be smaller when accounting for recent structural changes, such as the US transitioning from a large energy importer to a small exporter, and by rising US productivity. We see further gains for the dollar in the first half, with a three-month euro-dollar target of 1.04. In the second half of 2024, US political risks will become more important in the run up to presidential elections. In the meantime any recovery in global growth, perhaps from more forceful China stimulus, would also be negative for the dollar. For now, we retain an overweight to the dollar in portfolios.
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