Equity markets in the US, as measured by the large capitalization weighted indices, posted impressive returns in the first half of the year, with the S&P 500 up 15.3% on a total return basis. As was the case last year, these returns were primarily driven by a select number of larger, technology-adjacent companies- the so-called “Magnificent 7”. Even amongst this small group there were outsized winners: consider chipmaker NVIDIA, up 150.5% in the first six months of 2024. As a result, NVIDIA alone was responsible for roughly two-thirds of the S&P 500’s returns generated to the end of June, meaning investors who did not own the company were hard-pressed to keep up with US equity indices most often cited by market analysts.
Market returns have been driven by this narrow set of U.S.-based, large-cap, primarily tech-focused businesses for long enough now that investors could be forgiven for thinking that owning such companies is the ONLY way to generate an acceptable return in equity markets. Such a recency bias, overemphasizing the significance of the recent past over a longer timeline, has led investors astray over the years. Equity market returns were similarly concentrated in other periods like the early 1970s and late 1990s/early 2000s, and many market participants became convinced that the drivers of outsized returns of those periods would persist indefinitely, only to encounter costly shifts in sentiment. We believe that we may be in yet another such period, and for this reason, see grounds for caution when it comes to owning certain subsets of risk assets. At the same time, if history is any indication, this may also mean that our opportunity set may be set to widen significantly in the quarters ahead. While we will explore this in further detail later on in the letter, we first must outline some other drivers of relative performance as of late.
The first half of this year saw a number of factors that, though unrelated, each created further headwinds for client portfolios. To start, proposed tariffs in both the US and Europe on Chinese electric vehicles and their components have weighed on a number of our holdings tied to both the auto sector and lithium production. While the prospect of increased trade barriers represents grounds for concern, long term we are of the view that the businesses we own in these spaces stand to benefit from EVs taking an increased share of auto sales. In addition, on a wider scale, the need for energy storage solutions in light of changes to the grid and power generation infrastructure in much of the world are likely to create additional demand. Though we continue to believe in our investment thesis, in the near term, investor sentiment appears to have soured on the space.
At the same time, our traditional energy exposures have also faced headwinds, as worries over the path of global growth have crept into the market’s consciousness. Though the price of oil has risen so far this year, long-term concerns about fossil fuel consumption appear to be exacerbating these worries. On this front, we remain of the view that, for better or for worse, fossil fuels are likely required for quite some time. What’s more, we also believe they will actually be necessary to achieve any type of meaningful energy transition in the future, as well as to sustain increased demand from energy-intensive computing processes related to artificial intelligence. Here again though, short-term worries about the trajectory of global demand meant that many of the energy businesses we own underperformed somewhat in the first half of the year.
We would also note that these fears over global growth have been reflected in rates markets, where our shorter duration positioning has impacted the performance of our fixed income holdings. Though we believe that recent economic data out of the world’s major economies would suggest that both economic activity, and with it, inflation, may be slowing, we are of the view that, especially given current short-term rates, we are quite well compensated for our conservative positioning, especially given the path of interest rates from here remains far from certain.
Finally, geopolitical risk has also weighed upon portions of the portfolio, namely our European holdings. Snap elections in France sparked concerns about assets on the other side of the Atlantic, denting performance in the businesses we own in the region. As we have noted in the past, we continue to be of the view that despite these political ructions, which remain unresolved, we see a good deal of value in European equities, especially when compared to buoyant valuations in the US. While we will discuss this opportunity in greater depth below, we would for now note that the companies we own in Europe have quite far-flung operational footprints, levered more to global growth as opposed to the fortunes (political or economic) of the region.
Taking these idiosyncratic factors into account, along with the decision to sit out the meteoric rise of already fully valued, large-cap US tech businesses, there was a clear gap in performance between large capitalization weighted market indices and client portfolios. Such underperformance is always unsatisfying, but in many ways often feels worse in a period where one corner of the market is enjoying a great deal of success and popular attention, valuations notwithstanding. Fear of missing out, or “FOMO”, is unfortunately quite a real phenomenon and has likely compounded investor flows into these tech companies, making the disparity all the more pronounced. Indeed, some of you may be experiencing this to some extent, or at the very least, a dissatisfaction with the performance of your portfolio as of late, especially as major equity indices hit new records. We certainly feel this dissatisfaction as well, but do take solace in knowing that, in the longer term, our disciplined methodology has served us well.
One major component of that methodology revolves around purchasing and owning businesses at reasonable valuations. Though there is some (temporary) comfort from following the crowds, purchasing assets at extended valuations tends to result in meager returns. Conversely, history has shown us time and again that, over long periods, one investing truth stands out: valuation matters. As we noted earlier, many of the technology-related businesses currently in vogue today are pricing in a great deal of future growth at current valuations, especially when compared to the risk-free rate.
Source: Bloomberg
As one can see, the index looks rich versus much of history, especially in the context of rates being where they are. Simply put, the compensation one is receiving to take equity market risk is just not terribly interesting at the moment. As such, we continue to maintain a cautious posture in client portfolios.
We view this bias in our positioning as especially prudent when we consider that, despite the impressive trajectory of markets this year, there is no shortage of risks on the horizon. Economic data is increasingly muddled: on the one hand, demand for goods and services continues to remain fairly robust, even as inflation, though moderating, remains above pre-pandemic levels and rates remain elevated. This has surprised many, but we would note there are signs that, especially for lower-income consumers, this is beginning to change, as rising prices and higher borrowing costs take their toll. At the same time, employment data is beginning to show signs of softening, suggesting this situation may deteriorate further. We have been recently looking at certain consumer credit metrics that seem to imply this deterioration is already taking place, leaving us uncertain with regard to the path of the economy going forward. To be clear, we consider attempts to predict or time the economic cycle to be somewhat of a fool’s errand- one need only look back to last year’s plethora of calls for a recession that never materialized to see why this is the case. Nevertheless, especially as such calls have dissipated, we would note the current economic backdrop is giving us some degree of pause.
In some cases, investors (and markets themselves) have seemingly been of the view that some economic weakness may actually be a good thing, in that it could spur the Federal Reserve and other central banks to trim base rates from their current levels. While we feel this is likely in the offing, especially in the second half of the year, and note that some central banks have already begun a cutting cycle, we question just how much room there is to cut rates at the moment. Barring a serious economic dislocation, central bankers are likely to remain cautious when it comes to rate cuts for fear of reinvigorating inflation back to the levels seen in recent years, even if this weighs on economic activity. Since late last year, financial conditions have loosened back to their pre-hiking cycle levels of 2020/2021. As we noted in our Year End Review and Outlook 2024, those conditions preceded the bout of accelerating inflation we experienced in recent years, further suggesting the headroom for significant rate cuts may be limited. We have discussed the risk of policy mistakes by central banks in the past, but fear markets continue to price in a scenario in which inflation is tamed without any serious damage being done to the economy. Though we do not necessarily dispute the possibility of such an outcome, we are concerned about the extent to which risk assets are behaving as though this is a foregone conclusion.
Finally, on a related note, we see political risk likely to rear its head in the latter half of the year as the U.S. election season begins. While there are no doubt positive and negative implications for certain industries depending on the outcome of the presidential race, such things are actually of secondary concern to us. We believe the greatest (and most persistent) political risk that exists is Washington’s inability to rein in spending. As one can see below, it seems the only truly bipartisan initiative occurring in Congress today is driving up the country’s indebtedness to levels unseen since the end of the Second World War:
Source: Bloomberg
There have been plenty of arguments made for why this trajectory is sustainable, ranging from theories about technology spurring faster economic growth to the U.S. dollar’s world reserve currency status sustaining demand for Treasuries. We also recognize that concerns about U.S. debt levels have persisted among some investors for decades. Given these factors, why are we concerned now? While rising debt levels may have been acceptable during a period of tepid inflation and falling rates, this debt becomes problematic when conditions move in the other direction. Political gridlock in Washington likely means those in government will choose the path of least resistance, inflating the issue away, rather than choosing more concrete solutions the electorate would no doubt find unpalatable. Indeed, politicians on both sides of the aisle seem more interested in deficit spending on their constituencies rather than actually solving this issue, making the problem worse. To be clear, we are not making any predictions of a U.S. debt crisis or a hyperinflationary scenario, but rather the prospect of a longer-term fight with inflation that markets seem to be ignoring, at least for now.
Taking all of this together, we continue to see plenty of reasons to remain cautious. Though the economy remains robust, there are signs on the margins of deterioration. While it’s likely central banks will act if the global economy begins to slow, we question the extent to which they can act given fears over reinvigorating inflation. These fears may be further exacerbated by debt levels in many major developed economies, including the U.S., who in the coming years may have little choice but to accept higher levels of inflation to cope with their indebtedness. This interconnected set of risks could easily come to weigh on equity and credit markets, to say nothing of rates. While we again wish to make no conjecture about what lies ahead in the latter half of the year or beyond, we do believe it important to outline the major risks we are seeing, especially in the context of our current positioning.
The bulk of this letter heretofore has focused on performance headwinds in the face of runaway markets, along with an inventory of the risks we feel those same markets are facing (and ignoring). At this point, you could be forgiven for believing our team is quite pessimistic about the future. Yet however cognitively dissonant it may seem, we are actually rather constructive on the opportunity set going forward. When markets become this bifurcated on a valuation basis, it opens up opportunities for those willing to sift through the sectors and regions that are being overlooked. Dave, who is no “spring chicken”, vividly remembers a conversation over lunch about 15 years ago with a seasoned and successful professional investor who indicated that the 1970s were actually his firm’s best years performance wise. Anyone who looked at a chart of the S&P 500 during the 1970s would say that was absolutely impossible- after all, this was a rare decade in which the index posted an inflation-adjusted loss. Yet much like that period, we again feel that the current concentration in markets may be opening up a number of similar pockets of compelling potential value in risk assets.
Though it has slowed over the past year, we are of the view that inflation will, due to a variety of factors, remain structurally higher than what we encountered in the post-GFC, pre-pandemic world. Materials will be needed to achieve the green transition many major economies around the world have prioritized, artificial intelligence requires a great deal of energy, and a reconfiguration of supply chains means massive investments in new infrastructure. Commodities, and the businesses that produce them, have until recently been ignored for a decade or more with minimal investment in new capacity, despite these sources of further demand.
Source: Bloomberg
We continue to see these businesses generating impressive profits and trading at reasonable multiples even if inflation moderates further. We also see the opportunity set expanding in this space regardless of the near-term trajectory of the global economy. Slowing growth may actually make these businesses even more interesting, given the myopia of markets, which will focus on the results of the next few quarters, and ignore the potentially decades-long structural need for more commodities. We have been looking at everything in this space from miners and E&Ps to companies which provide the machinery and know-how to extract these raw materials, and we believe there is no shortage of potential.
We also remain of the belief that small and mid-cap businesses in the US remain an interesting opportunity going forward. Looking to index level metrics, many have recognized that these businesses are quite undervalued, but tend to point to the challenged fundamentals seen in this corner of the market. High leverage, middling profit margins and low return on capital metrics of indices like the Russell 2000 are all too often cited as reasons why small and mid-cap US equities are “cheap, but for a reason”.
Source: Bloomberg
However, our view is that those willing to roll up their sleeves, dive deep into this universe and perform rigorous fundamental diligence will ultimately be rewarded. Some detractors have questioned what will ultimately reinvigorate investor interest in these businesses. While certainly difficult to predict, we believe even slight disappointments on growth from the large-cap US tech sector may be enough, leading markets to widen their focus to some extent. As we noted, with these large cap, technology focused businesses priced for quite rosy futures, the slightest divergence may cause sentiment to sour, and lead investors to search for more compelling returns elsewhere. We would also highlight that there is historical precedent for such a rotation. Following the collapse of the Tech Bubble in the early 2000s (the last time small and mid-cap US equities traded at such a discount to their larger peers), the Russell 2000 outperformed the S&P 500 significantly in subsequent years:
Source: Bloomberg
Although the past performance that is illustrated in the chart above in no way guarantees future results, we do feel that a careful analysis of these businesses in sectors that we know well could provide some very interesting opportunities going forward.
In a similar fashion, we believe investors are failing to see the value in European equities, with the region maligned for lacking dynamism or innovation. We will be the first to admit the Old Continent faces a number of economic challenges, from demographic issues to debt (issues we see across the developed world, quite honestly). At the same time, Europe is also home to a great number of high-quality listed businesses ignored by investors, especially outside of their home markets. As we have illustrated time and again, the discount at which these businesses trade hasn’t been this low in over two and half decades and could easily narrow as investors look to diversify away from the largest US businesses should growth disappoint. This opportunity is of particular interest to us, as we feel sentiment here has been particularly negative for quite some time now.
Source: Bloomberg
What’s more, like their counterparts in the U.S., smaller European equities in the mid-2000s outperformed the S&P 500 as enthusiasm for U.S. tech titans waned, albeit on a more dramatic scale:
Source: Bloomberg
Again, past performance in no way guarantees future results, but we feel it important to note here that we now have several ways of leveraging our research in the region to spot potential opportunities and add them to a client’s portfolio. First off, we now have the ability to include European equities across a wider set of taxable accounts and can effectively own shares in these businesses as seamlessly as we would US-listed securities. Given this, we would expect that taxable accounts will likely own a number of securities listed in Europe going forward, as compelling opportunities present themselves. In addition, we would like to highlight that those seeking further exposure to this opportunity may want to consider an allocation to our Focused European Value Strategy, which invests in a select number of small and medium-sized businesses in the region, leveraging the same methodology as our core equity portfolios. If you are interested, we encourage you to reach out to Zach, who has spent a great deal of time analyzing this opportunity and is quite constructive on its long-term prospects.
Overall, we see the potential for the opportunity set to widen significantly in the quarters ahead, especially in the areas noted. However, it is also our belief that this is unlikely to come to fruition without a return of some degree of volatility to markets. Despite the concentrated drivers of returns, and despite the risks we’ve outlined, markets, at least for now, seem unconcerned. Consider measures of equity market volatility (as measured by the VIX Index) or credit risk (as measured by corporate bond spreads) as of late:
Source: Bloomberg
We doubt this state of affairs will last forever, and there is no shortage of factors that could shake the market’s euphoric ascent, especially in the latter half of this year. We raise this prospect not to cause alarm but to suggest clients should be prepared for potential volatility in the future. We encourage you to take inventory of how you feel about your current risk positioning at the moment, especially if we were to encounter a more challenging market environment. If you believe that your portfolio is not properly positioned for your needs in such an event, or that your circumstances have changed such that an adjustment is necessary, we strongly encourage you to reach out to us. We recognize that this has become an almost constant refrain from our team at this point, but believe it is important to highlight the importance of communication, regardless of current or future market conditions.
At the same time, as we also frequently mention, this dialogue need not be about any specific changes to your portfolio. If you are merely interested in hearing more of our team’s views on markets and the global economy, or the opportunities we are currently exploring, we always welcome the opportunity for a conversation.
We recognize that, especially in the current frenzied market environment, this may be a challenging period. As such, we truly appreciate the support and trust you put in our team and the work that we do. We wish you a relaxing summer, and all the best as we move into the second half of the year.
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