QuotedData’s Economic and Political Monthly Roundup – August 2024

Against a backdrop of recent tumultuous events in the US election race, American GDP rose to 2.8% in the three months to June, a notable increase from 1.4% in Q1. Following his exit from running for a second presidential term, President Joe Biden stated that this data ‘makes clear we now have the strongest economy in the world’. The S&P 500 index hit a new high mid-month, but has been selling off since. July also saw US inflation falling to 3.0% (year-on-year), a bit better than expectations. The US Federal Reserve kept rates on hold but chair Jay Powell said a cut could be on the table as soon as September.

On July 29^th, British Chancellor Rachel Reeves spoke of a £22bn ‘black hole’ in national budgets, inherited from the previous government. The Chancellor outlined that she would take ‘difficult decisions’ to resolve the issues in spending. Although, in more encouraging news, UK inflation remained unchanged in July at 2%, in-line with the Bank of England’s target. In response, the Bank of England decided to cut interest rates to 5%, the first cut in over four years. The CBI welcomed this but highlighted the narrow (5:4) decision in favour of the cut and said “At best, there is only mixed evidence that inflation persistence has been defeated. While the labour market is loosening and wage growth slowly easing, the unexpected strength in services inflation remains a red flag.”

In Europe, the likelihood of further rate cuts ‘in September is material’, according to former Bank of Ireland governor Stefan Gerlach. The ECB has maintained that its decisions will be driven by data that confirms easing levels of inflation. Ahead of the 2024 Olympics in Paris, French consumer confidence rose marginally from 90 to 91 points. However, European stocks in areas such as the automobile industry dropped by 2.3% in July and the STX EUR luxury goods sector fell by 2%, its lowest point in over six months.

At a glance

Source: Bloomberg, QuotedData

MSCI Indices (rebased to 100)

There were some big moves in July. The yen broke its losing streak, which is starting to weigh on Japanese equities (although it should only really affect exporters). Weak demand is offsetting fears of production disruptions in the oil market. The gold price continues to hit new highs and bond yields are falling, perhaps encouraged by the prospect of lower interest rates. In the equity markets, the UK was the best-performing index in this chart over July. Investors seem encouraged by greater political certainty as well as lower interest rates.

Source: Bloomberg, QuotedData

Global

The board of directors, Tetragon Financial Group, 31 July 2024

Despite a challenging first quarter, the U.S. economic backdrop remains supportive of a potential “soft landing” outcome across inflation, unemployment, and GDP growth. Resilient global markets continue to accept this as a “base case” despite persistent risks spanning two major geopolitical conflicts, the accumulative impact of elevated interest rates, looming tariffs, and an ever-sticky “last mile” for global disinflation.

The economic landscape is further complicated by growing political turmoil: recent election surprises across India, France, and the U.K. have set the stage for a tense election year in the U.S., which has already endured an assassination attempt on one candidate as well as the abrupt withdrawal and ensuing replacement of his incumbent adversary. The growing scale of global political uncertainty stands in stark contrast to recent market tranquility. While it is impossible to predict the precise path for politics or markets alike, we believe such a diverse array of potential outcomes will reveal opportunities to deploy capital into attractive themes and potential dislocations.

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Peter Hewitt, manager, CT Managed Portfolio Trust – 26 July 2024

Fear of recession has abated. Although the US is showing signs of slowing, it is still growing, in part due to loose fiscal policy, which is not likely to change ahead of the Presidential election in November and this may well continue into next year. The UK and Europe are experiencing gently rising activity levels with low levels of unemployment and, although China’s rate of growth has slowed, it remains well ahead of Europe and the US and is supportive of growth, especially in Asia.

Whilst inflation is clearly trending towards the 2% target level for most developed economies, it has proved stickier in the US, where growth has been notably more robust. Growth momentum is beginning to moderate in the US whilst the opposite is true for Europe, albeit from much lower levels. The key is that major Western Central Banks should be able to cut interest rates by the end of 2024. Expectations are for two cuts in the UK and Europe whilst only one in the US, with more likely in 2025. This is a favourable environment for stock markets. Lower interest rates should also permit leadership within equity markets to broaden out. In the US the top 10 companies by market value, dominated by large technology stocks, have driven stock market performance; however, even if their earnings growth remains strong, at an average forward price earnings ratio of 28x, their shares are, in relative terms, highly valued. This may mean dominance of stock market returns in the US by the largest companies will become less pronounced. Historically, lower interest rates have been a tailwind for medium sized and smaller companies, nowhere more so than the out of favour UK stock market.

The UK stock market is the only major market where valuations are below 20 year averages – the forward price earnings ratio is around 11x against a long-term average of 14x. Profits and earnings growth is picking up and a series of takeovers of a variety of UK companies across different sectors highlights that buyers, typically private equity and overseas companies, are seeking to take advantage of historically low valuations. Amongst smaller listed companies in the UK the de-rating has been severe; however, an environment of moderate growth in the domestic economy and lower interest rates is favourable for good stock market performance from this segment of the equity market.

Private equity trusts, as a sector, all moved out to very wide discounts, often in excess of 40%, in 2022 when both inflation and interest rates were on the rise and a fear of recession led to an expectation that underlying asset values for these trusts would fall. This proved not to be the case and most either held their value or in selective cases managed small gains. Most are now better placed to resume asset value growth, and many have introduced shareholder friendly capital allocation policies relating to dividends and share buybacks. 

Looking ahead, there are many uncertainties that could undermine a favourable outlook for equity markets. These include geo-politics, especially Ukraine or the Middle East, political elections, particularly that of the US President in November, or an unanticipated decline into recession if the Federal Reserve in the US maintained a tight monetary policy for too long. However, coming back to the fundamentals, it does appear that there is every chance of a favourable environment developing for equity markets. The risk of recession appears to be fading. Inflation will not return to pre-pandemic levels but will come back in most developed economies towards the 2% target level of Central Banks. Although forecasting interest rates is hazardous, most Central Banks will be looking to move rates lower over the next year. Growth should respond and there are optimistic signs of this in Europe.

Against this more favourable backdrop, some cautious optimism on progress from equity markets seems justified. This is especially so with the UK equity market which has been anchored at the bottom of most performance league tables since the Brexit vote in 2016. It is interesting that, in the final quarter of the financial year ended 31 May 2024, the UK was amongst the best performing equity markets despite all the uncertainties. There is a chance that this may continue in the current year.

At the time of writing the average sector discount for investment companies is 15%. This is at one end of the spectrum and outstanding value is apparent across many different sub-sectors. Patience will be both required and tested. However, from current levels there is a genuine opportunity of positive returns from the two portfolios of high-quality investment companies with strong balance sheets and proven, experienced management.

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Julian Bishop / Christian Schneider, The Brunner Investment Trust, 15 July 2024

Global equity markets were very strong in the six months to the end of May 2024. The FTSE World Index was up over 14% in Sterling, which strengthened slightly over the period. The UK FTSE All Share Index was up a similar amount. Together, Brunner’s benchmark was up just under 14% over the period.

Returns varied considerably by sector. Leading the pack were Technology, Financials and Industrials – three areas which account for about two thirds of Brunner’s portfolio. Lower quality, more indebted sectors like Telecoms and Real Estate lagged considerably. Brunner has negligible exposure here.

The Technology sector continues to garner the headlines. The US listed ‘Magnificent 7’ – Microsoft, Amazon, Nvidia, Tesla, Alphabet, Meta and Apple – now collectively account for about 1/3 of the entire S&P benchmark of the top 500 US companies, a level of concentration unprecedented in modern times. The Magnificent 7, of course, is an eye-catching journalistic term; in reality, all seven are very different and saw varying returns over the period. Nvidia, which produces graphics processing units (GPUs) used in artificial intelligence (AI) applications, was up an extraordinary 130%, propelling it close to a $3 trillion market capitalisation – an amount only ever equalled by Apple and Microsoft. Tesla, meanwhile, was down over 20% as the competitive realities of the brutal automotive industry were felt. In 2022 Tesla’s margins were 17%. In their last quarter, they were just 5.5%.

The comparatively staid Financials sector was the second-best performing area of the market over the period. Traditional banks and insurers provided most of the return as interest rates remained high, credit losses remained low, and as they re-rated from low levels.

The strong performance of banks, particularly, is worth commenting upon. By and large, banks have been a poor investment for many years. Many had their equity wiped out during the financial crisis and have spent the subsequent years strengthening their balance sheets to levels commensurate with modern regulatory requirements, which demand they are sufficiently capitalised to withstand most conceivable future adverse events. This has been enormously costly, heavily limiting, until recently, material dividend payments.

In recent times those factors have reversed. Although most Western economies are not exactly flourishing, most avoided outright recession and bank loan losses have remained well controlled – testament to the far more sensible lending standards imposed since the 2007-8 financial crisis. Interest rates have risen considerably, allowing banks to charge more for loans and gain more income for money on deposit with central banks. Observant depositors will have noticed that equivalent increases have not been applied to their current accounts. In industry parlance, the ‘net interest margin’ has increased, with positive ramifications for profitability.

Industrial companies also enjoyed a strong first half. The fiscal stimulus associated with the US Inflation Reduction Act is substantial. After many years offshoring industrial capacity, countries and companies are also reshoring or nearshoring production to offset geopolitical supply-chain risks. The construction of semiconductor foundries in Arizona is a case in point; hitherto they have virtually all been in the Far East. AI is also very capital intensive. AI data centres are huge and very energy hungry. A single AI data centre can easily consume 50 megawatts of electricity, the same as a small town. Electrification was already a longstanding industrial theme associated with decarbonisation. Technology has added another element to this longstanding trend.

After the mono-dimensional markets of the past few years it is interesting to see such different types of equity investments leading this year. On the one hand, markets are being led by companies which are creating scarcely believable technologies. On the other, traditional banks – a business model which dates to the Medicis – are having a field day.

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UK

Managers, Aberforth Partners, 26 July 2024

(The) good start to 2024 has its roots in the very low valuations ascribed by the stockmarket to small UK quoted companies as 2023 drew to a close – with sentiment so negative, it was never going to take much to bring improved investment performance.  The first half has indeed brought encouraging developments for the UK’s economy, its politics and its stockmarket.

On the economic front, recession has been a persistent concern over the past two years.  Higher inflation and interest rates threatened a slowdown in domestic activity, which became noticeable in the trading statements of smaller companies from the second quarter of 2023.  We now know that there was indeed a recession in the second half of last year.  It was, though, a mild and short downturn, much less severe than some commentators had expected.  Growth remains subdued, but, with the rate of inflation easing, there is the prospect of lower interest rates later in the year.  In turn, more accommodating monetary policy should herald more favourable trading conditions for companies and an upturn in the profit cycle.

To many outside observers, the UK’s political situation since the EU referendum has been baffling.  Perceptions of political dysfunction have discouraged investment in UK equities and affected their valuation relative to other markets.  However, the UK’s seeming monopoly on political uncertainty is becoming less clearcut.  On the one hand, the General Election has delivered a government with a decisive majority that should not be in thrall to the more extreme elements of the ruling party.  On the other hand, the politics of several other western democracies threaten to become less certain.  The EU elections have seen an upswing in support for populist parties and have precipitated a potentially destabilising parliamentary election in France.  Meanwhile, the US faces its own democratic test later in the year, with the outcome still far from certain.

Concerns that the UK stockmarket may not be fit for purpose intensified in 2023 when Arm, the semiconductor business, chose to list in the US.  Before that, there was a broadening recognition by government and regulators that the UK’s capital markets could be improved.  A slew of initiatives – such as the Edinburgh Reforms, the Mansion House Compact, the FCA’s review of listing rules and consultation for a UK ISA – has followed.  It is easy to be sceptical about each of these in isolation, but official recognition of the issue and the general direction of travel are encouraging.  However, taking a step back, it is worth reflecting on whether the UK stockmarket has a particular problem.  After all, de-equitisation and the loss of companies to private capital have been features of many markets for two decades.  The unusual stockmarket in the global context has not been the UK, but the US with the extraordinary and incredible valuations accorded to a small number of technology giants.  From their daily interactions with the UK stockmarket, the Managers believe that it can value companies fairly over time.  The valuation process may be complicated by concerns about the economic cycle and by politics, but these ebb and flow and currently enhance the opportunity in UK equities.

As equity investors mull this opportunity, the first half of 2024 brought clear evidence of how gaps between stockmarket valuations and companies’ intrinsic value can be bridged – M&A activity continued at an elevated rate.  Larger companies, overseas companies and private equity have identified the opportunity in depressed UK valuations and are emerging as the marginal buyers of UK equities.

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James Henderson and Laura Foll, investment managers, Law Debenture Corporation, 25 July 2024

Companies have been faced with an assortment of challenges in recent years. Many of them are now receding. The ‘cost of living crisis’ has partially eased, with wage increases now outstripping inflation. The problem in supply chains originating from Covid and then rippling out are mainly solved. The uncertainties around trade as a result of Brexit are clearer. The rise in interest rates is over and they are likely to come down later in the year. A reduction in rates will stimulate economic activity as investment projects go ahead and the resulting pick up in sales will improve corporate profitability. When turnover improves it is often the case company operating margins expand. The extent of the operational gearing is often a positive surprise to investors. All of this creates a good background for investors in equities. It will be happening at a time that UK valuations judged by historic norms are very low. The cocktail of falling interest rates, low valuations, economic growth and disciplined company behaviour is an exciting mix. Therefore, we remain positive on the outlook for UK equities, and the gearing level of the Trust reflects this. The improved prospects for UK companies should also help lead to further sustainable dividend growth.

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Frank Ashton, chair, Athelney Trust, 24 July 2024

Although we still have cases of COVID in the general population, it is now more an inconvenience than a threat.  However, we must not underestimate the long-term impact to individuals, mental health, debt (at all levels) and the resulting challenges as we continue to recover.

We are returning to more normal bands for UK economic measures, including inflation and wage growth, and the welcome prospect of more stable government, good for decision-making and business investment.

Much still rests, medium- and long-term on the new government delivering good growth, and there is the  prospect of unpopular measures to balance UK books in the future.

There is a real mountain to climb, given manifesto promises not to raise major taxes, current fiscal rules and UK public sector borrowing at £15bn (in May), £800m higher than a year ago.  National debt is currently about £2.7 trillion, roughly the same as UK GDP, and more than double the usual level (between 1980 and 2008).

The Ukraine war continues, as does the war in Gaza, with the potential for drawing others into those conflicts still a risk.

Then there is also the uncertainty raised by the US Presidential election in November, now heightened by the Trump assassination attempt.  The US will be forced to fund a massive increase in its budget deficit, according to analysts, likely to reach $1.9 trillion (compared to a February prediction of $1.5tn).  How the US will deal with this reality, the wars it currently supports, the ongoing trade tensions with China, and closer to home, trade with the UK and Europe, is hard to predict.

Despite these uncertainties there are also positive developments, as the UK becomes a comparative haven, resulting in the GBP strengthening to levels not reached since a year ago.  Deal flows have increased, and there is more foreign investment in the UK, lending support to the expectation that UK undervalued stocks will be increasingly attractive to buyers.

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Dan Whitestone, BlackRock Throgmorton Trust, 24 July 2024

Whilst the last six months witnessed another period of fund outflows for UK small and medium sized companies, May 2024 marked the first monthly net inflow since May 2021. That’s an incredible statistic really; the first monthly inflow after 35 consecutive months of outflows. Indeed, those 35 months of outflows total to around $16.5 billion, which in our view has acted as a significant drag on returns, overpowering fundamentals. Accordingly, the value of any listed UK small and medium sized company has increasingly been dictated by the clearing price of an outflow, a trend that looks to be ameliorating at long last, reflecting the slowdown in outflows through the period and finally the inflow in May. Maybe this is in part because so many market participants have effectively given up on the UK? Thinking about the UK more broadly, the allocation from UK pension funds to the UK stock market has shrunk from 52% in 1990 down to circa 4% now, which represents a withdrawal of circa £1.9 trillion from UK listed equities over the last 25 years. Our discussions with UK Wealth Managers suggest a similar path, and I would suspect the retail platforms of direct investments too. Maybe there’s just not much left to sell now? The challenges and industry concentration of the FTSE 100 Index are well understood, but the UK small and mid-cap market is a much more diverse and differentiated opportunity set comprised of many idiosyncratic compelling investment cases. One should not overlook the comparable returns that UK small and mid-sized companies have delivered in the last six months versus the US indices, so to go a step further, with such an extreme change in investor positioning, any improvement in the macro-economic backdrop that lifts sentiment could see the recent rally really accelerate considering how extreme positioning has now become.

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Andrew Joy, chairman, Herald Investment Trust – 23 July 2024

The UK market has faced heavy cash outflows from UK collective vehicles, which are predominantly used by domestic investors. However, perhaps because of these outflows, there has been a high level of takeovers which has relieved the selling pressure. All the takeovers of companies in which the company has been invested have been made by overseas entities. In my last statement I mentioned the effect of rising interest rates, but more recently it seems that in some cases domestic investors are realising capital gains for fear of an increase in the tax rate, and the inflows are from overseas corporates, private equity, and more recently direct investing from US investors in some of the larger names held by the Company. We hope that the pessimism from UK investors is misplaced. Now that overseas investors own the majority of the value in the UK market, a change of sentiment would be damaging. This explains the Manager’s progressive reduction in weighting in spite of the relatively attractive valuations in the UK, where the headwinds to earnings growth from the rise in corporation tax and the costs of implementing ESG policies, are now partially reflected in results.

In the UK the Company’s historic co-investors have either disappeared from the market or are similarly cash constrained by redemptions. The primary markets are not going to function without a functioning secondary market, which requires many players. Successful active fund management is not scalable, and this is particularly the case for investing in smaller companies. Meanwhile the costs of active fund management have risen materially. Markets will wither and die if new capital is not provided to fund the next generation of growth companies, and some of these companies will not attract funding elsewhere. Passive funds do not provide primary capital, nor efficient stock market valuations.

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Gervais Williams and Martin Turner, managers, Miton UK Micro Cap – 11 July 2024

The period of globalisation can be characterised as favouring `bigness’, which may explain why the US stock market has greatly outpaced others over recent decades. During globalisation, the valuations of other exchanges such as the UK have trailed behind the US comparatives. This position is even more extreme within UK-quoted microcaps, where over the last three years valuations have fallen to what we consider to be absurdly low levels.

Over the last decade or so however, the electorate has come to distrust the compromises that come with globalisation. This was evident as long ago as 2016 with the Brexit and Trump votes. Thereafter, the logistics nightmares of the pandemic have made the compromises that come with globalisation all the more prominent, and electoral pressure for change has become more persistent.

Beyond globalisation, policies such as reshoring manufacturing, which tend to boost inflation, are expected to lead to a much more challenging economic outlook. Interestingly, we believe changes like this favour companies funded with risk capital, such as those listed on stock markets, over those principally funded by debt, like private equities. Quoted companies generating cash surpluses (such as those that dominate the UK mainstream stock market) now have the potential to outperform greatly. In this context, we are not surprised that this is the moment when the mainstream UK stock market has broken out of its trading range on the upside. This is all the more significant given that it has done so at a time when numerous local investors have been aggressively reducing their UK equity weightings. Breakouts such as that of the UK tend to bring in new participants from overseas, boosting the outperformance trend further. As local selling moderates and in time ceases, we anticipate the new UK outperformance trend will accelerate further and become persistent.

Furthermore, we also anticipate that market trends will start to favour small cap stocks over large ones, in which the UK exchange is better represented than most other markets. Hence, far from being worried about the Trust’s prospects deteriorating after its recent underperformance, we believe its upside potential is now even greater than before, and more immediate. In part, this is due to UK-quoted microcaps standing on absurdly low valuations, but also because we anticipate that the current political and geopolitical trends will favour UK-quoted equities, and most particularly UK-quoted microcaps in future.

Will institutional investors ever return to the UK quoted microcap investment universe?

Inflationary pressures were benign during the period of globalisation, and asset valuations in general rose considerably. In addition, the opening up of international trade also enhanced world growth, so most businesses expanded. Overall, the returns of many assets have been unusually strong during globalisation.

As the favourable pattern persisted over decades, stock market returns were routinely well above inflation, and additional returns from smallcap portfolios became apparently optional for institutions. Indeed, institutions progressively favoured concentrating capital in large and megacap equities because they came with abundant market liquidity. Hence, although quoted smallcaps may have outperformed the majors during globalisation, the commercial returns from all sorts of mainstream assets were so copious that most institutional investors steadily reduced their smallcap participation. The adverse pattern has been most pronounced within the UK-quoted microcap investment universe, where the vast majority of capital is now provided by private investors. Amongst institutional investors, even those with dedicated UK smallcap strategies now routinely disregard quoted companies below a minimum market capitalisation, say, of £150m.

Recent elections have led to a Balkanisation of international relationships, and globalisation is now in retreat. There are fewer opportunities to sell goods across all international geographies, which constrains opportunity for many global businesses. Furthermore, the reshoring of manufactured goods, and greater immigration controls add to inflationary pressures, and hence are also expected to reduce asset valuations. The return on mainstream stock markets by implication may be much poorer in the future. Given that many quoted megacaps are currently standing on incredibly high valuations, many stock markets around the world may fail to deliver a commercial return for many years.

Even if UK-quoted microcaps were to start outperforming very substantially over the coming quarters, we doubt that institutions would immediately crowd into them. However, if the mainstream indices were to fail to deliver a commercial return for a long period, in time we do expect institutional capital to be reallocated into areas that are outperforming.

The smallcap investment universe is typically defined as comprising the bottom ten percent of market capitalisations of the overall stock market, so an allocation from the large cap ninety percent, into the smallcap ten percent tends to amplify its performance. Furthermore, as microcaps are typically defined as being the bottom two percent, an allocation from the large and smallcap ninety-eight percent into the microcap two percent can be expected to have an even greater amplification impact on performance. Alongside, as UK mainstream companies have fallen to undemanding valuations during globalisation, and UK-quoted microcaps have fallen to absurdly low valuations, the new outperformance trends have the potential to persist in scale for years.

For all these reasons, we expect UK-quoted microcaps to outperform greatly global large and megacaps, in a new trend that is boosted further by institutional capital being allocated increasingly further down the market capitalisation range. Even a tiny incremental allocation of institutional capital would have a major impact on UK-quoted microcap returns. And as the cost of microcap capital becomes less onerous, we foresee they will enhance their returns yet further through share issuance. Over time, the more that quoted microcaps outperform, the greater will be the willingness of institutional capital to participate. We anticipate something of a virtuous spiral from here, with additional institutional capital allocations being matched by an accelerating pattern of UK-quoted microcap outperformance in a new trend that could last for decades!

We believe that the full upside potential of the Trust’s strategy is still not fully captured. The issue is that investors’ expectations are currently framed in the context of a stock market that has become increasingly hostile towards UK-quoted microcaps.

Now that the mainstream UK stock market has broken out of its historic trading range on the upside, we believe that local market conditions are improving. Stock market breakouts tend to bring in new participants from overseas, boosting the outperformance trend further and help it become embedded. When institutional capital starts to be allocated further down the market capitalisation range, market conditions within UK-quoted microcaps will normalise again and investors should start to recognise the full potential of the Trust’s strategy. The key point is that even tiny increments of institutional capital have the potential to make a giant difference to UK-quoted microcaps market conditions, and hence the scale of their return potential.

In summary, the Trust’s strategy seeks to pick out stocks that have the potential to appreciate by many multiples of the original share price, and in our view the prospects for the Trust’s UK-quoted microcap strategy are now the best they have been for over thirty years. Enough said.

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John Dodd and Kartik Kumar, fund managers, Artemis Alpha, 1 July 2024

For all that has been written about the inexpensiveness of UK stocks (including by us), it is a fair challenge to highlight that corporate earnings growth has been challenged. We think that some of the headwinds faced are easing, and this increases the possibility of more robust earnings growth.

One main reason for this view is improved prospects for consumer spending. UK consumers spent 2% less than they did in 2019, while US consumers spent 14% more (as of Q4 2023). People have saved more after facing higher energy prices, inflation and interest rates.

The energy shock hit the UK and Europe harder than the US. According to the Bank of England, UK utility bills went up to more than twice 2019 levels, while the US bills increased by only 30%. In Europe, unlike the United States, gas prices set electricity prices, and in August 2022, gas prices soared to $600 per barrel of oil equivalent because of problems and fear from Russia/Ukraine. This was almost 10 times higher than in the US.

Gas prices have fallen to more normal levels owing to lower demand in Europe, better use of gas storage facilities, and improved LNG supply. UK utility prices are still high because of the price cap system that the UK uses. This is forecast to fall by about £500 in 2024. This, along with rising wages and the cut to national insurance, means that spending is likely to rebound, which should provide a tailwind to corporate profits.

Another reason is the prospect of a more stable political environment. Betfair odds suggest that Labour is more than 90% likely to win the next election, probably with a large majority. Both the Conservative and Labour parties have moved to the centre lately. This makes the set-up for the upcoming election very different from 2019, where voters were divided and policies were wildly divergent.

The rise in mergers and acquisitions activity shows growing confidence in UK assets returns.

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Asia

Neil Rogan, chair, Invesco Asia Tust, 25 July 2024

Trade friction between the US and China remains, with the US Presidential election adding noise and uncertainty. China has taken further steps to stabilise its residential property sector, where overdevelopment has led to a loss of consumer confidence and also some bank instability. Asian technology companies such as Taiwan Semiconductor Manufacturing and Samsung Electronics have performed well on the coattails of the “Magnificent Seven” tech stocks that have led the US stockmarket rally. India’s economy has continued to grow without so far threatening the high rating of its stockmarket. Domestic consumer spending growth is healthy across Asia; for example 4.8% in China, 5.7% in India, 5.1% in Indonesia and 2.2% in Taiwan (Morgan Stanley 2024 forecasts). And with overall forecast 2024 economic growth rates including 4.8% in China, 6.8% in India, 2.7% in South Korea, 5.1% in Indonesia, 3.7% in Taiwan and 2.2% in Singapore comparing favourably with the US at 2.2% and the Eurozone at 1.3%, there continues to be grounds for optimism.

On top of this, Asian stock market valuations are cheap relative to the world and cheap relative to their own history.

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Japan

Nicholas Price, portfolio manager, Fidelity Japan Trust, 29 July 2024

Japanese equities got off to a strong start to the year with the Nikkei 225 Index reaching a record high for the first time since December 1989. The market was driven primarily by central bank policy expectations centred on the Bank of Japan (BoJ) and the US Federal Reserve (Fed) and accompanying yen weakness, as well as strong gains in semiconductor-related stocks. Meanwhile, upbeat earnings results, including from Index heavyweights accompanied by share buyback announcements, served to galvanise market sentiment. However, waning expectations of US Fed rate cuts combined with heightened geopolitical risks, capped the upward momentum and key indices peaked in late March. Japan’s currency remained under broad-based pressure amid sustained monetary policy divergence with other major central banks and closed the period at a post global financial crisis low of around ¥203 against sterling.

At a sector level, financials, led by Insurance and Banks, generated the strongest returns, buoyed by higher interest rates and governance-related developments. Shares in power utilities gained on reports of higher dividend payouts, while commodity related segments outperformed. Conversely, domestic oriented industries that are struggling with rising logistics and labour costs underperformed. In terms of style, large-cap value stocks generated the strongest returns over the period contrasting with the far more muted performance of small-cap growth names despite a late rebound.

In economic news, real GDP contracted by 2.9% annualised in the first three months of 2024 after showing modest growth of just 0.1% in the previous quarter. Private consumption remained weak, declining for a fourth consecutive quarter due to persistent price pressures and negative real incomes. Meanwhile, the core Consumer Price Index (CPI) for May came in at +2.5% year-on-year, with electricity prices contributing to an acceleration from April’s reading of +2.2%. The core-core measure of inflation (excluding fresh food and energy) stood at +2.1% and remained above the BoJ’s price stability target. The summary of opinions from the BoJ’s June meeting indicated that more board members had considered adjusting monetary policy in response to upside risks to prices accompanying the recent weakness of the yen. A Bloomberg survey conducted in late June found that 33% of economists polled had expected the BoJ to raise interest rates in July, while those expecting an October increase stood at 42%.

Although economic growth tailed off towards the end of last year, nominal GDP expanded by 5% in fiscal year 2023, which is the strongest growth in more than 30 years. This marks a significant change for Japan as during the lost decades nominal growth was effectively zero and the economy was reliant on price declines to generate anaemic growth in real GDP. Furthermore, Japanese companies are raising wages at the highest rate since the 1990s, reflecting a combination of tight labour markets, balance sheet strength and political pressure. With the more volatile elements of inflation moderating, a return to positive real wage growth later in the year bodes well for consumer facing industries. We are also seeing solid trends in corporate capex, supported by cash-rich balance sheets, structural labour shortages, reflationary dynamics, and geopolitical factors. Seeing greater contributions from these key pillars of domestic demand are key for future economic growth.

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North America

Tony Despirito, David Zhao and Lisa Yang, BlackRock Sustainable American Income, 1 July 2024

The final quarter of 2023 began with relatively low expectations as rising interest rates remained. By October, US equity markets reached new lows as investor sentiment and confidence continued to wane. Inflation data softened faster than expected, keeping the Federal Reserve quite neutral on monetary policy and simultaneously increasing investor confidence. Slowly but surely, as positive economic data and better-than expected corporate earnings were released, the markets began to turn. Consumer spending and economic growth remained strong in the fourth quarter thanks to a resilient jobs market, indicating the US consumer remains relatively healthy. The majority of 2023 was certainly difficult to navigate with inflation, recession fears and heightened volatility, yet in the end, we experienced a powerful rally in the US equity market to close out the year. In terms of style, growth stocks outperformed value stocks as the Russell 1000 Growth Index returned 14.2% and the Russell 1000 Value Index returned 9.5% during the fourth quarter.

After a banner year in 2023, US markets, defined as the S&P 500 Index, continued their momentum in 2024 returning 10.6% during the first quarter, the best Q1 since 2019. Key drivers of performance may be attributed to a strong macro backdrop and above average earnings. The US economy continues to demonstrate a high level of resilience relative to the rest of the world. Gross domestic product (GDP) grew at 3.4%1 while employment remained stable. However, sticky inflation led to falling rate cut expectations, with consensus for cuts in 2024 falling from 6.5% in December to 3% at the end of March2. This supportive macro environment has translated into strong earnings for most sectors in the S&P 500 Index, with the median company posting 3.8% earnings growth year-over-year during Q4 2023. Cyclical sectors led the way including energy, consumer discretionary and real estate3.

Looking to the “Magnificent 7”4, it is worth noting that while Nvidia5 has continued its strong run, the others have seen a high degree of performance divergence. For example, Tesla was one of the worst performers in the S&P 500 Index during Q1, while Apple struggled as well. Lastly, the first quarter was notably strong when compared to other election years, when markets typically rally as policy clarity increases. This year’s unusual set up with each candidate having a presidential track record adds a degree of perceived clarity not usually found this early in election years. While the market rally broadened, growth outperformed value in the first quarter of 2024 with the Russell 1000 Growth Index returning 11.4% versus 9.0% for the Russell 1000 Value Index.

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Biotechnology and healthcare

Paul Major and Brett Drake, Bellevue Asset Management, 24 July 2024

During our fiscal H1 2024, the MSCI World Index delivered an impressive total return of +13.9% in sterling terms (+14.9% in dollars). The first half of the year was in many ways a continuation of FY2023; a very macro-led and narrow market, dominated by a few key “meme-themes” (Technology and particularly Artificial Intelligence being the predominant ones)

During this period, AI Chip maker NVIDIA delivered a dollar total return of 134% and accounted for almost 20% of the MSCI World Index’s total return. Hypothesised AI mega-beneficiaries Microsoft, Meta and Alphabet accounted for a further additional c.13% of the MSCI World Index’s return between them. In other words, one could say that around a third of the total market return during this period was attributable to four stocks around one theme.

Another way of illustrating this concentration effect is to compare the total return of the “Magnificent 7” to the “S&P 493” (i.e. the Index excluding the so-called Magnificent 7) over the same period. The dollar return of the former (+29.7%) is more than double the return of the latter (+12.7%)

NVIDIA for sure saw tangible upgrades in terms of revenues, profits and cashflows but the benefits thus far feel much more nebulous for the other companies. Indeed, some of the product rollouts can hardly be described as successes. It was ever thus in technology; it takes longer than expected for the real economic benefits to be visible.

The second notable macro characteristic was continued volatility around interest rate expectations that we feel has tended to overstate the level of impact on the equities market and wider economic outlook, as Illustrated by Figure 1 in the half yearly report, which shows the actual yield on 30-year US Treasury bonds since the beginning of FY2024; the summary of which is that long-term rate expectations have barely changed over this period:

It is difficult to recall a similar period when market leadership has been so narrow, both thematically and in terms of individual stocks. Irrespective of sector and style, the majority of active managers are going to struggle to keep up with such a dynamic.

The MSCI World Healthcare Index generated a sterling total return of +9.7% during our fiscal H1 2024 (+10.7% in dollars), again underperforming the parent MSCI World index. However, as suggested previously, this difference would largely ebb away if we adjusted for the outsized performance of that small cadre of mega-cap technology stocks.

It is worth calling out the sector’s own “Magnificent 2”: the GLP-1 obesity plays Novo Nordisk and Eli Lilly. During the period in review, these generated dollar total returns of 34% and 39% respectively and drove almost 40% of the index total return. Without the outsize contribution from these two names, the Index return would have been more like 7.6%, which is still a healthy annualised return figure in any “normal” year (whatever one of those is these days). While the Company does not own either of these companies, it does have holdings exposed to the GLP-1/obesity market opportunity which delivered comparable returns during our period of ownership within fiscal H1 2024.

In many ways, a decent normalised absolute performance should not be all that surprising. The newsflow over the period generally reflected further continuing stabilisation of behaviour amongst retirees in regard to the utilisation of healthcare services from an elective standpoint, an ongoing flow of new products in the drug and device spaces and a generally benign regulatory environment. From an operational standpoint, the healthcare sector has done exactly what one might have expected.

The total return performance by sub-sector is summarised in Figure 2 below and we would make the following comments:

The Generics sector return was almost entirely due to Teva (+72%), which rose strongly off recent lows on the back of better profitability and easing litigation concerns. The Facilities sector performed strongly on continued improvements in procedure volume trends and cautious comments from Managed Care companies (i.e. those paying the bills) that such trends would likely persist through 2024.

The Diversified Therapeutics sector includes Lilly and Novo and would have delivered a return closer to 4% if these two stocks had performed in line with their peers. Despite being a clear beneficiary of AI deployment, with numerous examples of successful utilisation of machine learning, the Healthcare IT sector continues to struggle on the sentiment side. Much of this sub-sector’s negative performance can be attributed to the Japanese software company M3 Inc., which fell >40% during the period.

The primary driver of the negative outcome in Diagnostics was portfolio holding Exact Sciences, which cannot seem to shrug off concerns over competitors developing colon-screening blood tests, despite their obviously inferior efficacy and thus questionable suitability for use as preventative screening tools.

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Commodities and natural resources

Tom Holland and Mark Hume, BlackRock Energy & Resources Income Trust, 31 July 2024

Looking back at the 2023 annual report we flagged “an abnormally high level of uncertainty for the year ahead”. Part of this reflected a record spate of elections in 2024 as well as persistent tensions between the United States and China “where tariffs continue to be the tool of choice in tackling the competitive threat of cheaper manufactured goods in the Energy Transition value chain”. Since then, the European Union has announced tariffs against Chinese Electric Vehicles. Against this backdrop, we believe there is likely to be higher and stickier inflation than we have seen in the last two decades and reinforces our view of a higher interest rate environment. Whilst risks remain elevated, we believe the flexibility that the Company offers remains key to achieving our twin objectives of growth and income as these uncertainties drive persistent dispersion.

AI and datacentre demand will be additive to prior estimates of baseload power demand which we see as supportive not just for renewables, but critically for natural gas and nuclear. Further, as technology companies seek to drive rapid build out of these energy intensive assets the demand for traditional investments will drive further bottlenecks on the supply side.

As we look into the second half of the year we are also closely monitoring the outcome of Federal-level elections and their potential impact on energy and climate policy. The UK (22 May) and France (10 June) both announced snap elections during the period. Subsequent to the period end, a Labour majority has been confirmed in the UK that will likely see an acceleration of decarbonisation efforts and should provide a positive tailwind for grid expansion and permitting. Finally, as we head towards the November US Presidential election it is not unreasonable to surmise that, under either a Republican or Democratic victory, it will do little to derail the underlying pace of capital investment into the Energy Transition space. The Inflation Reduction Act of 2022, for instance, has been a very positive force in job creation and capital formation in the United States – an outcome most politicians will tend to favour.

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Environmental

Jon Wallace, manager, Jupiter Green – 24 July 2024

We have a long-held conviction that global development is and always has been dependent on the natural world. While we remain highly cognisant of geo-political tensions, potential macro-economic weaknesses and regulatory risks for instance that impact upon our investment landscape like any other, we would highlight that observed changes to the environment, not least climate indicators, are more severe than anticipated and in many cases still not fully explained.

Our conviction also remains that this presents an ever-more compelling long-term growth opportunity for leading companies focussed on delivering real- world solutions to protecting the climate as well as wider forms of natural capital, including water resources and biodiversity.

It is notable that growth drivers within our environment solution themes continue to be buoyed by an appreciation of the broader benefits of environmental solutions amongst corporations and governments. Areas where this is apparent include the role environmental technologies are playing in helping to address growing energy security concerns, and the benefits to human health of tackling longstanding and ’emerging’ pollutants in water resources.

In our view, this will continue to provide resilience in investment returns at a time when there is a risk that policy commitment to environmental agendas, at least at the headline level, may wane or even take a backwards step, with the US election later this year a notable case in point. However, we are encouraged by the clear signals of a widespread recognition that, irrespective of political leaning, environmental technologies and services will play a pivotal role in the economy of the future.

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Financials

Nick Brind, George Barrow and Tom Dorner, Polar Capital Global Financials Trust, 3 July 2024

We remain constructive on the outlook for the sector as we continue to believe the investment background looking forward has fundamentally changed with interest rates ‘normalising’ and the need for significant investment in reshoring, defence and decarbonisation by developed countries. We believe the sector will be a key beneficiary of these trends. It is also the biggest spender on technology and is expected as a result to be one of the biggest beneficiaries of AI in improving efficiency.

That said, this is a year when many elections have had or could have a bearing on financial markets, as we have seen in France, India and Mexico. While the rapid rise in interest rates has been a tailwind for the banking sector, it is also a risk, though it has so far had relatively little impact on the credit-worthiness of borrowers. The exception has been the office commercial real estate sector where a bigger driver has been the change in working patterns resulting in lower occupancy levels.

Nevertheless, we believe that it is unlikely that interest rates will return to the very low levels that we have seen previously. The prospect of future cuts in interest rates should ease concern on asset quality while remaining at a level that is supportive for net interest margins. Equally insurance companies have benefited from the rise in interest rates and bond yields, which has boosted investment income and therefore profitability, but are much less sensitive to short-term move in interest rates.

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Technology

Ben Rogoff and Ali Unwin, managers, Polar Capital Technology Trust – 16 July 2024

Market Outlook

If the market surprise of 2022 was how high inflation remained for so long, 2023’s revelation was how little impact the fastest monetary tightening cycle in a generation had on the real economy. Various explanations include: a delay in the ‘transmission’ of higher rates given the high proportion of mortgages and corporate debt which had been fixed at very low rates during the ‘zero-rates’ era; the benefit of interest income on ‘excess consumer deposits’ in supporting consumer spending; corporate unwillingness to let go of the workers they had fought hard (and paid up) to attract and retain. In contrast with prior years, our base case for 2024 is broadly in line with consensus on many of the key near-term debates (inflation, rates, valuations) and our belief is that where we do differ, the range of outcomes is narrower. Some of the other ‘known’ risks are more binary in nature (e.g. US presidential elections).

In its April 2024 update, the IMF projected 3.2% global growth in 2024, 30bps higher than its October 2023 forecast, and 3.2% in 2025. This outlook is described as “surprisingly resilient, despite significant central bank interest rate hikes to restore price stability”. The persistence of US growth is striking, now expected to accelerate modestly from 2.5% in 2023 to 2.7% in 2024, against expectations for a deceleration to 2.1% for both years in the IMF’s January 2024 update. Despite strong economic growth, the disinflation process remains broadly on track and “monetary policy should ensure that inflation touches down smoothly”: global headline inflation is expected to fall from 6.8% in 2023 to 5.9% in 2024 and 4.5% in 2025.

Our base case remains that central banks have won the battle on inflation. Much of the earlier excess inflation proved to be supply-side driven including covid disruptions (e.g. container freight rates increased 5x between 2020 and late 2021) and exogenous commodities price shocks from Russia’s invasion of Ukraine. Demand imbalances have also played a part, including government stimulus and demand swings for goods versus services. Common causes have seen common solutions: disinflation dynamics have been reasonably homogeneous across countries. Goods disinflation has been widely observed while services has proven stickier, around c3-5% in developed economies.

For its part, the Fed kept long-term inflation expectations ‘well-anchored’ and prioritised credibility above all else; the ‘5yr5yr’ – a market-implied expected average inflation rate over a five-year period that begins five years from today – remained in a 2-2.5% range despite headline CPI inflation in the high single-digits. This proved sufficient to deliver a ‘soft landing’ most thought impossible, judging by the c75% of economists who expected a recession coming into 2023, and the Fed futures curve which anticipated the Fed would have to cut rates by the second half of 2023. We expect the Fed to manage the balance between keeping rates restrictive enough to ensure inflation returns to target and cutting early enough to prevent a recessionary outcome.

The path of inflation is the key determinant of Fed policy, and it will (rightly) remain ‘data dependent’, but policymakers are clearly cognizant of the need to manage de facto tightening from higher ‘real’ rates as inflation trends lower and policy rates sit unchanged. Indeed, real rates are already around c2%, versus an average 3% level at which the Fed has historically started cutting, and other central banks including Sweden’s Riksbank, the ECB and the BoE have either begun cutting or signalled they will soon. The ‘maximum employment’ aspect of the Fed’s ‘dual mandate’ will also likely receive more attention, and arguably Chair Powell introduced a form of ‘labour market put’ at the January FOMC press conference: “If we saw an unexpected weakening in… the labor market, that would certainly weigh on cutting sooner. Absolutely.”

Equities tend to rally after the Fed begins a cutting cycle, although the returns are (unsurprisingly) better in non- recessionary scenarios. Deutsche Bank found that the S&P 500 has returned +7% in the 12 months following the first rate cut in recessionary scenarios, and +18% in non- recessionary scenarios. Longer-term, Goldman Sachs found a c50% positive return over 2 years absent a recession and negative mid-teens returns when a recession occurred. Interestingly, the overall level of the market coming into the rate cutting cycle has made little difference historically. Since 1980, there have been 20 times when the Fed has cut rates when the S&P 500 was within 2% of all-time highs, and the market has been higher a year later on all 20 occasions.

Investors should also be comforted by central banks’ increasing ability and confidence in using their balance sheets to deal with sector or asset-class specific issues. Indeed, one of the great challenges last year was understanding how an aggressive Fed tightening cycle did not cause a spike in unemployment or a recession. In addition to the reasons suggested above, liquidity provided by years of Quantitative Easing plus covid-era balance sheet expansion (from 18% of GDP in 2019 to 28%) mollified the impact of monetary tightening from rate cuts. In addition, central banks have been very willing to use their balance sheets to support the economy and the debt and labour markets (and, by extension, risk assets), as seen with the Fed’s Bank Term Funding Program (BTFP) and the Bank of England’s successful intervention during the LDI crisis. We expect balance sheet operations to remain a permanent part of the landscape.

Valuations appear extended, but not unreasonable. Equity market valuations have rebounded since June and October 2023 lows (c15.5x) and the S&P now trades on 21x 2024 consensus earnings and 18.5x 2025, based on +11% and +9.5% EPS growth. Historically, equity valuations have expanded following the end of Fed hiking cycles, but multiple expansion is typically accompanied by a decline in bond yields. Economic growth appears positive but moderating (total revenue growth tracks nominal GDP growth normally), which suggests upside to revenues (absent AI-related areas) might be limited. S&P profit margins are back to pre-GFC highs and elevated versus history, having troughed in Q4 2022. Several incremental headwinds to further margin expansion suggest profit growth could be more similar to revenue growth in 2024, although analysts are still assuming significant operating leverage with S&P 500 expected earnings growth (+11%) ahead of revenue growth of 4.9%. However, we are optimistic longer-term that AI could drive sufficient labour productivity for knowledge workers to make a material difference to the c$53trn global wage bill (c54% of GDP). Our valuation base case is that significant further multiple expansion is unlikely from this point, and equity returns should better track EPS growth absent a recession or bull case scenario.

Market Risks

The most significant risk to the market outlook is the prospect of a recession or ‘hard landing’. Past economic downturns have seen S&P 500 EPS decline by 11% peak-to-trough and the index level fall by -24%, although prices and valuations typically bottom faster than earnings. The median forecasted probability of a US recession in the next 12 months fell steadily from 65% to 30% during the fiscal year. However, there remains a possibility that the ‘long and variable lags’ of the fastest monetary tightening cycle in a generation will ultimately push the economy into recession. Cracks in commercial real estate have caused concern, but the office market accounts for just 2-3% of banks’ loan portfolios while office investment is only 0.35% of GDP.

We believe the odds of a US recession are still relatively low, despite warnings from several traditional leading indicators such as the yield curve (still inverted) and the Conference Board’s Leading Indicator, which has never experienced such a large 6- month decline without a recession. On the monetary side, the money supply has never contracted this fast without some sort of negative outcome – even in our favoured parallel the post-WW2 ‘recovery loop’, there was a brief recession in 1948-49 as the economy transitioned from a wartime to a peacetime footing. Central bankers may have more data (and some other tools) to help the economy adjust, but if there is an asset quality problem rather than a liquidity problem, there is only so much they can do.

The most bearish market view is any challenge to the idea that the Fed actually has managed to get inflation sustainably under control, and the threat from a ‘second wave’ of inflation could necessitate further tightening. There was a second (and third) wave of high inflation in the 1970s related to geopolitical developments (Vietnam war, energy crisis, deficit spending). This would hurt equity performance: markets were flat between 1967-1980 and credit outperformed significantly as yields averaged >7%.

A longer-term issue which could contribute to a higher neutral interest rate and lower equity multiples is the growth in public debt, which has reached record levels as a percentage of GDP in many countries. Historically (e.g. 1919, 1946, 1995), peak government debt-to-GDP has been resolved by a combination of lower fiscal deficits (or surpluses) and an acceleration in GDP. This has not (yet) occurred; since the 2020 peak, GDP growth has been strong, but the federal deficit in FY23 was c$2trn (7% of GDP), doubling from $1.0trn in FY22.To date, this increased deficit has been of limited concern to the bond market but our working assumption is that it ‘cares’ about deficits in a non-linear way, and perhaps 5% on the 10-year US treasury might mark a potential ‘break point’. However, we also acknowledge that being the reserve currency of the world may allow for ongoing structural US deficit financing with limited penalties.

Beyond a recession, we are most concerned about geopolitical risk, a topic we covered in depth last year. This risk is heightened in what is an election-heavy year, where countries accounting for >60% of global GDP are holding elections – US, India, and UK among them – but also because there is an emerging narrative about the reversal of the post 1980s ‘peace dividend’ which has supported global growth, trade, stability, and asset values. The emerging ‘multipolar’ world could reverse this feedback loop as trade and supply chains decouple, higher inflation and higher deficits become embedded – the ‘1970s scenario’. China represents its own category of geopolitical and economic risk. A bearish view might consider the ‘success’ of China’s initial lockdown as its zenith as a global power before the inherent limitations of an investment-led growth model and/or totalitarian leadership were laid bare. China’s nominal GDP growth has decelerated to the lowest level since the 1970s which helps explain the weakness in Chinese equity and property markets. This could reflect a new normal for China after three decades of double-digit nominal GDP growth.

In terms of US-Sino relations, there are several paths that a deterioration might take in 2024. These include further outbound investment restrictions, export controls, and even the revocation of ‘Most Favoured Nation’ status, something of which Trump is in favour. China may also be at risk of exporting deflation to the rest of the world but the economic impact to the US should be contained (exports to China make up 0.6% of US GDP), and a direct effect of a 1% shock to Chinese growth on US GDP is estimated at less than 0.01%.

A far greater risk comes from the potential for an escalation in tensions surrounding Taiwan as President Xi described unification as “a historical inevitability” in his 2024 New Year’s address. A second Trump presidency would bring an added element of uncertainty and higher likelihood of a miscalculation. A recent ‘war game’ simulation estimated the potential impact on the global economy of a war in the Taiwan Strait at c$10trn or c10% of global GDP, significantly larger than the GFC or the pandemic. As it relates to PCT, Taiwan accounts for 60% of global semi shipments and >90% of leading-edge semi manufacturing capacity. For context, OPEC has about 40% of global oil capacity. It might take 5 years + to rebuild Taiwan’s semiconductor capacity and would undoubtedly set the evolution of AI back materially.

Increasing market concentration has been a feature of the post-GFC market, with the largest 10% of stocks’ accounting for a portion of the overall stock market (c.75%) not seen since the Wall Street Crash of 1929.

This is not just a technology sector phenomenon as large caps are outpacing small caps nearly everywhere, even on a sector-neutral basis. The rejuvenation of small caps has been long called for by active managers (including us), but the case for broadening is not straightforward.

A more supportive rate environment should help small cap outperformance as we saw in Q4 2023, when yields dropped sharply back to c3.8% and small and mid-caps led the market higher. As we saw then, the upside from a small cap rally can be explosive as Russell 2000 bull markets have produced average gains of 131%, with 7 of 11 bull markets producing triple-digit gains. However, the earnings picture is complicated as large-cap market dominance has reflected higher EPS estimates, in contrast with small-caps where earnings have trended lower since the start of 2022. Absent an earnings recovery, it is hard to argue for structurally higher small-cap multiples.

The risk profile of small caps is also less appealing: the Russell 2000 has a record percentage of unprofitable companies with significantly more debt to refinance in the next few years, in stark contrast with strong balance sheets at larger corporates. Finally, the dominance of large caps may simply reflect the changing nature of the economy as larger companies have enjoyed increasing returns to scale, formerly having been subject to diminishing returns. This reflects a number of structural changes including the increasing relative importance of network effects, globalisation and potentially large cap companies’ ability to develop and exploit proprietary software. In fact, returns on capital for large companies were generally lower than for smaller companies in the 1980s and 1990s, but since 2000 they have become significantly higher for larger companies. The gap may also reflect different attitudes to investment. For example, total capex and R&D spending for the Magnificent Seven this year is expected to total c$350bn and the Magnificent 7 reinvests c60% of their operating cash flow back into capex and R&D, or about 3x rate of the other ‘S&P 493’. Our view is that while a broadening of the market is certainly possible and would be welcome, change of leadership often require a break in the cycle.

There is risk to equity markets from competition from other asset classes. Yields on equities, high grade bonds, T-bills and REITs recently converged for the first time in 20 years. As such, there is far greater competition for capital with investors able to collect the same earnings yield as the S&P 500 at varying risk/return profiles. If rates trend lower as expected, we should expect some rotation into US equities, although equity ownership as a percentage of total assets is already at record highs.

Our broader conclusion remains unchanged from our interim report: whether there is a recession or not and what equity markets do over the next six to 12 months perhaps misses the point. Astounding new innovations such as AI augur well for a longer-term innovation-led growth and prosperity cycle. Markets appear fully valued if we think the timeline to AI’s economic impact is 5+ years away, but much more reasonable if that timeline is sooner. The shortening timeline to Artificial General Intelligence (AGI) – the ability to understand, learn, and apply knowledge across a broad range of tasks and domains at a level comparable to human intelligence- presents a further upside scenario.

Technology Outlook

Earnings outlook

Having stabilised in 2023 with growth of 3.5% y/y, worldwide IT spending is expected to reach $5.1trn this calendar year representing an increase of 8% y/y, in current dollar terms. This represents a notable acceleration and an upward revision from the +6.8% forecast in January. While Gartner believe it will take until 2025 to translate into enterprise budgets, it is clear that AI has already become a corporate imperative with c45% of CIOs planning to adopt AI within 12-24 months. Strength expected in datacentre spending (+10% y/y) suggests that the digital groundwork for AI is being built ahead of enterprise adoption, led by hyperscalers. Likewise, an expected rebound in devices, following two very weak consecutive prior years, is predicated on AI-related product cycles.

For 2024, the technology sector is expected to deliver revenue growth of 9.3%, while earnings are expected to increase by 18% which would represent the best year for earnings since 2021. These forecasts are well in excess of anticipated S&P 500 market growth, where revenues and earnings are pegged at 4.9% and 11% respectively. The technology sector’s outperformance is expected to continue in 2025 with early forecasts for 10.8% / 13.8% comfortably ahead of market expectations (5.8% / 9.5%). While macroeconomic conditions may create crosscurrents, we believe technology fortunes this year will be determined by the path of AI progress.

Valuation

The forward P/E of the technology sector has expanded during the past year. A year ago, valuations had recovered to c24x forward P/E, having ended 2022 at c.19x. Since then, valuations have increased further as technology earnings and stock performance (especially Mag-7) ‘crowded out’ the broader market. At time of writing, technology stocks trade at 26.5x, well ahead of five (23.9x) and ten-year (20.3x) averages. This reflects the arrival of AI as an investment theme and a much improved inflationary backdrop. The premium enjoyed by the sector expanded during the past year with excitement around AI resulting in the sector making post-bubble highs (1.4x the market multiple), levels last seen briefly during the pandemic period. At time of writing, this premium has fallen back to c.1.3x – at the high end of the post-bubble range. While this suggests less valuation upside in the near- term, we believe that AI represents a unique moment for the technology sector such that the post-bubble range (between 0.9-1.3x) may no longer be valid.

Magnificent 7

However, the valuation question is greatly influenced by a select group of mega-cap stocks that – as well as driving returns last year – also dominate technology indices. As such, this year we present some high-level thoughts on the so-called ‘Mag-7’ given the implication for future returns, prospects of a broadening market and, of course, our own positioning.

While 2023 proved a remarkable year for the group, returns are highly sensitive to the starting point; since the beginning of 2021, Mag-7 – at time of writing – has only outperformed the S&P 500 by 10%. At time of writing, the group sports a premium valuation; a forward P/E of 29.6x as compared with 20.9x for the overall index and 18.6x for the remaining 493 S&P 500 (SPX) companies. However, Mag-7 accounts for c.29% of SPX market cap and is expected to generate c.22% of SPX net income. One might argue a little extended, but very clearly far from bubble territory. Moreover, the group is expected to deliver three year compound annual revenue growth of 12% versus 3%, higher margins (22% vs. 10%) and a greater re-investment ratio (61% vs. 18%) than the SPX493. This superior profile has shown little sign of abating as in Q1 2024, expected S&P 500 earnings growth of +6% y/y is expected to come from Magnificent 7 earnings growth tracking to +48% y/y while the remaining ‘S&P 493’ are forecast to deliver -2% y/y. These metrics reflect the group’s uniqueness, with each member dominating large markets, enjoying scale advantages or natural monopoly status while investing heavily in new opportunities to avoid the so-called innovator’s dilemma. Most also have strong AI stories in our opinion, and all are what we consider non-fungible companies and stocks. As such, we expect to retain sizeable positions in the largest stocks in the benchmark over the coming year, assessing each on its own merits and not defaulting to a market broadening narrative, even if we (and other active managers) strongly desire it.

Next generation / longer-duration stocks

Next-generation valuations have also expanded as we predicted in last year’s Annual Report when we suggested it was ‘highly likely’ that we had already seen the lows. Since then, an improved inflation outlook and moderating cloud optimisation headwinds have seen software valuations recover to c.7.0x forward EV/sales, having bottomed at around 5.1x (and peaking at 16x in 2021). According to KeyBanc, this leaves them ahead of five and ten-year pre-covid averages of 6.1x and 7.2x respectively. Higher growth stocks have experienced a greater valuation recovery with companies growing revenues above 20% today trading at 10.9x forward EV/sales; down 62% from highs but well ahead of pre-COVID five-and ten-year averages of 7.8x and 7.0x respectively. In contrast, unprofitable growth stocks have recently made new valuation lows, trading at less than 3.0x forward EV/sales.

Survival of the fittest

The partial recovery in software valuations (and related lack of market interest in unprofitable growth stocks) reflects a slower growth environment ameliorated by higher industry margins. This year, the median software growth rate is forecast at 14-15% as compared to 17% in 2023, and 26-27% in 2022. However, the adoption of the so-called PE playbook, as highlighted last year, has become the norm for most software companies and has been rewarded by the market. Unlike prior downcycles, the recalibration was rapid, reflecting unique post-pandemic challenges – bloated and disconnected workforces, waning product and corporate relevance, the end of ‘free money’ and, more recently, the birth of genAI. The focus on more profitable growth has seen the median software company’s free cashflow margin expand by a remarkable 1500bps from c.5% in 2019 to c.19-20% in 2024E. This recalibration has seen the best companies become better versions of themselves. For instance, while CrowdStrike stock has more than recaptured 2021 highs, over the past c.3 years it has grown revenues from $1.1bn to $2.9bn while expanding operating margins (OMs) from 10% to 19%. ServiceNow – recently at all-time highs – has grown revenues from $5.5bn to $8.5bn while expanding OMs from 25% to 29%. In addition, both companies should be able to use AI to deliver further margin improvement as well as monetise the technology via AI-enhanced product lines.

Against this backdrop, unprofitable companies are not merely anachronistic – they represent a pool of companies unwilling or (more likely) unable to deliver margin expansion. They are former pandemic / WFH winners, derivative plays on now unloved themes, SPACs, or companies that might have changed the world in 2040 had zero interest rates prevailed. They are the broken toys used by equity investors to play themes that didn’t last or never happened. Some may yet reinvent themselves, but history suggests most will disappear, to be combined, reconstructed, or dismantled by private equity. As such, we continue to tread tentatively in longer-duration stocks, doing our best to avoid the siren call of ‘cheaper valuations’.

More M&A activity likely

Following a dismal 2023 for M&A, this year has got off to an encouraging start. After a notable absence of strategic M&A, 2024 has already seen HP announce the $14bn acquisition of Juniper Networks, while Synopsys and Ansys are set to combine in a $35bn stock and cash transaction. More recently, IBM scooped up Hashicorp for $6.5bn, representing c.8.5x EV/CY25 revenues and a 42% one-day premium, while in the UK, there was recently a bidding war between Viavi and Keysight for Spirent. In addition, private equity is likely to remain active with c.$2.5trn in ‘dry powder’ having acquired Alteryx, New Relic and most recently, Darktrace. We expect AI to play a part in greater M&A too, as point solution companies continue to struggle versus platforms with LLMs likely to prove highly disruptive to pre-GenAI vintages. Nonetheless, a recovery in M&A activity should provide some downside support to current valuation multiples.

Cloud / AI Update

Cloud reacceleration

After decelerating for ten quarters, public cloud revenue growth finally reaccelerated in Q4’23 reflecting the combination of waning optimization activity and ramping AI workloads. In Q1’24, aggregate cloud revenue growth reaccelerated 3ppts sequentially to +24% y/y – remarkable given a greater than $210bn industry revenue run-rate. We are hopeful that the post-COVID optimization process is largely complete, a view supported by CIO surveys that suggest cloud spending should more closely track consumption from here. More importantly, AI workloads are beginning to ‘move the needle’ with AI called out as a meaningful contributor at Microsoft (7pts of Azure revenue growth in its most recent quarter) and Amazon (“multibillion-dollar revenue run rate” in AWS). We expect these tailwinds to grow stronger as the public cloud remains a key conduit for accessing AI. Foundation models with ever greater parameter counts require larger clusters of connected AI servers, while the compute requirements of AI applications are said to double every 3.5 months; both needs fit well with cloud flexibility and scalability.

A new architecture for AI

The hyperscalers also have the ‘deep pockets’ required to invest in AI infrastructure, which due to extreme performance required by AI training is heralding a significant shift in IT architecture from serial to parallel compute. We consider the architectural break far more significant than the transition to cloud from on-premise compute. This is apparent from an AI server bill of materials (BOM) said to be 25x greater than a general purpose cloud server. A useful parallel for this might be comparing a Toyota Prius with Formula 1; both are cars, but one is designed for general purpose and efficiency (cloud), the other for extreme performance (AI).

Unprecedented growth

The nascent ‘AI war’ that began a year ago (when Microsoft looked to leverage its OpenAI relationship to challenge Google’s search business) has given way to something far more significant, accompanied by an unusual urgency that feels reminiscent of the 1990s. Having increased by c.5% during 2023, datacentre capex will materially accelerate this year with all of the US hyperscalers raising future spending intentions in both Q4’23 and Q1’24. At time of writing, hyperscaler capex is expected to exceed $170bn in 2024, representing growth of 44% y/y. This is sharply higher than earlier expectations of +26% after Q4 results, and +18% at the beginning of the calendar year. According to Gartner, AI servers will account for nearly 60% of hyperscaler total server spending in 2024.

To date, the greatest beneficiary of AI infrastructure spending has been Nvidia as its GPU chips sit at the epicentre of the new AI architecture. In its most recent quarter, the company registered datacentre revenues of $18.4bn, a remarkable 409% y/y increase. Growth at this scale is extremely unusual in technology history, leading many to suggest that AI spending is a ‘bubble’. We strongly disagree and consider instead that we are early in the accelerated buildout of a general purpose technology.

Building the AI rails

Sizing the AI infrastructure opportunity is difficult to say the least – in last year’s paper we had the temerity to suggest that AI capex “might exceed $100bn”. Since then, Jensen Huang, CEO of Nvidia, has sized the AI market at $1Trn while Dr Lisa Su, CEO of rival AMD, has suggested the market for AI chips will reach $400bn by 2027, which including other component, system and networking costs implies an $800bn opportunity. At face value this suggests that AI spending could increase at a 70% CAGR through 2027 by which time it would reach c.0.8% of global GDP.

This would be extraordinary, but not unprecedented given that between 1830-1839, US railroad investment increased from 0.2% of GDP to just above 0.9% by 1839, corresponding to a 31% CAGR in nominal terms. After a digestion period, railroad investment reaccelerated, averaging 1.7% of GDP between 1850 and 1859. This astonishing period included a blow-off (bubble) phase after 1850, with investment peaking at 2.6% of GDP in 1854. At the height of the equivalent UK railroad boom, investment averaged 7% of GDP for three years. More recently, the dotcom period witnessed telecom companies spend $1trn (in today’s money) building out the Internet during the five years following the Telecommunications Act of 1996. While both historic parallels are useful reminders that infrastructure builds often end badly, current AI spending appears to us to be in its infancy.

The Biggest Opportunity

Underpinning AI spending is the scale of the AI opportunity, reflecting its would-be general purpose technology (GPT) status. Because it addresses knowledge work, economist Erik Brynjolfsson has described AI as “the ultimate GPT – the most general of GPTs”. Accenture estimates that as much as 40% of all working hours will be supported or augmented by language-based AI while McKinsey believe that generative AI could automate 30-50% of tasks in about 60% of occupations, adding the equivalent of between $2.6-4.4trn in economic output annually by 2030.

These longer-term opportunities are buttressed by early AI monetisation. Less than four years after launching a ‘capped profit’ arm in 2019, OpenAI is said to have reached a $2bn revenue run-rate with more than 92% of the Fortune 500 as customers. Meta has also demonstrated its ability to monetise GenAI by improving advertiser ROI and reducing the cost of customer acquisition.

Enterprise adoption of copilots (AI-powered companion software) and premium AI-enabled products has also been encouraging. These tools enable knowledge workers to be more productive; Github Copilot (launched by Microsoft in collaboration with OpenAI in 2022) is helping software developers code up to 55% faster by writing 46% of the code. Lexis+ AI – a legal GenAI assistant from RELX – allows users to “draft clauses, legal documents.. and summarise case law.. (and) the reasoning behind the case”. Law enforcement technology provider Axon recently announced ‘Draft One’, AI-powered software capable of auto drafting police reports based on body-camera footage, saving officers an hour per day on paperwork; in Colorado, police experienced an 82% decline in time spent writing reports. Payment provider Klarna also announced it had replaced 700 full-time contact centre employees with AI agents saving the company $40m per annum. These are early glimpses into AI innovation and disruption, less than  two years after the launch of ChatGPT.

Happening now

Rapid adoption and monetisation of nascent AI tools points to a faster than expected diffusion rate. History shows that the delay between invention and widespread use of new technologies has fallen significantly over time, while analysis of earlier GPTs by the Brookings Institute suggests that implementation lag halves with each successive GPT: 80 years for steam, 40 years for electricity, and 20 years for ICT. We expect AI to take less than 10 years to diffuse widely as it ‘stands on the shoulders of giants’ – technologies such as cloud, internet, leading edge semiconductors and billions of smartphones. Key AI breakthroughs did not happen overnight; the Cloud is nearly 20 years old. NVIDIA has been designing GPUs since 1999. Billions of smartphones and other connected devices have created vast datasets for training AI models and a near-ubiquitous channel for its distribution.

The idea of rapid AI diffusion is visible in real-world developments that include growing recognition among policymakers of the importance of AI and the need to address it through legislation with the number of AI-related bills passed into law increasing from just one in 2016 to 37 by 2022. The Hollywood writers’ strike in May 2023 was another notable development as 11,500 film and television writers began industrial action amid concerns around the AI’s role in scriptwriting, fearing that AI-generated scripts could undermine writers’ work and compensation. While some investors may be concerned about the risk of slower AI diffusion, the actions of those most exposed to the technology and legislators charged with controlling it suggest otherwise.

A model of improvement

Diffusion, monetisation, and corresponding capex are highly dependent on continued AI model progress. We believe the advent of the transformer model in 2017 represented a key breakthrough which is why we describe it as the ‘Bessemer moment for AI’. As with steel in 1856, this breakthrough has resulted in discontinuous technology progress; the parameter count of OpenAI’s GPT-4 (2023) is rumoured to be one million times larger than the DeepMind model that beat Lee Sedol at Go just seven years ago. Higher parameter counts have significantly increased the learning capacity of AI models, enabling them to handle a broader range of general-purpose tasks.

Recent model progress includes multimodality (able to analyse images and audio) and far larger token context windows (the amount of information that can be processed in any prompt). In February, OpenAI announced Sora, a remarkable AI ‘text-to-video model’ able to generate video based on descriptive prompts with “an emergent grasp of cinematic grammar”. The furious pace of model improvement recently saw Google’s Gemini Ultra become the first model to exceed the ‘human expert performance’ threshold on MMLU, an AI benchmark which measures knowledge across 57 subjects. Improved performance is also helping ameliorate earlier technology challenges with newer LLMs such as GPT-4 experiencing lower hallucination rates (incorrect model outputs). The expected launch of OpenAIs GPT-5 over the summer as well as the launch of Meta’s 425bn-parameter Llama 3 and Amazon’s 2trn parameter Olympus will serve as important waypoints to assess continued AI model progress.

Our confidence in continued AI progress is underpinned by scaling laws which have so far predicted improvements in model performance based on increasing model size, the amount of training data and computing power applied. This is a complex topic to tackle here, but to us it is highly reminiscent of Moore’s Law, which famously stated that the number of transistors on a microchip would double approximately every two years. Humans struggle to model non-linear change, but Moore’s Law held true for many decades, predicting the exponential progress of semiconductors that followed. We believe that for as long as they hold, scaling laws predict a continued non-linear pace of AI model improvement and ever-greater investment required to stay on the curve. In a recent interview, Mark Zuckerberg defended Meta’s decision to significantly increase AI spending with reference to scaling laws:, “I think it’s likely enough that we’ll keep going. I think it’s worth investing the $10bns or $100bn+ in building the infrastructure.

General intelligence

Zuckerberg’s excitement (and capex plans) reflects an apparently shortening timeline to artificial general intelligence (AGI), a point where AI might achieve the cognitive abilities of humans across a wide range of tasks. This would have seemed remarkable -crazy even – just a few years ago, but within the AI community, AGI is widely considered attainable in the near future. Founder of DeepMind Demis Hassabis has said AGI could be less than a decade away, while Shane Legg, Google’s chief AGI scientist, believes there is a 50% chance of general intelligence by 2028. Sam Altman also believes it could be reached within the next four or five years. A shortening timeline to AGI might make sense of a series of peculiar recent AI developments including the late 2023 debacle at OpenAI when Altman himself was fired and rehired in a matter of days, as well as decision by Geoffrey Hinton (‘The Godfather of AI’) to leave Google in May 2023 so he “could talk about the dangers of AI”. It might also explain why Altman has mooted the idea of raising $7trn – twice the size of UK GDP – to ‘reshape the semiconductor industry’. After all, if we are indeed close to achieving AGI, the world is going to need a lot of chips.

Welcome to the AI-era

We expect AI to profoundly change the world. At a prosaic level, AI should deliver a significant productivity boost, as was the case with prior GPTs. Current expectations for US productivity to average c.1.4% this decade look mismodelled; GS believe that AI could increase US productivity by 1.5% annually over the next decade, while Erik Brynjolfsson expects US productivity to average “at least 3%”.

Risk to jobs

If so, the coming decade could be “the best ever” although we acknowledge that concerns about AI risk to jobs is understandable given its scope and pace of AI improvement. However, history demonstrates that humans have adapted well to prior technology disruption; in 1850, agriculture explained two-thirds of US jobs before mechanisation steadily reduced this to just 4% by 1970. Despite this, and subsequent technology innovations, median G7 unemployment has “oscillated based on economic cycles, rather than any technological waves” since 1750.

While knowledge work is in the crosshairs of this new GPT, we expect the first wave of AI to complement rather than substitute human work, as is the usual pattern of technology change. Even when AI adoption becomes more disruptive all is far from lost, as the agricultural experience demonstrates. While focus will inevitably fall on jobs ‘lost to AI’ there should be many more made possible by the union of human + machine.

Unfortunately, we cannot know what new opportunities will be made possible by AI. However, we do know that earlier tools and GPTs created opportunities that were previously unthinkable. For instance, the sewing machine changed the relationship between humans and clothing. Previously, clothes were prohibitively expensive; Singer’s sewing machine (1855) transformed this by increasing stitches per minute 22-fold, reducing the time it took to produce a shirt from 14 ½ hours to c.1 Today, apparel is a $2trn industry.

Likewise, the telegraph – the precursor of all modern communication systems – “freed communication from transportation”. By changing the relationship between information and distance, the telegraph (1837) challenged price arbitrage, changed the way wars were waged, created the ‘information industry’ (news agencies such as Reuters and AP) and gave life to the first ‘fintech’ application – wire transfer – introduced by Western Union in 1871.

Hopefully these two lesser known case studies help explain why we know AI will create massive new markets, and challenge existing relationship that exist today. However, we cannot yet know what form these will take, just as Morse – who tried to sell his telegraph system to the US government for $100,000 – did not fully understand its commercial potential.

Idea Generation

We know that earlier technology tools and GPTs have changed relationships. Our early bet is that AI changes the relationship between people and ideas. Transportation technologies (horse, canals, railroads, containers, aviation etc) tamed distance by transforming the movement of physical goods (freight, people). Communication technologies (telegraph, telephone, internet etc) tamed distance by changing the velocity of information. We suspect AI will transform the speed of knowledge creation after years of declining research productivity. The ability to inject limitless AI into research should meaningfully accelerate scientific progress, and unlock new ideas, just as the telegraph acted as “an agency for the alteration of ideas”.

Technology Risks

Given its centrality to sector fortunes, the key risk posed to technology stocks relate to AI. A complex and fluid topic, the most important of these is that the AI monetisation timeline disappoints, perhaps because early productivity gains prove limited. Greater availability of AI chips might also lead to a less intense demand environment, leading to concerns about industry growth. Other potential AI- related risks include greater antitrust scrutiny and other legal challenges relating to data use. We remain sanguine that regulation designed to slow AI proliferation will prove manageable as countries talk a better story than they implement given the strategic importance of AI. We also note that better provision of guardrails could actually accelerate AI diffusion, just as improved safety following the regulation of the aviation industry acted as a tailwind for consumer adoption. We should also remind investors that should AI become a GPT that there are likely to be far more losers than winners from today’s cohort of companies within and beyond the technology sector. However, the most significant AI risk relates to model improvement failing to keep up with scaling laws which would negatively impact hyperscaler capex plans and our (AGI-related) bull case.

Beyond AI, there are many macroeconomic risks that are covered elsewhere in this report. As previously highlighted, the most important of these relate to inflation (failing to return to pre-pandemic levels) and recession (brought on by higher interest rates or sharply higher energy prices). As such, the timing and magnitude of interest rate cuts is likely to remain a key focal point for investors. In addition, there is likely downside risk to technology spending should CEO confidence meaningfully deteriorate. Similarly earnings estimates will remain subject to macroeconomic turbulence with less scope for cost cutting now technology margins have recovered to 25.6% in Q1’24, up from 22.4% a year ago. While we hope this would be disproportionately felt by non-AI segments, it might also result in weaker consumption trends and a disappointing recovery trajectory for cloud spending.

Valuation remains a key risk too, particularly following the absolute and relative re-rating in technology stocks. Heightened sensitivity to earnings disappointments during Q1 earnings season is symptomatic of elevated valuations and investor expectations. While we believe the re-rating is appropriate given the arrival of AI as a key investment theme, higher risk-free rates and/or diminished prospects of interest rate cuts could challenge this view. We are also dismissive of the notion that AI stocks are in a bubble, akin to the dotcom period in the late 1990s. While there are features of today’s market that rhyme with that earlier period, we do not believe investors are really considering trillion dollar market opportunities, scaling laws and an accelerated path to AGI. Factors that would challenge this view include much higher valuations (tech traded above 2x the market multiple in 2000), a ‘hot’ IPO market dominated by immature AI companies and the application of new valuation metrics necessary to justify elevated valuations. None of these conditions exist today.

As in prior years, regulation beyond AI remains a key risk too, with potentially adverse outcomes in outstanding antitrust cases against Alphabet and Amazon likely to impact other natural monopolies within our sector. In Europe, large ‘gatekeeper’ technology platforms will be forced to comply with the Digital Markets Act (DMA) designed to foster greater competition, with fines of up to 10% of global revenues for non-compliance. However, we believe worst- case outcomes will continue to be averted, in part because many of these companies represent the vanguard in the emerging AI battleground with China. Instead, deteriorating US-Sino relations may represent a more significant risk, given that Taiwan represents a critical geopolitical fault line and could potentially impact a significant portion of our portfolio.

Concentration risk

In addition, it would be remiss of us not to again remind shareholders about the concentration risk both within the Trust and the market-cap weighted index around which we construct the portfolio. After another year of large-cap outperformance, this risk remains elevated. At year end, our three largest holdings – NVIDIA, Microsoft, and Alphabet – represent c. 27% and c.35% of our NAV and benchmark respectively while our top five holdings (which additionally includes Apple and Meta) represent c37% and c53% of our NAV and benchmark respectively. We continue to believe that this concentration risk is justified because they are unique, non-fungible assets that capture the zeitgeist of this technology cycle and appear well positioned for AI given their significant scale advantages.

That said, we remain unafraid of the idea of moving to materially underweight positions in the largest index constituents should we become concerned about their growth or return prospects, or should we find more attractive risk-reward profiles elsewhere in the market. This past year, we have meaningfully reduced our Apple position to c820bps underweight at the end of the fiscal year. However, the timing of a more concerted move away from mega-caps remains highly uncertain, not least because in aggregate the stocks continue to enjoy strong relative earnings revisions while valuations remain far from ebullient.

Conclusion

We hope this (long) outlook section adequately conveys our excitement about Generative AI. We truly believe the AI story is just beginning. Where others may predict steady diffusion, we expect AI adoption to follow the pattern of electrification which was “sweeping and widespread”. For now, we (and the Trust portfolio) are heavily focused on the companies helping build the AI ‘rails’: chips, systems, storage, networking. We believe these are the most direct beneficiaries of an infrastructure build-out that is only a few quarters old. After decades of understandable investor focus on software enabled by the cloud, AI has turned the spotlight back to hardware; the c.25x higher bill of materials of an AI server epitomises an architectural shift away from general purpose cloud in favour of high-performance compute. In addition to large holdings in NVIDIA, AMD and Broadcom, we have added a series of Asian suppliers (PCBs, systems, testers and more) that we expect to benefit from higher ASPs and growing AI share of their revenue mix. We are also intrigued by edge AI opportunities in traditional technology segments such as PC and smartphone – markets we typically eschew as growth investors. While we will tread carefully in these otherwise mature areas, AI has the potential to steepen innovation curves, shorten replacement cycles and render massive PC and smartphone installed bases obsolete. Combined with Cloud and several infrastructure software companies, these AI enablers explain around two-thirds of the Trust portfolio today.

In time, there should be other software winners too; for now we have gravitated towards the largest incumbents, particularly those with large, unique, and critical datasets such as Microsoft, SAP, and ServiceNow that are able to monetise their domain expertise via copilots or premium-priced products. Longer-term, we remain unsure about how the deterministic, packaged software industry of today will coexist with the probabilistic nature of AI models. How will software innovation and codified ‘best practice’ contend with recursive AI able to adapt, learn and iterate?

While this question is longer-term and more theoretical in nature, there is already genuine investor debate about whether Adobe (not held) – a truly remarkable software company – is a ‘winner’ or ‘loser’ from AI less than two years after the launch of ChatGPT. This speaks to the pace of model improvement, as well as the reach and disruptive capabilities of AI. We expect this debate and the shadow cast by AI to extend within software and other technology subsectors as AI becomes ever more capable. This is why we introduced a so- called ‘AI lens’ to our investment process last year; not only to help us identify potential AI winners, but to ensure that we have properly considered and debated the risks posed by the nascent General Purpose Technology (GPT).

Our approach may appear premature and at odds with the current consensus view that AI will take a reasonably long time to diffuse. History also suggests we might be early given that incumbents can benefit from the early adoption stage of a new GPT as it creates incremental opportunities to leverage existing (if soon to be obsolete) investments, particularly while the new technology is inferior, expensive, or limited in scope. However, if we are right about rapid AI diffusion and model improvement (our base case), investors may have less time than they think to avoid the potential losers from AI. Our experience investing during the internet, cloud and smartphone cycles reminds us it is considerably easier to spot early losers from disruptive new technologies than it is to identify the early winners.

The combination of accelerated infrastructure build-out and concomitant model improvement, together with potential for more rapid disruption elsewhere explains why we have pivoted the portfolio towards AI during the past year. While this may result in somewhat greater daily volatility, our enthusiasm for AI will continue to be matched by a pragmatic (and highly liquid) approach to portfolio construction given heightened levels of uncertainty and opportunity associated with AI disruption and a new computing stack.

Following a number of thematic ‘false-starts’ in recent years, we understand why some investors might default to bubble at times like this. However, we believe AI represents the next general purpose technology. If so, relationships between computers and humans, humans and ideas, are likely to be upended. One of the biggest impediments to the development of AI has been Polanyi’s paradox, that “we know more than we can tell”; tasks which humans can intuitively understand how to perform but cannot verbalise or formally encode. Generative AI may have solved this riddle by finding the unknown relationships across vast bodies of data. In the near future, AI may tell us more than we can know today. At times like this, it may be tempting to seek shelter from the uncertainty that discontinuous technological change brings. Instead, we attempt to embrace the unknown, taking comfort from the fact that many of the smartest people who ever lived were unable to know in advance- as Samuel Morse exclaimed in 1844 in his first telegram -‘what hath God wrought’

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Debt

Bronwyn Curtis OBE, chair, TwentyFour Income Fund

With inflation continuing to prevail and relatively high levels of wage growth remaining, the market expectation remains that base rates will be likely to remain

Outside the political drama, demand for floating rate bonds has increased significantly over recent months, which is expected to persist, and this positive technical, absent of geopolitical surprises, should keep ABS credit spreads range bound.

The ongoing war in Ukraine and tensions in the Middle East remain catalysts of risk sentiment in all financial markets, meaning spread volatility is likely to remain. As spreads have rallied to levels last seen prior to the Russian invasion, the Board is supportive of the Portfolio Manager’s focus on Western European secured assets: mortgages, auto loans and Collateralised Loan Obligations (“CLOs”) with short maturities.

A moderate deterioration of fundamental performance (such as unemployment, house prices, corporate earnings and defaults) is expected by the Portfolio Manager. The Portfolio Manager expects to see increasing arrears levels in consumer credit, but not to levels seen during the Global Financial Crisis and remain confident based on strong stress test results.

Increasing demand for the asset class and higher for longer rates are expected to remain drivers of performance in the medium term. Throughout the reporting period, UK pension funds have slowly returned to the European ABS market, which has delivered the liquidity that pension funds needed. The Portfolio Manager expects that demand for ABS is likely to increase significantly once UK pension funds have rebuilt their liquidity profile.

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Managers, TwentyFour Income Fund

In late May 2024, the latest UK inflation data was released, showing a fall nearly to the 2% target. It was swiftly followed by the announcement of a general election called for 4 July 2024. After a somewhat subdued campaign, the result followed polls with a decisive victory for the Labour Party (“Labour”) led by Keir Starmer.

With the current macro environment and the fact that Labour is bound by the same fiscal rules as the previous government to limit borrowing and debt, we expect a relatively limited impact on inflation and the subsequent decision due from the BoE of when to cut rates, but we continue to remain sensitive to the impact of the new government’s policies and impacts on the market.

In the US, the Republican Presidential candidate, Donald Trump, was found guilty of 34 felony counts, whilst his opponent President Biden fumbled in debates and appearances, however, the November 2024 election result still remains a close call. In France, President Macron called emergency parliamentary elections after the European elections showed right-wing populists making large gains across the bloc, leading him to dissolve the National Assembly and gamble on national polls. The elections duly showed a significant swing to the right, and an indication of a hung parliament, leading to French government bond yields hitting 12-year highs.

With spreads having performed very well during 2024, despite elevated geopolitical risks posing a threat, we expect the strong demand/supply technical to persist in the medium term.

We continue to see the best value in primary transactions and short-dated BBB and BB-rated RMBS and CLOs, and expect the pace of Euro CLO issuance to persist, with a healthy ABS pipeline for the remainder of 2024. With more older CLOs reaching the end of their reinvestment periods and a healthy leverage loan market, we expect to see an increased amount of older CLOs being called as well as a further pick up in refinancings of the 2022 and 2023 vintages. We will look to reinvest this increasing amount of portfolio amortisations in primary supply.

We anticipate resistance to short-term spreads tightening from here, however, we do see a scenario where the excess demand, particularly in ABS markets, outweighs this effect. Primary supply has been met with very strong demand so far in 2024 and although total volumes are strong, we had expected to see more RMBS deals come to market, but recognise that specialist mortgage lending volumes have likely been suppressed during 2023. In the first half of 2024, €71 billion of primary issuance came to market, which is well above the typical €50-60 billion that was printed in the recent 5 years, and has resulted in an increase of the European ABS market size to €520 billion. We anticipate that the current strong demand/supply technical will remain in place as a driver of medium-term performance. In the longer term, we continue to see geopolitical risk as the key risk for market volatility and value flexibility in positioning and therefore expect to keep elevated levels of liquidity, especially as European ABS continues to benefit from higher rates for longer.

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Leasing

Edward Buttery, chief executive officer, Taylor Maritime Investments – 22 July 2024

We are optimistic about the long-term prospects for our segment as geared ships fulfill an important role in the global economy, carrying a diverse range of necessity goods via a wide range of ports in emerging and developed countries. In the short to medium term, we are encouraged that freight rates started the 2024 calendar year higher than in 2023; typically, we expect commodity demand to strengthen in the second half (notwithstanding a softer summer period). Indeed, the demand growth forecast for 2024 is strong at 5.2%.

Current projections for 2025 suggest an easing of demand (assuming Red Sea disruption has receded by the end of this year). Given the uncertainty around the Red Sea situation, we could see continued strong bulker demand. If expected interest rate reductions materialise this should have positive impact on market sentiment and increased demand for inventory rebuilding as business confidence returns.

Overall market downside is expected to be limited given a prolonged period of slow fleet growth (around or below 3% for the last seven years), the still relatively modest orderbook (9% of fleet capacity) stretching out to 2027 and 2028, elevated newbuilding prices discouraging new orders and the potential for scrapping with 10% of the Handy fleet and 5% of the Supra/Ultra fleet now 25 years or older. As the industry focuses on cutting its emissions, environmental policies will cap effective supply with operating speeds continuing to reduce and time taken to retrofit energy saving devices removing older less efficient units from the active fleet.

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Renewable energy infrastructure 

Lucinda Riches CBE, chair, Greencoat UK Wind, 23 July 2024

There are currently approximately 30GW (£100 billion) of operating UK wind farms (15GW onshore plus 15GW offshore). The Company expects the UK wind market to grow two to threefold over the next decade. The Group’s market share is approximately 7 per cent. As at 30 June 2024, the average age of the portfolio was 8 years (versus 5 years at IPO in March 2013).

As progress towards a net zero electricity grid continues, the decarbonisation of transport and home heating through electrification, and the production of green hydrogen, are emerging as significant sources of responsive demand for green electrons by 2030. Together these sources of demand alone are expected to require a further 30TWh per annum of electricity in the next five years. This is approximately one tenth of the UK’s current annual electrical demand and approximately five times the Company’s current annual electrical output.

Further sources of responsive demand are expected to materialise in the coming five years including, for example, an expansion of capacity to power data centre demand as the use of AI increases.

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Property

Diversified

Balanced Commercial Property Trust

Richard Kirby, fund manager:

The second quarter of 2024 saw the economic pressures that have weighed heavily on the real estate sector begin to ease. Against this more positive backdrop, the MSCI Monthly Index delivered a total return of 1.7%, the joint strongest quarterly return since June 2022. This has been driven by an income return of 1.5% led by occupational markets. Over the quarter, all sectors delivered rental value growth, which was 0.8% at the market level, whilst vacancy rates remained broadly stable at 10.4%. The MSCI Monthly Index reported capital growth of 0.2% over the quarter, with April 2024 seeing the end of an 11-month run of consecutive valuation declines at the market level.

Rebased pricing combined with resilient occupational markets is beginning to translate into increasing investor confidence. This is particularly true of the retail warehousing and industrial & logistics sectors, where strong occupational fundamentals are supportive of income resilience and growth. The most notable feature of the investment market continues to be a constrained supply of available stock within these favoured sectors, with preliminary volumes for H1 2024 down circa 10% against already weak comparatives from H1 2023.

With the exception of offices, all other sectors have delivered positive total returns over the quarter. While the hybrid working model appears to have stabilised, the office sector continues to suffer from weakening investor confidence as occupational markets remain uncertain and obsolescence continues to pose an existential threat to secondary assets.

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Logistics

SEGRO

David Sleath, chief executive:

Urban warehouses located in Europe’s largest cities and big box warehouses located in major logistics hubs and along key transportation corridors are in high demand from occupiers, driven by the long-term structural drivers at play in our sector – digitalisation, supply-chain resilience, urbanisation and sustainability. There is a shortage of modern, sustainable space due to low availability of land, restrictive planning policies and, more recently, a significant fall in speculative construction starts across Europe. This tight supply-demand dynamic combined with an improving macroeconomic situation will support higher take-up levels and help to drive continued rental growth.

Asset values appear to be at an inflection point in the UK and bottoming out in Continental Europe, and the prospect of interest rate cuts later in the second half should provide support for continued recovery in investment market conditions. We believe this will present further, exciting opportunities to drive future returns. Overall, we believe the present market environment offers an attractive opportunity for profitable medium-term investment.

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Retail

Shaftesbury Capital

Ian Hawksworth, chief executive:

The investment market has been active for some time demonstrating demand for high quality prime central London real estate. Transactional evidence is now being reflected in more stable valuation yields and rental growth is delivering improved valuations and income. The occupational market in the core West End is strong and has been improving for some time.

Both the occupational and investment markets continue to demonstrate polarisation of demand to the strongest locations, as retailers become ever more discerning on a growing number of criteria. There is greater emphasis on global locations, consumer experience and service together with better digital engagement. Retail demand is strong, with units attracting interest from multiple customers. Our portfolio remains a preferred destination for market entry and retail expansion. Trading conditions are positive with excellent performance in certain categories.

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Student accommodation

Unite Group

Joe Lister, chief executive:

Structural factors continue to drive a growing supply/demand imbalance for student accommodation. Demographic growth will see the population of UK 18-year-olds increase by 124,000 (16%) by 2030 (source: ONS). Application rates to university have also grown significantly over the long term, reflecting the value young adults place on a higher level of education and the life experience and opportunities it offers. Strong wage growth in recent years has seen graduate earnings keep pace with inflation at a time when tuition fees have been frozen for seven years, supporting the overall attractiveness of a university education. Undergraduate applications for the 2024/25 academic year are encouraging, with application rates for UK school leavers meaningfully ahead of pre-Covid levels and robust demand from international students, particularly China and India. Applications to high-tariff universities, to which the Group is aligned, have grown 15% since before the pandemic, significantly outperforming the wider sector.

The supply of student accommodation cannot keep pace with student demand and many university cities are already facing housing shortages, which are particularly acute for the strongest universities where our investment is focused. Private landlords are leaving the sector at pace in response to rising costs from higher mortgage rates and increasing regulation, such as EPC certification and local authority licencing schemes. Since 2021, there has been an 8% reduction in the number of HMOs in England (source: Department of Housing, Communities and Local Government), equivalent to 100,000-150,000 fewer beds available for students to rent.

New supply of purpose-built student accommodation (PBSA) is also down 60% on pre-pandemic levels, reflecting viability challenges created by higher build and funding costs. In many markets, property valuations are now below replacement costs, further constraining new supply. Once allowance is made for first generation university-owned beds leaving the market each year through obsolescence, we expect to see almost no growth in PBSA supply in the near term.

The combination of these factors has significantly increased demand for our product in many cities and we expect this trend to continue for a number of years.

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Healthcare

Primary Health Properties

Mark Davies, chief executive:

The commercial property market continues to be impacted by economic turbulence and the uncertainty of interest rates continues to weigh on the real estate sector. This is severely impacting liquidity across the wider real estate market especially those sub-sectors impacted by changing behaviours such as offices and retail. Conversely, structurally supported sectors such as healthcare and distribution where income security and rental growth are more assured are starting to see pricing stabilise.

We believe healthcare and in particular primary care real estate, remains a structurally supported sector and benefits from the demographic tailwinds of a population that is growing, ageing and suffering from increased chronic illnesses, which is placing a greater burden on healthcare systems in both the UK and Ireland which in turn compounds the need for both fit-for-purpose and additional space. However, future developments will now need a significant shift of between 20% to 30% in rental values to make them economically viable and we continue to actively engage with both the NHS, ICB and DV for higher rent settlements. Despite these negotiations typically becoming protracted, we are starting to see positive movement in some locations where the health system’s need for investment in new buildings is strongest such as our recent development at South Kilburn, London.

Primary care asset values have continued to perform well relative to mainstream commercial property due to recognition of the security of their government backed income, crucial role in providing sustainable healthcare infrastructure and more importantly a stronger rental growth outlook enabling attractive reversion over the course of long leases.

The continued lack of recent transactions in the year has resulted in valuers continuing to place reliance primarily on sentiment to arrive at fair values. Yields adopted by the Group’s valuers have moved out by 13bps to 5.18% as at 30 June 2024 (31 December 2023: 5.05%) to reflect perceived market sentiment for the sector. We believe further significant reductions in primary care values are likely to be limited with a stronger rental growth outlook offsetting the impact of any further yield expansion.

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