November 2023 Insights | Insight Private Clients

Annualised performance data in euros at 31st October 2023

We know that equities are valued by assessing a stream of future earnings, discounting those cash flows by an interest rate, and then adding a risk premium. Over the last decade, interest rates fell to historic lows and liquidity was abundant, thanks to your local central bank. Good times led to strong corporate earnings growth and P/E multiple expansion, excellent news for equity investors. Alas, times change, and those good times may now have passed. Today, interest rates are high(er), and liquidity is being drained from the system to the tune of $80 billion per month in the US. So far, corporate earnings have remained resilient and P/E multiples have remained elevated.

In a pro-capital world, companies hold the pricing power. During boom times, as productivity rates rise, companies prosper, their share prices appreciate, and economies tend to operate at close to full employment. During downturns, as corporate margins contract and capacity utilisation rates decline, unemployment rates tend to rise. Today we are living in an ageing society where retirees are starting to outnumber those in the workforce. There are fewer employees available to work. It is possible we are transitioning to a pro-labour world where unemployment rates remain structurally low and pricing power transitions from the board room to the factory floor. It is too early yet to tell, but there are signs that employee power is on the rise. If true, this will mean pressure on corporate earnings and margins, and another headwind for equity investors to navigate.

Today’s stock market is dominated by a handful of tech giants. Companies like Apple, Microsoft, Amazon, Google, and Meta are quasi-monopolies that continue to operate in a pro-capital world. The recent sharp rise in interest rates has had limited impact on the share prices of these tech titans. They still command pricing power in the sectors in which they operate. They continue to dominate their competition. Their share prices also benefit from the relentless demand for passive indexation strategies that have dominated the investment industry in recent years. The larger the market capitalisation of a stock, the more money is allocated to the name, irrespective of valuation; a flawed strategy but one that still persists.

November 2023 Insights | Insight Private Clients

Outside of this narrow tech-dominated field, an increasingly pro-labour world comes into view where small and medium sized companies operate in a more challenging and competitive environment. Wage pressures are rising. This is impacting corporate margins and is reflected in the recent share price performance of the Russell 2000 Index (small and medium market cap companies) relative to the S&P 500, which is dominated by the mega-cap stocks. Since peaking in late 2021, the Russell 2000 has fallen -29%. Meanwhile, the S&P 500 is just -8% off its late 2021 highs.

If inflation rates remain sticky in 2024 or fall to a new floor above the Federal Reserve (and ECB) target levels of 2%pa, we can expect a lot more investment analysis and research next year explaining why corporate margins are being negatively impacted and potentially why stock markets are having a more difficult time.