Strong equity market performance in 2023 has many investors entering 2024 optimistic about the economy and markets. While we see risks in the broader market, we also see neglected investment opportunities at home and abroad.
A Year That Defied Expectations
▪ The aging population and widespread deleveraging made consumers and businesses less sensitive to rising interest rates.
▪ The economy was simply returning to normal after the convulsions of the pandemic (see sidebar).
▪ It takes time for rate hikes to slow the economy, and we have yet to see their full impact.
All four of these explanations may be true to some degree. We see a path for the soft-landing investors have now come to expect, but this is not our base case. We think the most aggressive monetary policy tightening in 40 years is likely to slow the economy. While this has not happened yet, consumer spending is slowing, often a signal of a broader slowdown ahead.
We see several potential negative surprises that could trip up the market in 2024. Most notably:
▪ Lackluster results from the so-called Magnificent Seven could lead to a repricing of these mega-cap stocks.
Some bulls attribute the recent strong growth in profit margins to improving labor productivity, which goes through long waves, with wars or major crises often acting as inflection points (Exhibit 1). Optimists suggest the 2020 pandemic was the much-needed catalyst to push the U.S. economy out of a long decline in productivity and income growth. It’s possible. For example, there has been a five-fold increase in working from home since the pandemic began. Recent research has found that working three days a week in the office and two at home does not reduce productivity and allows firms to save on recruitment and employee retention costs.
The Magnificent Seven
There’s another reason we are skeptical of continued broad strength in profit margins and returns. Both depend on continued strength for the S&P 500’s seven largest companies by market capitalization: Apple, Microsoft, Amazon, Nvidia, Alphabet (Google), Meta (Facebook) and Tesla. Together, these stocks delivered over 60% of the Index’s return in 2023— and each of them gained more than $300 billion in market capitalization, more than the total market cap of all but 20 names in the Index.
For the past decade, superior products and business strategies have driven rapid sales and earnings growth for the Magnificent Seven. But the most recent data suggest that sales growth for these companies is now running no faster than nominal GDP growth. In addition, government pressures in Europe and the U.S. are beginning to erode their monopolistic positions and pricing power.
This is concerning. Expectations of continued rapid sales and earnings growth—and fear of betting against a juggernaut— have led almost every class of investor to have significant exposure to these companies. As a result, each appears to be somewhere between fully priced and extremely expensive. Given their outsize weight in the S&P 500, disappointing results for these widely-held and richly-valued stocks could drive a decline in the Index.
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