2024 Midyear Equity Outlook: Opportunities Amid a ‘New Normalization’

• Many Covid-era trends are now resolving: Consumers have largely spent down their savings, industry backlogs and supply issues are clearing (at a staggered pace), and pricing has begun to soften. But this “new normalization” does not mark a return to the old status quo, with ongoing innovations and the near-shoring trend having permanently altered the landscape.

• Companies continue to innovate despite recent challenges, creating promising investment themes. These include AI advances, net-zero and green energy spending, electric vehicles (including batteries and other components), and treatments for cancer, rare diseases, obesity, and diabetes, such as GLP-1 agonist drugs.

• We believe the remainder of 2024 is an ideal time to tap opportunities in companies that may look less promising in the short term but benefit from enduring structural tailwinds, including those noted above. Overly negative short-term sentiment could create opportunities in quality companies that have strong business models and solid prospects for future growth.

The Covid era ushered in abrupt changes in industries, businesses, and consumption patterns that have rippled across global economies and asset markets. Consumer savings ratcheted up at the same time that production and supply chain disruptions were rolling across industry segments, causing wild pricing dislocations as extreme supply/demand imbalances gave many companies unprecedented pricing power.

As Covid-related pressures wane, we’re now seeing a resolution of many of these trends: Consumers have largely spent down their savings (see chart), industry backlogs and supply issues are clearing, and pricing has begun to soften. Yet these trends do not mark a return to the old status quo. The near-shoring/friend-shoring trend has permanently altered many supply chains, and continued innovation is reshaping industries across the globe.

Here we look at how this “new normalization” and the pricing dislocations it is causing may create equity investment opportunities in the second half of 2024 and beyond.

Consumers’ Covid-Era Savings Are Largely Depleted

The latest earnings results suggest that while consumers are still spending, those at the lower end have become squeezed. While their spending is not falling off a cliff, they are gravitating more toward value.

Source: Federal Reserve data as of 1 April 2024.

Destocking concerns may undervalue quality companies

The ramifications of Covid created backlogs of swollen inventory that have been clearing in a desynchronized pattern across industries, starting with semiconductors and then rolling into consumer goods, medical equipment, transportation, and logistics, along with housing-related industries. Others, such as industrial automation and general industrial companies, including electricals, machinery, and miscellaneous durables, are now normalizing.

Industrial automation companies provide a case in point. Many of these companies benefited from more-robust order books during Covid than they had ever seen but are now experiencing major declines in orders. This has created investor concerns about the recent weakness and uncertainty about true end-market demand. Moreover, some companies that grew accustomed to the level of pricing power they enjoyed during Covid may be in for a rude awakening.

We believe any overly negative sentiment could create opportunities in quality companies that have strong business models and solid prospects for future growth but are currently out of favor with investors (who may be painting whole industries with a broad brush). But robust fundamental analysis and on-the-ground insights into local industries are critical to find companies that are best positioned to both weather the current cycle and benefit from longer-term trends.

Companies are still innovating – and that’s good for investors

Despite the tough challenges companies have faced in recent years, they continue to innovate – and a few areas in particular are creating more significant investment themes.

The AI evolution. Artificial intelligence remains a powerful driver for a number of quality businesses and products. That said, concerns have emerged about concentration risk and overheated valuations, along with the potential for a turn in sentiment. These concerns are amplified by the lack of AI revenue in recent software earnings, which could signal a potential overbuild of AI infrastructure. Despite these challenges, increased spending by cloud service providers indicates ongoing investment in AI capabilities. While the lack of recovery in IT spending is disappointing, we view this as a temporary phase associated with the evaluation and development stages of AI implementation. Companies are still exploring how to best integrate AI effectively and navigate challenges around security and privacy, but we expect a recovery in spending as they transition into broader implementation.

Our 2024 outlook for AI-related semiconductor and hardware spending has become more optimistic following first-quarter earnings results, driven by raised capex forecasts from hyperscale companies and rising demand from enterprise and government verticals. However, we continue to approach these investments with a careful eye toward each company’s stage in our Lifecycle Categorization Research (LCR) model, which helps to determine our view of its prospects over the medium to long term. A leading electronic design automation (EDA) software company provides a good example of this approach. The company benefits from the increased spending on AI and semiconductors, but it also offers more resiliency through potential inventory or economic cycles due to its reliance on R&D budgets, which tend to remain stable even during downturns. While we remain positive on other more cyclical semiconductor firms, we believe companies that also benefit from these longer-term themes can help balance a portfolio’s risk profile while enhancing return potential.

Green space. Net-zero and green energy spending remain a key theme, and we are maintaining exposure to companies that benefit from these trends and are helping to move them forward. In the US, while the red state/blue state divide has created some uncertainty, we generally have not seen companies retreating from their net-zero commitments. In Europe, perhaps counterintuitively, there have been headlines lately about a potential pullback; however, we believe this is more a function of budget constraints bumping up against some very ambitious plans. Indeed, our analysis continues to show that companies are still spending significantly on the implementation of net-zero and green initiatives – the pullback reflects a dose of reality, but spending plans are still very strong. In short, we still believe in the longevity of this theme, but the discussion has become more nuanced.

Electric avenues. China has taken a strategic stance that electric vehicles (EVs) are an area where it can essentially leapfrog everyone else: while the rest of the world is pulling back a bit, China is moving full steam ahead on production of both the vehicles themselves and the batteries powering them. We're also seeing that theme reflected in companies globally that provide the connectivity inside of EVs, whose businesses are still going strong because of their proportional exposure to China, with Korea another notable player in EV battery production. The market has become concerned about EV penetration slowing as automakers in Europe and the US pull back on ambitious plans. But we believe this has affected sentiment more than reality, since Asia is the dominant market for EVs and developed market EV penetration is still growing, just not as ambitiously as planned.

Slim returns? In healthcare, advances in the treatment for obesity, diabetes, cancer, and rare diseases are another key source of growth. Demand for obesity drugs continues to rise, and the market sees great long-term potential despite near-term supply constraints and high prices. We maintain exposure to the innovators in drugs and devices as well as the life sciences companies that supply them with cutting-edge new technologies.

Looking past current conditions to tap opportunities

We believe an active approach to global equities is especially critical now, with both industry sectors and entire regions continuing to normalize at different times and at different paces. Taking a medium- to long-term investment view is key when determining whether a company that is challenged by current (and likely transient) conditions is positioned to succeed over time.

In Europe, for instance, conditions appear to be at their lowest ebb, with European companies trading at significant discounts to some of their global peers. Yet many of these companies are actively innovating and are leading the effort to decarbonize industries, and compelling opportunities can arise if investors roll out of a region en masse.

For example, in the first quarter of 2024 we analyzed a European building materials company that would generally fare better in a low-interest-rate environment, given the nature of the industry. The company is also heavily exposed to inflation, as higher production costs could make its product prohibitively expensive. For these reasons, the company might not look attractive to an investor taking a very short-term view; the key in this case is looking further out. A large part of what made the company compelling to us is its strong green spending angle, which we believe is a longer-term tailwind riding on a more durable theme: Buildings account for roughly 40% of global emissions, and this company’s products provide the ability to reduce 60% to 70% of a building’s emissions.

Looking toward the remainder of 2024, we think it is an ideal time to tap opportunities in companies like these that may look less promising in the short term but benefit from enduring structural tailwinds. As a new normalization rolls across industries and regions, we believe robust fundamental analysis of companies that considers where they are in their lifecycle will help determine those with the brightest future prospects.