- We find ourselves in a "rolling recession" where various parts of the economy take their turns contracting. Despite this, we believe some segments of the economy have reached their bottom: Digital Economy and Semiconductors.
- We see a recovery in the digital economy and semiconductors sectors. The companies in these sectors are also a key beneficiary of long-term trends driven by generative artificial intelligence (AI) which we believe the markets are currently underestimating.
- In our view, there will be an uptick in corporate earnings, led by the aforementioned sectors. Coupled with a resilient US economy, we believe strong earnings growth will provide support for share prices.
- That said, we caution against an aggressive “all-in” equity strategy, particularly in light of a “rolling recession” and the fact that equities remain relatively expensive compared to fixed income.
- We recommend investors to increase their exposure to equities, but also to selectively focus on areas that we find particularly attractive.
The ongoing debate over the economy’s trajectory, whether it is a hard or soft landing, has intensified in recent months. The truth is, we find ourselves in an environment that can be described as a “rolling recession”.
This concept slightly deviates from the textbook definition of a recession. For example, the National Bureau of Economic Research (NBER) specifies that a recession should involve “a significant decline in economic activity that is spread across the economy and lasts more than a few months”. A “rolling recession”, on the other hand, occurs when various parts of the economy take their turns contracting. Just as one industry begins to recover, the slowdown “rolls” into another part of the economy.
Currently, we believe that the bottom for certain segments of the economy is here. It opens up pockets of opportunities within the stock market, allowing investors to capitalise on the anticipated rebound in share prices. This also warrants our decision to adopt a more positive stance on equities.
The bottom for these industries is already behind us
Certain industries, like the digital economy and semiconductors, have recently suffered a slump.
Digital Economy: Following the return to normalcy post-pandemic, the demand for computers and software applications moderated as people spent less time online. Inflation also played a role. Tech companies responded by cutting costs to offset increased expense through downsizing and undertaking mass layoffs, unwinding the pandemic-driven surge in hiring (Figure 1). Meanwhile, businesses slashed advertising budgets against the challenging macro backdrop, causing tech companies to see declines in their digital ad revenues.
Figure 1: Tech layoffs have already peaked
Nonetheless, we are optimistic about the future earnings of big tech companies. The recent earnings season signals a recovery in enterprise software and digital ads businesses, driven by the rising influence of generative artificial intelligence (AI). Margins are also improving after an increased emphasis on cost-saving measures.
Moreover, the tech sector remains as a key beneficiary of long-term trends we believe the markets are still underestimating. Unlike some past trends (e.g. the metaverse) that generated more hype than anything, AI is proving that it is here to stay with its practical and tangible solutions. With deep pockets, easy access to talent and a huge repository of user data to train AI models, big tech companies are poised to thrive in this new era of technological disruptions. The rising influence of AI models, coupled with increased corporate investments in digital transformation, also points towards a sustained growth in demand for cloud computing.
(Related article: The earnings recession is over. Big Tech is set to lead the next phase of growth.)
Semiconductors: On a similar note, the semiconductor industry experienced a downturn post-pandemic due to an oversupply of chips. Chipmakers have responded by slashing prices and cutting down on production as they work through excess inventory, resulting in sales growth falling as much as -20% year-on-year. Currently, monthly semiconductors sales have been recovering as the oversupply gradually dissipates while demand strengthens thanks to the rapid adoption of AI.
We anticipate that excessive adjustments to production levels will contribute to higher sales numbers in the future as chipmakers are currently underestimating the long-term impact AI will have on chip demand. In addition, the positive influence of base effects and the massive incentives provided by governments globally would drive higher semiconductor sales growth moving forward.
Figure 2: The semiconductor industry is coming out from a downcycle
Turning more positive on equities
Overall, we expect to see a pickup in corporate earnings, led by companies in the digital economy and semiconductor industries (Figure 3). At the same time, the earnings downgrade cycle is likely set to turn, driven by the resilience of the US – the largest economy in the world. The US has proven its exceptionalism, notably as the tight labour market has held up consumer spending. Business investment is also solid, as companies continue to allocate resources to buildings and equipment that will allow them to manufacture more goods and offer more services. These factors should lend support to share prices, paving the way for some upside from global equities.
Figure 3: Digital economy and semiconductor companies will lead the earnings recovery
Investors have lamented that equity valuations appear slightly richer compared to historical averages. Currently, the MSCI AC World Index trades at 14.6 times its 2-year forward consensus earnings, reflecting a 2% premium to its 10-year average.
Interestingly, the MSCI AC World Equal Weighted Index, which adjusts for record high market concentration within the seven largest companies (referred to as the “Magnificent Seven”), suggest global equities are trading at an 11% discount to the 10-year average (Figure 4). A similar trend is observed at a country level – equity valuations appear less stretched in the equal-weight S&P 500, trading at a 6% discount to their long-term average (versus a 6% premium for the aggregate S&P 500).
Figure 4: We take a look at equity valuations on an aggregate and equal-weight basis
But regardless of how one looks at it, we hold the view that earnings growth provides a strong support for the forward returns of equities. Earnings are an important part of the P/E equation. Notably, over the past decade, a substantial portion of returns in global equity markets has been propelled by earnings growth rather than shifts in valuation (Figure 5). Looking ahead, this would be especially true for the digital economy and semiconductor companies, characterised by robust fundamentals and superior earnings growth. We also think that the upside from long-term megatrends such as cloud computing and AI has not been fully priced in.
Figure 5: Earnings are usually the main driver of share prices
Equities are looking better, but don’t ignore fixed income entirely
To be clear, we are not advocating an aggressive “all-in” approach on equities, especially as a “rolling recession” suggests potential contractions in some parts of the economy moving forward.
Moreover, equities remain expensive relative to fixed income. The spread between earnings yield and bond yield has narrowed to one of its lowest point since 2007 (Figure 6). This suggests investors would no longer be compelled to pile into risk assets like equities in order to chase yields or returns – signalling the diminishing relevance of TINA “There Is No Alternative” (to stocks).
Figure 6: Bonds have never been more attractive since 2007
A significant factor contributing to this is the fact that bond yields have surged to their highest levels since 2008. For example, the Bloomberg Global Aggregate Bond Index (duration: 6.7 years), which measures a basket of global investment grade government and corporate bonds, now offers a yield-to-worst of nearly 4% (as of end November 2023). Meanwhile, investors who do not wish to take on duration risk can look towards bond indices of shorter durations such as the Global Aggregate 1-3 Year Index (duration: 1.9 years) which presents appealing yields of 3.8%.
Starting yields historically tend to be a good gauge of future bond returns over the longer term. Today’s elevated starting yields suggest the potential to receive attractive returns and also offer greater cushion against mark-to-market losses if rates continue to rise. In a scenario where rates stay put, fixed income appears poised to perform well too.
We recommend increasing exposure to equities
Considering the factors mentioned above, we recommend investors to increase their exposure to equities. This shift will enable investors to capture the potential upside from equities more effectively. It is also crucial to note that we are not advocating an “all-in” approach to equities. Instead, we think investors should selectively focus on areas that we find particularly attractive.
Our preferred markets are the Digital Economy and Semiconductors on the back of superior earnings growth. Geographically, we like the “New Asian Tigers” of Japan, Singapore, and South Korea as they show significant economic growth and development potential.
Table 1: Recommended equity products
|
Market |
ETF |
Unit Trust |
|
Digital Economy |
||
|
Semiconductors |
||
|
Japan |
||
|
Singapore |
||
|
South Korea |
Despite bond yields being at their highest levels in over a decade, we recognise that fixed income is unlikely to outperform equities moving forward as the economy has proven to be more resilient than expected. Selected opportunities are still worth pursuing though. Notably, we find short duration, investment grade bonds a compelling option considering the sticky inflation, resilient economic growth as well as the fundamental strength of IG issuers.
Table 2: Recommended fixed income products
|
Market |
ETF |
Unit Trust |
|
Singapore-Centric / Short Duration |
- |
|
Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in VanEck Semiconductor ETF.
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