Richard Warne, Senior Portfolio Manager, Copia Capital

For professional advisers only

Improving economic activity and decreasing inflation continued in the second quarter of 2024. Richard Warne, Senior Portfolio Manager at Copia Capital, gives an update on markets over the last three months and highlights some interesting investment opportunities.

A positive start for risk assets

It has been a good start for equities with all regions delivering positive returns. The standout has been the US, though it’s just small sub-set of the market that has driven these returns. The excitement over the potential of Generative Artificial Intelligence (Gen AI) has propelled the likes of Nvidia, Meta and Alphabet. While they’re great companies, valuations have become very expensive, leaving little room for disappointment. We’ve preferred other regions, such as the UK, Japan and emerging markets, where there are positive drivers for these markets and valuations are cheap. Using the UK as an example, we’ve observed political turbulence across Europe, and elections are a prominent issue in the US. For perhaps the first time in a while, the UK might experience political stability (with Labour holding a dominant position in the House of Commons), while challenges persist elsewhere.

Magnificent 7 continues to dominate

The ‘Magnificent 7’ have again remained the dominant driver of returns for the US market, while also contributing significantly to global equity returns. The likes of Nvidia have delivered +150% returns this year, while the broader US market is +17%. The S&P Equal Weighted Index (provides an indication how the ‘average’ company is performing) has just returned +5% so far this year, showing the huge performance disconnect between the majority of stocks in the market versus the few that have performed*. While small caps in the US have delivered a negative return so far, over the long-term small caps tend to outperform their large caps counterparts but have lagged behind for some time. However, with the potential for interest rate cuts, this could be a positive driver for that part of the market, and we’ve been adding global small caps to client portfolios in small, measured steps.

The US market as it stands today has never been so expensive and this is something we want clients to be aware of. Furthermore, the US now equates to nearly 72% of the MSCI World Index, all of the top 10 stocks in the global index are from the US and the 3 largest positions (Microsoft/Apple & Nvidia) each have a weight larger in the index than the UK market in total¹. However, this could change. For example, in 1988 the Japanese stock market had been on a rampage for more than a decade and was 45% of the global equity market index². The market looked untouchable. However, the market peaked in the following year and then nosedived, with what followed becoming known as Japan’s ‘lost decades’. It may not happen exactly like this for the US, but it shows that regimes can change and underlines that valuations and the price paid for an asset matters, and we believe will ultimately be the driver of long-term returns.

US election on the horizon

At the same time, we have elections coming up in the US. What might Trump 2.0 bring should he win? With Biden stepping out of the race and Kamala Harris filling the Democratic spot, this might not be a one-horse race that had been predicted. If Trump does win, with the huge fiscal deficits that the US has, he may target cash rich technology companies to shore up the governments balance sheet. Of course, this isn’t certain but is a risk that needs to be considered.

It is early days but has the rotation started? So far this month we have seen the technology heavy Nasdaq Index (which is dominated by the likes of the ‘Magnificent 7’), sell-off, while the broader market and small caps have rallied.

UK market looking positive

We think there are multiple factors that makes the UK market look attractive and positive catalysts are in place. The valuation of the UK is cheap – the market is trading on historic 20-year lows, and this gets more pronounced as you go down the market cap spectrum. If you look at the US, it is very expensive relative to its own history, and that is the case even if you strip the technology sector out. Historically the UK normally trades at a 20% discount to world equities, today that discount is over 40%³. Valuation is cheap but that is only one part of the equation. UK companies are buying back their own shares at levels we have never seen before. They are sending a message of ‘the best use of our own capital to generate a high internal rate of return, is to buy our own shares’ and are voting with their feet.

In terms of share buybacks and dividends, the UK offers a yield of 6.3% which is far more attractive than any other equity region. Of course, volatility will always occur, but this level of all-in yield is a great underpin to the market. Coupled with this we are seeing huge number of mergers and acquisitions (M&A) across the UK. There have been 27 deals so far this year, totalling about $48.5bn in deal size, eclipsing last year’s figure of $25bn⁴.

Furthermore, while most M&As were driven by private equity last year, this year over 70% has been through corporate buyers, highlighting that companies see the high-quality cash flow of many UK listed companies and cheap valuations. The average premium that is being offered is around the 40% level. With inflation falling and disposable incomes increasing, this plays directly into the UK economy. As you go down the market cap spectrum of the FTSE 250/350 this is where you get higher exposure to UK domestics. With the new Labour government talking about cutting red tape in relation to the building sector and looking to stimulate growth, this should help domestic focused UK listed companies.

Outlook and positioning

We have not drastically adjusted portfolios over the last quarter as the risk barometer has been Green over this period (portfolios are already risk-on at their maximum equity weights). However, we have been adding to small cap equities which are cheap and should benefit if rates cuts start to come through. Inflation is getting towards central bank target levels making this highly likely (we have already seen the European Central Bank ECB, cut rates this quarter). It is highly like the Bank of England and Fed will follow in due course⁵. We have been shifting the mix within fixed income, increasing the allocations from short-dated bonds into longer-dated UK Gilts and US Treasuries. This has increased our duration i.e. increased the sensitivity to interest rate moves – again a play on the expectation of interest rate cuts.

The risk barometer output firmly remains in positive territory with a reading of +0.59, this was +0.42 at the end of March. There will always be bumps in the road but the landscape for equities and bonds generally looks positive especially if inflation continues to fall and interest rates are cut, which will help growth and encourage consumers to spend.

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¹ Refinitiv Datastream, Copia Capital Management. 

² Nikkel Industry Research Institute

³ Morgan Stanley, 31 March 2024

⁴ Jupiter, July 2024

⁵ As of the 1 August 2024, the Bank of England cut interest rates by 0.25% to 5%