Equity Market Outlook
Softening jobs data and easing inflation pushed the Federal Reserve to cut rates by 50 basis points in September, yet near-term clouds may not be as threatening as bearish economic prognosticators perceive. In our 4Q Equity Market Outlook, we parse a host of indicators to gauge where we go from here.
- Absent a significant deterioration in private consumption and investment, we believe monetary and fiscal tailwinds should help support U.S. economic growth over the next six quarters.
- We believe inventory and capex cycles appear ready to rebound; the credit cycle is turning up; consumers are still spending; and jobs data tends to lag sales and production, both of which have been picking up lately.
- Portfolio Considerations: As in Q3, we remain underweight the Technology, Communication Services and Consumer Discretionary sectors; we also continue to prefer value over growth and small caps over large caps. Finally, we suggest incremental regional adjustments relative to the MSCI ACWI—including downgrading from overweight to market weight in the U.S., upgrading to market weight in Europe, holding steady at market weight in Japan, and maintaining an overweight in China.
—Raheel Siddiqui, Senior Research Analyst, Global Equity Research
Just a few months ago, it seemed like nothing could derail a stock market stunningly dominated by a handful of technology giants. In our 2Q Equity Market Outlook, we warned that extreme market conditions have a way of unwinding swiftly and that our proprietary signals unambiguously called for underweighting big tech in favor of defensive sectors (such as utilities, consumer staples and health care) and smaller, more value-oriented names—and indeed, since July 1, the so-called Magnificent 7 have advanced 170 bps versus a 780-bps jump for the rest of the S&P 500.1
Meanwhile, a slowdown in the broader economy has become widely apparent as the ISM Manufacturing PMI, real final domestic sales (a good proxy for the domestic U.S. economy) and the Philadelphia Fed’s Index of Coincident Economic Activity have all deteriorated.2 Upbeat news in jobs data is also hard to find as unemployment and underemployment rates are up 0.8 and 1.4 percentage points from their respective troughs (see figure 1); the pace of non-farm jobs has slowed by half since the beginning of the year;3 and total employment was revised downward by 449,000 positions over the prior 12-month period.4 Rounding out the list of concerns are rising credit card delinquencies and business bankruptcies, a moribund housing market,5 and depleted excess consumer savings.6
Against this darkening backdrop and with risk aversion on the rise, it’s little wonder to us that the Federal Reserve moved to cut interest rates by 50 bps in September. Dismayed by souring jobs reports, some market watchers have begun to fear a recession may start as early as Q1 2025.
Despite the economy’s recent loss of momentum, we do not expect a recession in the near term.
In our view, the more likely outcome is a recovery in the traditional economy, which we believe was affected by tighter monetary policy more than the tech sector. While we acknowledge that dwindled savings and a weakened labor market could threaten a benign transition from the ongoing slowdown to the next expansion, we think the risk to growth is less than many recession forecasters think.
A big challenge in gauging the vector of the U.S. economy is that not all economic indicators paint a similar picture. While lagging indicators continue to move in the wrong direction, coincident and leading indicators have been flatlining or improving for many months, a trend that we believe is inconsistent with the recession thesis.7
Here is a closer look at why we think fears of a near-term U.S. recession could be overblown.
Monetary and Fiscal Policies Appear Supportive of U.S. Growth.
Absent a significant deterioration in private consumption and investment, we believe monetary and fiscal tailwinds should help support U.S. economic growth over the next six quarters.
Monetary policy impacts growth via various channels—including short- and long-term borrowing costs, corporate credit spreads, the value of the U.S. dollar and equity markets (via the wealth effect)—albeit with a lag. Goldman Sachs estimates that the lagged effect of easing financial conditions during 2024 could boost GDP growth by approximately 0.6 percentage points in both Q4 and Q1 2025 before fading to zero by 4Q 2025; fiscal spending, meanwhile, could add another 0.15 to 0.20 percentage points, with contribution to growth remaining positive until Q3 2025 (see the left side of figure 2).
We believe these policies have the potential to add 1.8% percentage points to growth over the next 12 months and provide a solid footing for the economy; furthermore, we think it would take a swift and significant deterioration in private consumption and investment to trigger a U.S. recession during this timeframe.
Global central banks have also been easing policy, providing a potential tailwind to growth. A remarkable 30 of the 61 central banks we track have eased policy in the past six months (see the right side of figure 2), and an additional 24 have been on hold (i.e., not tightening). Outside of recessions, this is the most coordinated monetary-easing effort by global central banks in the past two decades. Global easing has historically been stimulative for global manufacturing, albeit with a 15-month lag, and industrial activity tends to drive much of the fluctuation in global growth—which is why we expect the manufacturing economy to improve in the quarters ahead.
The Inventory Cycle and Corporate Capex Look Ready to Rebound
Companies in the S&P 500 Index (excluding Financials, Utilities and Real Estate) have been destocking since the beginning of 2023 to reduce excess inventory relative to falling demand. In our view, that destocking cycle now seems complete, and restocking—which is additive to industrial and overall economic growth—is set to begin (see the left side of figure 3).
Inventory growth typically follows sales growth, with a typical one-quarter lag. In light of the rebound in sales growth over the last seven months, we expect the nascent restocking cycle to continue gathering steam.
There is also reason to be hopeful about capex trends. While AI-related capex has dominated the headlines over the past year, we believe ex-tech capex is ready to rise (see the right side of figure 3). As corporate earnings outside of tech and the Mag 7 continue to rebound, we believe capex growth within these more traditional sectors is likely to follow suit, with the usual lag of two to three quarters. Increasing capex investment is another sign, in our view, that a recession is likely not around the corner.
The Credit Cycle Is Turning Up
Credit is often called the oxygen of the economy, and since credit gets converted to economic activity rather quickly, we believe credit trends can be timely gauges of economic activity.
Yet again, the data give us hope: As shown on the left side of figure 4, the most recent Senior Loan Officer Opinion Survey (SLOOS), a leading indicator of credit trends in the U.S. economy, showed that lending conditions have been easing across nearly all categories, from consumer loans to real estate. We believe this trend bodes well for consumer credit growth, which has gathered momentum since May (see the right side of figure 4).
Consumer credit amounts to a massive $5 trillion, but the even larger category of Commercial Banks’ Loans and Leases (about $13 trillion) has also been growing at a healthy 2.6% annual rate since the beginning of the year.8 We believe these improving credit trends are more consistent with a healthy and strengthening economy than one on the precipice of recession.
Consumers Are Still Spending
Real Disposable Personal Income (RDPI), the most significant driver of U.S. consumer spending, accounts for roughly 76% of U.S. GDP. Thus far in 2024, RDPI has been growing at an average annualized rate of 3% (see the left side of figure 5). If this solid trend holds up, so will consumer spending, in our view—especially among those in the bottom 75% by income, many of whom have been not only constrained by elevated inflation, lower credit availability and diminished savings, but also denied the wealth effect created by rising home prices and equity markets.
Consumer spending patterns are also sending positive signals, in our view. After tightening belts for nearly two years, consumers have boosted spending on discretionary purchases since April (see the right side of figure 5). While increased spending on essential items can be a prelude to recession, larger discretionary outlays are, in our experience, a far more encouraging sign, making a consumer-led recession seem unlikely.
The Jobs Market Lags Economic Activity
While softer employment data has sparked concerns about a recession in the near term, we believe the bears are missing an essential point: Jobs data tends to lag the central economic activities of sales and production, both of which have been picking up lately, and we expect the labor market to stabilize and strengthen in sequence.
In our view, concerns that employment weakness will worsen toward recession may be exaggerating the economy’s vulnerability and unfairly discounting the rising strength in leading and coincident indicators. That said, we will not hesitate to change our economic assessment should RDPI, domestic final sales, industrial activity and employment begin to trace a recessionary arc.
In our 3Q Equity Market Outlook, we were constructive on stocks, but cautious about the richly valued Technology and Communication Services sectors, as well as the historically low levels of short interest among the tech-heavy Nasdaq Composite Index. Since then, earnings growth across the rest of the S&P 500 Index has started to broaden, deflating the tech sector’s significant growth-scarcity premium.
We also expected market volatility to pick up ahead of the U.S. presidential election (followed by a post-election relief rally) and suggested tactical adjustments, such as underweighting the Technology, Communication Services and Consumer Discretionary sectors. And given our economic view, we advised tilts toward value over growth, and small caps over large caps.
Many of those views proved prescient in Q3 and we maintain them heading into Q4, along with a few regional adjustments.
Sector Tilts
Underweighting the Technology, Communication Services and Consumer Discretionary sectors was beneficial in Q3, and we believe many of these allocations still apply in Q4.
- The annual earnings growth differential between the Mag 7 and the other 493 stocks in the S&P 500 Index has gradually moderated to 17% versus a peak of 65% in 4Q239 (see the left side of figure 6). We believe the growth gap could narrow to 5%—the longer- term average10—as earnings growth broadens and accelerates across the market with an improving economy.
- While Mag 7 relative valuations have receded since last quarter, we believe this group still appears to trade at a 28% premium to its theoretically justifiable price-to-book valuation relative to the expected next-12-month return on equity (see the right side of figure 6).
- Concentration in Tech and Communication Services within the S&P 500 Index remains elevated at 39.8%, but down from its historical high of 41.8% in June.11
Value Over Growth
Last quarter, we thought value stocks looked ready to outperform growth stocks in the near term. Since July 1, the Russell 1000 Value Index has outpaced the Russell 1000 Growth Index by 624 bps, yet we maintain our value tilt.12
- The representation of growth stocks relative to value stocks continues to fade among the stocks in the top momentum quintile of the Russell 1000 (see the left side of figure 7).
- We believe our proprietary return/risk ratio—which we use to gauge shifts in relative performance—continues to evolve in favor of the Russell 1000 Value Index. (For more details on our return/risk ratio framework, see our 2Q Equity Market Outlook.)
- Value has tended to outperform growth during the 24 months following the start of a rate-cutting cycle (see the right side of figure 7).
Source: LHS: Neuberger Berman Research and FactSet, data as of August 31, 2024; RHS: Fama French Database, Neuberger Berman Research and FactSet, data as of August 31, 2024. For illustrative purposes only. Past performance is not indicative of future results.
Small Over Large
Since July 1, small caps have outperformed large caps by 319 bps13—a trend we foreshadowed in our last report—and we think they still have more room to run.
- We believe favorable macro trends—such as healthy credit growth, anticipated additional rate cuts, the likely onset of a U.S. capex cycle, and (not least) the extreme relative valuation differential between small and large caps—should continue to provide tailwinds for small caps.
- As an asset class, small caps have more exposure to the Industrial sector than to the Technology sector compared to large caps, which we view as a big reason for their relative underperformance over the last decade (see the left side of figure 8). In recent months, Industrial stocks (which we are overweight) have outpaced Technology stocks (which we are underweight), and we expect that trend to continue.14
- As shown on the right side of figure 8, the representation of small caps relative to large caps continues to increase in the top momentum quintile of the Russell 3000 Index.
- Finally, we believe our return/risk ratio analysis continues to evolve in favor of the Russell 2000 Index vs. the Russell 1000 Index.
Source: LHS: Neuberger Berman Research and FactSet, data as of August 31, 2024; RHS: Neuberger Berman Research and FactSet, data as of September 20, 2024. For illustrative purposes only. Past performance is not indicative of future results.
Regional Allocations (relative to the MSCI ACWI)
U.S.: Downgrading to Market Weight
The relative performance of the Technology sector plus the Mag 7—which together account for 42% of the S&P 500 Index weight— has exhibited a strong year-to-date correlation (74%) with the relative performance of the S&P 500 Index vs. the MSCI ACWI.15 Given our belief that the Technology sector should continue to underperform relative to the broader market, we suggest reducing exposure to the U.S. in line with the broader global index.
We believe this allocation is consistent with the signals from our bottom-up leadership cycle16 analysis, which is hitting a peak, and our top-down return/risk cycle analysis, which has already peaked (see figure 9).
Source: Neuberger Berman Research and FactSet. Data as of August 31, 2024. For illustrative purposes only. Past performance is not indicative of future results.
Europe, Australia and Far East (EAFE), and Emerging Markets (EM): Leaning In Selectively
Should technology and AI-levered names continue to underperform versus more traditional sectors, as we anticipate, EAFE and EM could be poised for greater leadership within the ACWI (see figure 10).
Source: Neuberger Berman Research and FactSet. Data as of August 31, 2024. For illustrative purposes only. Past performance is not indicative of future results.
Japan: Maintaining Market Weight
While we maintain our market weight position in Japan, we remain very constructive on the subset of Japanese equities undertaking longer-term shareholder-friendly corporate governance reforms.
What concerns us is that Japan is poised to raise interest rates, thereby strengthening the yen and tightening financial conditions, which we believe could slow Japan’s economy over the next 18 to 24 months. In our view this would put Japan at a particular disadvantage relative to a rising majority of nations where the central banks are easing monetary policy.
Stocks within the MSCI Japan index generate an extraordinary 55% of their revenue from outside Japan, hence the strong negative correlation between Japanese stocks and the yen (-73% since 2020).17 We believe a rising yen could pressure Japanese stocks despite solid progress on structural reforms.
Europe: Upgrading to Market Weight
Recent news from the Eurozone has been mixed: The ECB is further along its rate-cutting cycle than the Federal Reserve; growth in the Eurozone’s M1 money supply has picked up, and demand for housing loans has increased for the first time since 2022 (see figure 11).
These trends have coincided with a reacceleration in the OECD’s European Leading Economic Indicator.18 We believe our leadership and return/risk cycle frameworks are at the cusp of turning favorable on Europe, and therefore recommend upgrading Europe to a market weight relative to the MSCI ACWI. We will need to see more encouraging activity in bank lending and positive earnings revisions before further increasing our suggested exposure.
China: Maintaining Overweight
Though our upgrade last quarter proved early (a risk we acknowledged in our report), it appears as though our thesis on China has begun to play out.
In mid-September, sentiment on the Chinese economy and stock market had soured, valuations had pulled back and positioning had eased. China was on track for a rare GDP growth-target miss19 as negative fiscal and monetary impulses threatened to crimp growth in 4Q, and signs of economy-wide deflation were evident. Meanwhile, potentially longer-term structural challenges remain, including a debt overhang and unfavorable demographics.
Still, the MSCI China Index had not underperformed relative to MSCI ACWI over the previous six months,20 which led us to believe that much of the bad news had perhaps been priced in. To us, this implied that the timing was right for a comprehensive policy response, and that’s just what the authorities delivered—including a range of lower interest rates, financial support for property markets, and a flurry of measures designed to stimulate banking and investment. The result was a solid 29% rally in the MSCI China Index since September 10.
We acknowledge that the specter of deflation could derail the rally if aggregate policy measures fail to adequately stimulate aggregate demand. However, we also believe a handful of fundamental catalysts—such as an industrial rebound (in response to global monetary easing), a revival in the U.S. capex cycle, and stronger Eurozone growth—have the potential to support Chinese corporate earnings and keep the rally going.
For now, the representation of Chinese stocks within the ACWI’s top quintile appears to be bottoming (see the left side of figure 12), increasing the potential for outperformance and supporting our overweight stance.
Source: Neuberger Berman Research and FactSet. Data as of August 31, 2024. For illustrative purposes only. Past performance is not indicative of future results.
India: Downgrading to Market Weight
In our view, downgrading India from overweight to market weight makes good sense as elevated valuation, sentiment and equity positioning meet slowing nominal GDP, government spending, corporate capex and loan growth. The leadership of Indian stocks within the MSCI ACWI also appears to be peaking (see the right side of figure 12).
For detailed recommendations across sectors, factors, styles and geographies, see the section titled “Investment Themes and Views.”