Exploring Opportunities Beyond the AI Revolution: A Guest Post by Chris Hogbin

A small group of companies that are considered to be the big winners of the artificial intelligence (AI) revolution have played a key role in determining the development of the stock market. But beneath the surface, there are many other companies with robust earnings potential. Recent tech enthusiasm has eclipsed interest rate, inflation and recession worries, pushing the MSCI ACWI index up 14% year-to-date. Growth stocks performed better than value stocks.

In the first half of 2023, ten US stocks accounted for 54% of the MSCI ACWI’s gains. This group, which includes NVIDIA, Microsoft, Apple, and Alphabet, is widely recognized as a direct beneficiary of generative AI. One explanation for why these stocks have so dramatically eclipsed the rest of the market: The US Federal Reserve’s attempts to slow the economy and thereby cool inflation have raised fears among investors about the sustainability of corporate earnings. Against this background, the supposed winners of artificial intelligence are particularly popular because they are regarded as a structural engine for lasting growth that can also survive weak economic phases.

At first glance, current market valuations look relatively high. At the end of the second quarter, the S&P 500 price-to-earnings (2024E) was 17.7 compared to 14.9 at the start of the year. Without the top 10 companies, however, the market’s price-to-earnings ratio is a much more reasonable 15.3, offering an estimated 9.9% earnings growth for 2024. So the market beyond the AI ​​darlings could hold more opportunities than is generally assumed. Especially if you put the earnings prospects of the individual companies in the context of economic concerns: interest rates could continue to rise in the USA, inflation is still too high in Europe and China’s economic recovery is faltering.

With this in mind, the key question for equities is: how closely do earnings forecasts match economic expectations? Just a year ago, the estimates seemed overly optimistic given widespread expectations of a slowing economy. However, over the past 12 months, earnings expectations for 2023 have fallen sharply in many sectors, particularly in the US. Of course, earnings expectations could still be revised further, but at least the US could be about to bottom out. For example, the decline in earnings revisions in the US last year is consistent with declines in previous shallow recessions. Additionally, our analysis suggests that long-term global earnings forecasts — three to five years out — are well below their long-term average. Stocks of companies whose business development is better than expected could therefore have upside potential.

At the moment, all indications are that inflation is falling while central banks are keeping interest rates higher for longer. This would support real interest rates and put pressure on stock valuations, which are a function of the discount rate used to value future corporate earnings. In this complex transition, companies with attractive share valuations and robust long-term earnings prospects offer the best risk/reward trade-off.

Investors should always focus on the companies’ underlying businesses. With AI enthusiasm currently unfolding alongside a historic shift in investment conditions, caution is warranted and a disciplined approach is paramount. A strategic focus on how companies in different sectors can generate long-term business growth is key to success.