Fundamental equity outlook: banking bargains, AI ascendancy & Asian ambitions

BANKING ON EUROPE’S RESILIENCE

The shifting dynamics in bond investment, with many investors increasingly seeking neutrality in duration, are also manifesting in the equity markets. Market players are capitalising on higher-yielding opportunities in emerging markets and implementing investment strategies in quality investment grade credit as a defensive carry play. This is adding an interesting dynamic to the financial markets, stoking speculation about the formation of potential investment bubbles, and impacting value distribution across sectors.

Undervalued diversified banking models, particularly those of European banks, have come into the spotlight as interesting investment options. Despite facing similar macroeconomic risks as US banks, they possess certain advantages like stickier deposits, a slower tightening cycle, and a promising Q1 performance. Although there is a perceived risk of liquidity issues due to the winding down of both quantitative tightening and targeted longer-term refinancing operations, European banks have shown resilience, bolstered by stable regulations. However, they have not been immune to the reverberations from recent US regional banking turmoil. Still, the appeal of these institutions persists, buoyed by higher rates, favourable regulations, and attractive valuations, making them promising candidates for a slight overweight position in investment portfolios.

The UK real estate market is also emerging as a potential investment hotspot, as valuations appear to be bottoming out. While high-interest-rate environments typically exert downward pressure on property values, let’s keep in mind that the under-pricing of European-listed real estate stocks has led to a repricing that exceeds that of their underlying assets. As the dust settles, the disparity between share and asset prices is anticipated to narrow, contingent on the evolution of interest rates.

Meanwhile, the small-caps segment offers a more dichotomous landscape. After repeated headwinds faced by US small caps, their European counterparts seem to be faring better, offering superior earnings-per-share growth and immunity from a weak USD. Maintaining a slight overweight position in EU small/mid-caps seems advisable thanks to their value potential in the long term, despite short-term uncertainties prompting a shift to quality, low-volatility stocks with consistent growth.

Europe’s equity leadership over the past nine months, with a 12% outperformance, raises questions about its long-term staying power against the US. Despite a 7% subsequent underperformance, Europe holds an edge due to valuation gaps, expected forward EPS growth, and improving fundamentals. However, a strong overweight in European equities is less convincing given external factors such as the waning energy crisis and potential disappointments from China.

The resilience of the European market may be tested by credit tightening and a diminishing energy boost. As the story unfolds, if the US dollar weakens, equities outside of the US, including Europe, might offer more promising prospects. As we venture further into this financial year, the tale of European equities offers a blend of uncertainty and potential for the discerning investor.

AI’S GAMBLE: CASHING IN CHIPS OR ROLLING THE DICE?

Generative AI’s infiltration into equity markets has all the trappings of a transformative phenomenon in the making, yet the question lingers: Is this a revolution akin to the advent of the internet or the iPhone, or just another inflated trend like crypto or Meta?

AI has undoubtedly captured the imagination of investors, hinting at a potential reconfiguration of the economic landscape. However, unlike previous hypes, the absence of ‘easy money’ and lack of widespread speculation in AI stocks suggest that any frenzy is still nascent. While certain stocks have basked in the AI limelight, the broader market remains surprisingly subdued.

As we inch forward, a complete overhaul of the computing stack is anticipated, potentially breaking down sectoral barriers. The adoption of AI technologies, despite their steep implementation costs, is steadily gaining traction. Yet, echoing historical patterns, a lag between technology uptake and productivity growth might imply that the broader economic benefits of machine learning might not be fully visible until the 2030s or later.

The investment landscape offers both risks and opportunities with this new wave. The early adopters of new technologies usually garner the largest profits initially, but this advantage diminishes over time as new entrants draft off the pioneers. In the case of AI, data is king – the more, the better. This data dependency could limit the number of dominant AI players, potentially resulting in large platform or network companies such as Meta, Apple, Google, Tencent, and Alibaba reaping most of the AI profits. AI-enabled chip producers are also potential players, given the expected surge in demand. However, alongside the opportunities, exploring the risks such as ethical considerations, data safety, workforce impact, machine dependency, and geopolitical issues is crucial to fully appreciate the scope of this emerging trend.

REWRITING ASIA’S ECONOMIC CALLIGRAPHY

As China continues to dominate global economic discussions, its role as a leading growth engine appears to be wavering amid real estate woes and a deflationary trend. This raises the question: How does this shift the landscape of opportunities across the rest of Asia?

Despite a recovery that’s less robust than expected, China’s improving conditions, underpinned by appealing valuations and a favourable domestic demand narrative, are causes for optimism. Analysts retain a bullish stance, undeterred by a softening global manufacturing outlook. Meanwhile, the influence of election spending in Indonesia and Taiwan warrants observation.

Japan presents an intriguing proposition, with its rational stock rises supported by low P/Es and improving earnings. The current environment benefits from the Bank of Japan’s deferred monetary tightening, yen depreciation, and a tardy reopening phase. Its potential to de-couple from the global cycle, inflation tailwinds, and attractively priced equities with net cash companies give it an edge.

India, on the other hand, shines with the cessation of monetary tightening and easing inflation. Coupled with sustained growth expectations, a potential property market cycle, and revived foreign interest, India presents a compelling investment opportunity, notwithstanding its low MSCI benchmark weight. It thrives on an ‘Anything BUT China’ (ABC) sentiment, alongside other positive themes. The imminent infrastructure transformation, initiation of a new capex cycle, and strong macro indicators signal a promising outlook. However, political risks are looming should BJP (i.e. the Bharatiya Janata Party) lose power. Despite these uncertainties, the consensus leans towards PM Modi’s re-election, adding a touch of stability to India’s prospects.

Finally, investors should also consider that structural growth, driven by changes in the supply chain, might speed up due to increasing global political risks. Politics and rising wages are making large companies rethink building factories in China. With China responsible for nearly a third of all global manufacturing, even a small shift to nearby markets could greatly benefit them. We’re seeing this happen in areas like semiconductors, where new investments in Southeast Asia have grown over seven times from 2019 to 2021, even with the challenges of COVID-19. This pattern could speed up as new investments are put into action, infrastructure gets better, and more production capability is moved. This is good news for both emerging markets like India and the ASEAN region, and developed regions like the US and Europe.

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