What Will Stop the Rotation Out of Large-Cap Tech?

There is no shortage of news these days. Market volatility has picked up, the political landscape is evolving very quickly, and the Fed is on the verge of changing tack regarding monetary policy.

Below is an update on some of the major themes percolating through the market.

The S&P 500 broke a 356-day streak this week of avoiding a decline of 2% or greater. It suffered its largest decline since December 2022, when it fell 2.3% on Wednesday before bouncing back somewhat on Friday. The pummeling was even worse for the Nasdaq, which fell 3.7% that day and underperformed the week. The beneficiaries were small and mid-cap stocks, which extended their gains over the last month relative to the S&P 500.

Rotation was again the dominant theme in last week's volatile trading. Small caps rose 3.7%, while the Nasdaq lost more than 2%. Chinese equities and Japanese stocks were the big losers. The Nikkei 225 fell 6% ont he week.

Will the rotation continue? The critical question is whether mega-cap tech earnings can live up to the loft expectations. GOOG and TSLA did not. Next week, we will get earnings from the rest of the Magnificent 7. Their results may dictate whether the rotation out of tech will take a pause or gain further momentum.

The rotation into lagged market segments certainly has a technical component. The Nasdaq, specifically large-cap tech, had reached extreme overbought territory, and the June CPI was the catalyst for a correction. The tech drawdown reached 10% last week, near the levels of previous drawdowns over the last year.

However, part of the move may also reflect improving fundamentals of the rest of the market. According to analysts' expectations, the gap in earnings growth between mega-cap tech and the median S&P 500 company is expected to converge in the coming quarters. Goldman estimates the annual earnings growth rate differential between MSFT, NVDA, AMZN, GOOGL & META and the rest of the market will converge from 32% in 2024 to 9% in 2025 and just 5% in 2026.

One obstacle for the U.S. market to overcome is the high expectations for Q2 earnings. Expectations have crept up, and it will be difficult for the market to exceed the 8% consensus EPS growth rate. There is little room for companies to surprise to the upside, especially given the emergence of economic weakness during the last three months.

According to street estimates, an improved earnings outlook for Europe is also on the horizon. Schwab, for example, forecasts that earnings from Europe's STOXX 600 index will converge to the S&P 500 earnings growth rate next year.

Converging growth rates between the U.S. and Europe may be the catalyst that arrests Europe's chronic equity market underperformance. Notably, Europe has not benefited from the rotation out of mega-cap tech into relatively undervalued sectors.

Equity and rates markets have spent the last few weeks discounting a series of cuts in the overnight rate over the next year. Since the start of May, USD 1y1y rates have rallied almost 100bp to 3.65%. The earlier part of the year saw unwinds of market expectations for aggressive cuts amid firm economic activity and an uptick in inflation. But as the US labor market comes into better balance, global growth is softening, led by Europe and China, and inflation is approaching the Fed's 2% target, expectations for rate cuts have grown. The first cut is likely to come in September.

The health of the consumer is always front and center when it comes to the economy. U.S. credit card data supports the notion that consumers are getting streched. The share of credit card balances past due reached a series high going back to 2012. Roughly 2.6% of credit card balances were 60 days past due in the first quarter, up from a low of 1.1% in 2021 when consumers were flush with cash from pandemic-era support programs.?The share of credit card balances 30 days and 90 days past due also climbed in Q1.

The housing sector is also a concern for potential homeowners. The low inventory of existing homes for sale in much of the country continues to push prices higher. The non-seasonal adjusted national median existing-home price in June rose to $432,700, a record in data going back to 1999 and a 4.1% increase from a year earlier, according to recent data from the National Association of Realtors. Meanwhile, high inventory levels of new homes keep a lid on new home prices, which have been flat for the last year and are now selling for less than the median existing home.

Looking at affordability levels, it is not hard to come to the conclusion that a correction in the real estate market is certainly possible. One factor preventing a correction is the structural shortage in housing. The U.S. housing shortage was 4.5 million homes in 2022, according to an analysis from Zillow last month. The structural shortage and the reduced supply of existing homes from homeowners "trapped" in the homes due to mortgage rates significantly below current levels keep existing home prices high relative to the rent that can be earned.

Signs of stress are emerging across the pond, as well. Bankruptcies in Germany are soaring. Reasons for the spike in business failures include the lingering effects of the pandemic years, escalating energy prices, elevated interest rates, expiration of state measures that prevented bankruptcies during the pandemic, and the overall challenging economic environment, particularly for Germany's export-oriented economy.

The situation in China appears to be getting worse. China’s Q2 GDP growth rate of 4.7% came in well below estimates of 5.1%. Retail sales were a notable concern, dropping 2% year-on-year. The government responded with more monetary stimulus. The PBOC surprised the market last week by reducing the interest rate for one-year loans to commercial banks to 2.3% from 2.5%. 2-year Chinese bond yields fell on the news, falling to a new cycle low of 1.52%.

China's economic malaise is impacting the commodity market. Industrial metals have given up all of the gains from the spring rally. China’s Third Plenum provided little comfort to industrial metals traders who were looking for signs that the government would take additional action to support the property market, the biggest driver for industrial metals demand.? Industrial metals are also under pressure from the unwind in AI-related trades. Industrial metals like copper and silver are key components in the buildout of data centers and the electrical grid.

China’s refined copper exports more than doubled in June, reflecting weak internal demand. The export surge is creating an inventory overhang that hurts spot prices. LME copper stockpiles have more than doubled since the middle of May to the highest level since September 2021, with most of the build-up seen in warehouses in Asia.

Europe is closely watching political developments in the U.S. The big fear is the potential for additional tariffs imposed by a Trump administration. The Goldman European Tariffs Exposed basket is composed of European companies expected to be negatively impacted by potential additional import taxes imposed by the U.S. The index, which screens for companies that manufacture in Europe and export to the U.S., has shed 6.9% so far in 2024, with accelerating losses following the increase in odds of a Trump election win in November. By comparison, the Euro Stoxx 50 has returned 7.7% over the same period.

The weakness in China is impacting luxury goods manufacturers. China is a major luxury goods market, and the demand drop hurts earnings for many European brands. For example, LVMH reported a significant 14% decline in sales for the region encompassing China during the second quarter of 2024. Swatch Group, the Swiss watchmaker, experienced an even more dramatic downturn, reporting a 30% drop in sales in China during the first six months of the year. Porsche AG saw its stock fall due to a combination of supply chain issues and slowing sales in China. The GS EU Luxury Goods equity basket is down 1.8% YTD compared to a 7.1% increase in the STOXX 600 index.

Other EU companies with exposure to China have also underperfromed.

European equities, in general, have struggled this year, trailing U.S. stocks by 6.5% YTD. Such underperformance has been the norm over the last decade, the MSCI Europe index has trailed the MSCI US index in 8 out of the last 10 years. The perennial underperformance, mostly caused by inferior earnings growth, has led to a large and growing valuation gap.

Switching to commodities, oil prices have been remarkably stable over the last year, contributing to a drop in realized volatility. There have not been any major supply or demand shocks despite still elevated geopolitical tensions in the Middle East. Lower crude oil volatility helps businesses and governments with economic planning and should help consumer confidence. Stable energy prices also reduce the upper bound of inflation expectations, providing some comfort to central banks that are embarking on monetary policy easing campaigns.

Despite a more stable inflation outlook, corporate insiders are not optimistic. Corporate insiders are selling their companies' shares at the fastest rate in at least a decade. Only three S&P 500 sectors - Consumer Staples, Materials, and Utilities - show insider optimism, according to data compiled by Insidersentiment.com. The insider buy ratio (percentage of companies with net insider buying) has dropped to 13.6% in the first three weeks of July 2024, its lowest level in at least a decade. This is significantly below the past decade's average of 26%.

Insiders may not be optimistic, but over the last decade, the U.S. has proven to be the best place to invest, giving rise to the narrative of "U.S. exceptionalism."

U.S. economic exceptionalism refers to the concept that the U.S. economy and markets are structurally superior to other developed nations. For the last decade, the U.S. economy has grown faster than other G10 countries and its stock market has outperformed the rest of its peers. The multi-trillion dollar question is whether the outperformance is due to factors such as more flexible labor markets, technological innovation, superior productivity growth, open capital markets, and energy independence or whether most of the gains are related to expansionary fiscal policy over the last 15 years that has clearly exceeded all other developed countries.

According to data compiled by Crescat Capital, the average fiscal deficit in the U.S. since the 2009 financial crisis is a massive 8.1%. By comparison, the average deficit in the EU is 3.3%. Deficits, of course, have to be financed, and it is not a coincidence that debt payments as a percentage of GDP are rising. U.S. public debt net interest payments are forecasted to be 4.6% of GDP in 2025, more than double that of the next highest country, Greece.

Japan has also run huge deficits for the past decade, but there is a big difference: the deficits were financed at interest rates near 0%. Japan's public debt net interest payments, despite the massive debt/GDP ratio, is a mere 0.5%.

A bet on the continuation of U.S. economic exceptionalism requires faith that current levels of fiscal support are maintained. A convergence in fiscal policy between the U.S. and the rest of the world will probably mean a convergence in GDP growth, corporate profits, and forward equity returns.

Putting it all together, the rotation out of large-cap tech into cheaper segments of the market is likely to continue unless the rest of Mag 7, which reports next week, delivers earnings and guidance that exceed analysts' already lofty expectations. Lower rates and the increased likelihood of a more business-friendly government in Washington come November should also be a fundamental tailwind to financials and smaller firms that manufacture and sell predominantly in the U.S.