by Jurrien Timmer, Director of Global Macro at Fidelity Investments
There is life after the Mag7
It was another eventful week, with the Mag 7 and hyperscalers getting punished for spending too much of their previously ample free cash flow, while the broader market picked up the slack. At the same time, energy prices soared again, taking its toll on bond markets around the world. Following a lot of hawkish talk coming out of the Fed in recent weeks, the pressure is on for the FOMC to back up its rhetoric by raising rates soon. The twin tail risks of market concentration and the return of the Fed Model are both on display as we sift through second quarter earnings season.
The S&P 500 index has not made a new high since June 2 and the Mag 7 have been trading sideways (and under-performing the index) since last November. Yet, this loss of leadership has thus far not done too much damage to the major indices, thanks to strength in the non-AI space. Since that June 2nd high, the S&P 500 index is down a modest 2.4%, the GS AI basket is down 13%, the Mag 7 is down 9%, the S&P equal-weighted index is up 2% and the GS ex-AI basket is up 5%. Diversification at work, and fortunately there are lots of fish in the sea right now, unlike the 2014-2024 period when the Mag 7 was the only game in town.
Here is the Mag 7 in action. It’s not quite a bullish broadening but at least it’s a benign broadening (so far, at least).
The S&P 500 equal-weighted index has now out-performed the Mag 7 by 11 percentage points over the past 3 months.
The truce between the US and Iran went took a step back last week, pushing oil prices back up towards $100. The 12m forward price is only $3 below the initial spike in February and inventories remain critically low, as the truce did not last long enough to replenish supplies.
The bottlenecks in the Middle East have put bond markets back in bear-steepening mode. The US 10-year yield is now at 4.7%, which is well into the 4.5-5.0% “danger zone.” When the risk-free asset is valued competitively against risk assets, the latter needs to get cheaper when the former does so as well. That’s the Fed Model in action. Fortunately, earnings growth is strong enough to offset some of the valuation contraction, leaving the stock market in a sideways range.
The FOMC meets next week, and for now the odds of a July rate cut are modest at 38% (per Bloomberg’s WIRP). Odds of a September hike are 100%, however, so at some point the Fed will need to back up its hawkish talk with action.
The rise in yields last week was on both the nominal and real side, with the inflation break-even staying put at around 2.3%. The 10-year real yield is now a generous 2.43%, which in my view is a better value than the 4.7% nominal yield.
Inflation break-evens remain eerily quiet, even though the Bloomberg Commodity Spot index is accelerating higher again. Inflation protection still seems mispriced to me.
The expected rate hikes (now 48 bps) are keeping the US dollar bid. The dollar index has not moved much for over a year, but a chartist might look at that range and see a large base brewing.
The AI space continues to correct, as investors continue to question whether too much money is being spent by the hyper scalers, while the surge in speculative flows into the semiconductor space is now at a loss. I suspect it will take some time for the space to find its footing again.
For now, all eyes are on earnings season, with some big players reporting next week. The estimated growth rate (per Bloomberg) is up 300 bps since the start of the quarter, which is relatively modest but logical given the high expectations.
However, the dollar earnings estimate (again per Bloomberg) has soared by $10 in the past week, apparently driven by a GAAP reporting nuance from a couple of large companies. I would rely on the growth rate per the above chart for a better sense of the earnings picture.
On a year-over-year basis, earnings are up 23% while the P/E ratio is down 5%.
From a structural perspective (with regards to the secular bull market), the big question is whether the bull can hold up if its biggest leaders fade from prominence. Below we see that the payout ratio of the Mag 7 has fallen to 37% as companies switched from buying back shares to investing in capex. It’s not necessarily a bad thing as long as the ROI of that capex is good, but if investors are forced to settle for two birds in the bush instead of a bird in the hand, it might affect valuations. It really does look like we have entered the post-Mag7 era.
Below we see how dramatic the deterioration has been for the Mag 7 in not only the payout CAGR but also the payout ratio. Fortunately, there are plenty of options in terms of regions and sectors that offer equally compelling growth rates and better payout ratios. This is a great thing for active investors who paint the global landscape with a broad brush.
Structurally, the past 17 years have produced outsized beta, with the 10-year CAGR of the S&P 500 price index gaining 13.7% while the 10-year income has been a modest 3.9%. If the Mag7 are indeed no longer going to lead the market, my hunch is that the next 5 years or so will produce less beta. That means that we will need to harvest more income instead. Fortunately, there are plenty of fish in the sea these days.
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.
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