US equities: Beyond the pullback

0:00Hey, everybody. It's Ronnie. It's July 30th. Markets are volatile, and we've got the perfect guest to help us work through that. I want to welcome Venu Krishna to the Barclays Brief. He's our head of U.S. equity and equity-linked strategy and somebody that I really rely on in times like this. So, Venu, there's so much going on in markets right now, and we want to tackle all of it. But just to set the stage a little bit, I want to take us back to the end of March. We were in the midst of the Iran-induced market sell-off. And in that time, you came out with a S &P price target that was north of 15 % above current levels.

0:35It was a very bold call. What gave you the comfort and confidence to take that step? So, Rani, first, thanks a lot for inviting me. I appreciate it. Yes, that was a bold call, and we got a lot of flack for that. It lasted for about two weeks. Right. And what I would say is that at that point, you know, first, we did recognize that the macro backdrop had become very fragile. We had a war in the Middle East, AI disruption had started, and there was emerging stress in the private credit market. When we took a step back, what we noticed was that U.S. nominal economic growth was meaningfully better than other developed economies.

1:09Consumption was durable. The labor market was slowing but not collapsing. There was a growth impulse from the big, beautiful bill still working its way. And most importantly, AI capital spending was strong and was seeing continued momentum, which meant that the secular growth engine in technology was showing few signs of stopping, though we didn't realize that the road is going to be bumpy. The other interesting thing is from a positioning standpoint, we saw that things are a lot more balanced. Long-only funds had reduced exposure. Hedge funds had also degrossed moderately. A systematic risk appeared to be more symmetric, and options flow was telling us that there was no panic yet.

1:47So in other words, there was a lot more dry powder than the start of the year. So overall, our takeaway was that the macro regime had turned messier, but not hostile, to risk assets. And so that is what caused us to be incrementally bullish on equities. What we saw was solid guidance on tech, better industrial production and PMIs, durable nominal growth, and more than offsetting the ex-US sort of weakness and also a tough comps for consumer spend. What this meant was we picked up our earnings into double digits, more than 20%, and we established a mid-teens number for next year. So in other words, we are starting with an extremely strong earnings space.

2:26And mind you, when we raised our price target, we didn't assume any re-rating. In fact, we cut our multiples to recognize increased macro risks, both from the AI spending side and the overall Middle East crisis. Look, fantastic call. So let's move into the here and now. You're a student of markets, and we're in a time of massive technology-driven change. You recently published a piece on disruption winners and losers. Can you take us through the framework you used to assess these historical transitions for industries and markets? Absolutely, Ronnie. So we started with a simple question that as AI disrupts industries, how do you tell the eventual winners and losers?

3:07So as you know, software was the first industry to be disrupted, but we knew it's not going to be the last. We knew that healthcare, industrials, transportations, and a whole bunch of other sectors are going to follow. So what we did was looked at the prior disruption events. Over the last three decades, we picked up five instances. Digital ads disrupting print media, streaming disrupting home entertainment, smartphones replacing feature phones, shale gas disrupting coal, and e-commerce disrupting brick and mortar. So what we were trying to do is look for characteristics that separated incumbents that adapted from ones that struggle.

3:47So for each industry, we essentially ran a hypothesis on financial metrics across a broad category of measures like profitability, leverage, growth, productivity, etc. Of course, we made sure that these metrics were standardized by their respective industry averages so that they become comparable. So in that assessment, which characteristics stood out to you for the winners and for the losers? Yeah. So, Ronnie, the most interesting finding from our work was that winners weren't necessarily the fastest growers or the biggest spenders. We've got a lot of big spenders out there right now. Yeah. But what we found is that what matters is a combination of strong net income margin, strong free cash flow margin, low leverage, and high productivity, defined as cash flow per employee.

4:31And if you think about the people are spending right now, they have all these characteristics at this point, except the free cash flow, which in the near term is sort of taking a hit. So I think what the point is, what this tells us is that if companies have sufficient dry power to not be hamstringed by either high leverage or inefficient use of labor, then they have a lot of room to position themselves as the ground shifts beneath them, right? And so that is the point of this exercise. Ultimately, what we are trying to do is extract a resilience factor, which you can use to position your portfolios in certain industries which are undergoing disruption.

5:10And so where does that work make you want to lean in or lean out from a sector perspective or in general right now? Yeah. Based on this finding, you know, you want to start where the hit has been the worst. And that means the software sector itself. So, you know, people have written off the software sector for dead. And our view is that that's where you want to start looking for value because it's not going to be dead. Some of them are going to adapt and some of them are indeed going to die. And that's the point of this exercise. And so what we did was we created a what we call a resilient software basket based on these metrics, which we found statistically significant.

5:44And what's interesting is that this particular basket over the last one year has outperformed the broader software market. And this, by the way, is a period in which the concerns were at the peak over the last one year. What's also interesting is when there was a recovery in between more recently, once again, this basket outperform. Now, that said, this basket does underperform S &P. At the end of the day, it is a long-only basket, which has a beta exposure to the software industry at large, which obviously took the biggest hit and is in the recovery stage right now on a selective basis. So let's move this back to the broader market.

6:19You had that great call in March. We're now near your price target from then. So how have your views evolved? And how do you see the direction of travel for the market at large from here? Ronnie, we remain optimistic. In fact, interestingly, at the end of June, we once again raised our price target and earnings. Right now, our earnings number is well above 20%, a shade behind where the consensus is. So I think the core reasons are still the same, but some of the macro environment has changed. Obviously, the Middle East crisis is back to the forefront. But now on top of that, we have the interest rate risk.

6:51Inflation is sticky. And there are uncertainties around the scale, funding, and monetization timeline of CapEx and AI-led disruption. But when you put everything together, end of the day, we see strong earnings momentum. And once again, in establishing a price target, we again cut our multiples we're going to use to be conservative. In other words, we continue to grow into the earnings rather than relying on multiples, which are clearly at risk because of macro concerns. And so of all the things out there, what could happen that could spur a change in your views and make you more negative? So let me identify three big concerns I have.

7:28The first is fundamental, but it affects at the GDP level and also at the stock level, and also now credit, which is if there is a meaningful shift in the AI narrative. And there are different ways it can happen. What if power constraints become really big and that reduces the ability of these companies to build their data center growth? What if models plateau? They're not plateauing. In fact, in the last six to nine months, they've been improving at a very fast pace. Third is, what if they lose access to funding? Now, at this point in time, we don't think that's a concern. They have raised billions of dollars from equities, convertible bonds, and credit.

8:03But there's some digestion issues happening in the credit markets. And then there's a second concern is about interest rates. Our work has shown that historically equities are negatively correlated to the 10-year nominal rates once you start coming to the 5 % threshold. So we're clearly in danger zone. So watch out for that. And the last is correlation risk. This market has been characterized by historically low correlations within S &P, between sectors, within sectors, within even big tech. It's a collection of six stocks. In other words, returns dispersion is extremely high. So I worry as to what can cause that to reverse.

8:36Typically, the catalysts are macro. So in this case, the macro would be either rates going up fast because of inflation concerns, let's say, or if there's a serious hiccup in the AI narrative because now it's important not just at the stock level, but the GDP level as well. Okay, so let's finish with the advice that you're giving to our clients right now. What are you telling them to do in this interesting market environment? Yes, let me point out five simple things we're telling investors. First is remain optimistic on U.S. equities, but recognize that upside will be limited. You're not going to get the kind of returns you got in the last three years.

9:10Second, we still think tech is a good place to sit, especially big tech, because we like the combination of declining multiples and strengthening earnings. Third, you know, this is not a market in which you make broad sector calls. This is a market in which you pick individual stocks and specific teams to play this market because of that low correlation and high sort of dispersion market environment. The other one is that, you know, our view is that we are still in the early stages of AI disruption. So brace yourself because you're going to have at least another two to four years of AI disruption-related events in the market.

9:44And the last I would say is that since macro risk, especially rate risk, is high, be extremely cautious on what multiples you're willing to pay for any particular stream of earnings which you see. Vanu, that was fantastic. Thank you so much for everything you do for our clients and for spending some time with us today. Thank you, Rani. In summary, Vanu is advising clients to stay invested because he expects earnings growth to remain high while multiples have compressed. But he also cautions that the large gains we've seen at an index level in recent years may not repeat, so a focus on specific themes and individual stocks will be critical.

10:18Clients can get more detail on all of the news views on Barclays Live. Please remember to hit subscribe wherever you listen to your podcasts to be alerted when new episodes of the Barclays Brief are released. you