Brookmont Capital Management - Commentary
by Craig Love, on August 10, 2023
AI Fueled Exuberance Leads Market Rally
The equity market in the first half of 2023 was dominated by 7 stocks that were all mega-cap technology stocks. These 7 stocks drove the market-cap weighted, S&P 500 up 16.38% while the equal-weighted S&P 500 was up 6.10%. The Russell 1000 Growth Index outperformed the Russell 1000 Value Index by 25.31%. The main driver of this performance was multiple expansions versus an increase in actual or estimated earnings per share. The S&P 500’s average price-to-earnings ratio expanded 14%. This multiple expansion was also heavily concentrated amongst the “Big 7” mega-cap tech stocks (see first graph). This multiple expansion is mostly attributed to the emergence of generative AI and the potential future earnings that these technology companies could earn from incorporating AI into their existing products and services. There is no doubt that AI will help all companies improve productivity in the future and companies such as Nvidia, Meta, and Microsoft will play a large part in bringing AI-based products and services to the economy.
For example, the Brookmont investment team expects AI to help increase Microsoft’s Core Azure revenue growth by 2% - 6% by 2026. The potential applications of AI are numerous and ever-expanding. Microsoft is well-poised to tap into these burgeoning opportunities, particularly given its extensive and devoted user base. By incorporating AI capabilities into its flagship productivity suite (Microsoft Office), the company could bring about a revolution in platform engagement and significantly boost productivity. Moreover, this move could not only result in an increase in per-customer revenue but could also further enhance Microsoft's competitive advantage. Through smart integration of AI services into its existing platforms, Microsoft stands to consolidate its market position, adding to its already robust competitive moat.
Another bullish sign for the broader market is the expectation from many sectors that AI will transform their business eventually leading to increased EPS. McKinsey expects generative AI to add $6.1 trillion to $7.9 trillion annually in total economic benefits when applied across industries (including new use cases and increased labor productivity), substantially boosting its previously estimated economic value of $11.0 trillion to $17.7 trillion from non generative AI and analytics. By some estimates, a quarter of work tasks could be automated by AI alleviating negative labor force demographic trends. S&P 500 companies mentioning AI in their calls leaped from 15% at the end of last year to nearly 40% in the second quarter of 2023.
More than AI Driving the Enthusiasm
The Mega Cap Technology stocks drove the performance in equity markets but there were several other factors that prevented the US from slipping into a recession after nearly 400 bps of rate increases since early 2022. The resolution of the negative supply shocks from COVID and the Russia-Ukraine War has provided some economic lift to the world economy. Specifically in the US, investments in industrial structures have led to manufacturing and non-residential output surpassing consensus estimates. Manufacturing spending focusing on computer, electronic, and electrical infrastructure has increased 235% in the past 12 months through May and other manufacturing spending has been up 7%. This higher level of infrastructure spending has helped insulate the US Economy from the dragging effects of interest rate increases. Businesses have had time to prepare for a period of economic slowdown which makes the effect of the slowdown less intense and leads us to believe that a soft landing could be possible.
Consumption and jobs are slowing and core inflation is sticky
Consumer spending was already subdued and may continue to decline as consumers continue to deplete their pandemic excess cash buffers. These cash buffers are expected to last only until year-end or early 2024, which should lead to more normalized spending activities. Despite this consumer confidence remains robust supported by the strong but softening labor market. The Conference Board Consumer Confidence Index of 117.0 reached its 2-Year high in July.
After nearly three years of forbearance borrowers brace themselves to resume federal student loan payments in October. Consumers burdened with student loans typically face average monthly repayments of approximately $400. This could create a headwind of up to $6 billion per month, potentially reducing discretionary consumer spending by 1% to 2%. We expect a substantial portion of this headwind to be absorbed by luxury-oriented, discretionary purchases in the soft goods category, including clothing and footwear brands. Meanwhile, hard goods such as furniture and appliances, due to their durability and essential functionality, are less likely to be impacted. Therefore, under the current market conditions, hard goods retailers like Home Depot and Lowe's are better positioned to outperform the sector. For instance, around 100,000 appliances break down daily which require replacements. Additionally, in the medium term, two key catalysts could further boost the home improvement sector: 1) Approximately 50% of US homes are over 41 years old, marking the highest level since World War II. 2) Home equity levels are at record highs, and with house prices appreciating, homeowners are likely to invest more in home improvements. As per Education Data Initiative, nearly half of the people that have or had student loans had already delayed their home purchase before buying. Although borrowers aged between 30 and 44 years are responsible for ~49% of the national student loan debt, they constitute only about 22% of the total homeowners in the US. Therefore, these factors could further fuel spending within the housing and home improvement sector.
The high-quality companies that we select to invest in have forward-thinking management teams and are well-situated to capitalize on the increased velocity of innovation that AI will bring to the economy. Additionally, they have significant cash reserves and easy access to credit, allowing them to invest organically in operations and take advantage during recessionary periods to capture additional market share. The likelihood of a potential recession and hiking cycle reversal should make quality dividend growers more attractive relative to other options.
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