Dominating headlines in the second quarter was the market momentum in the United States, which was largely driven by mega-cap technology amid enthusiasm around artificial intelligence (AI). While outperformance in the United States was narrowly led by a handful of stocks, performance outside the United States was broader, particularly in Europe and Japan.
Let’s review what happened more broadly in the second quarter—and what to expect in the third.
Economic Expectations
The global economy proved resilient in the first half of the year. Headline inflation across most regions peaked with signs of monetary easing, and corporate earnings have generally surprised to the upside.
Regional banking stress seemed to subside. The U.S. Federal Reserve (Fed) continues to be vigilant about the banking turmoil, providing increased liquidity when necessary, and net lending volumes remain healthy at 2018-2019 levels. We thus think the potential for further distress is unlikely.
Looking to the second half of the year, expectations are a bit disconnected. There are projections for gross domestic product (GDP) growth in many areas, but earnings estimates have been revised down, with emerging markets skewing the lowest. Thus, despite the market’s focus on the risk of a continued slowdown or recession, we believe we could actually experience upside to corporate earnings expectations for the balance of the year if economic growth plays out as expected.
Global central banks remain vigilant in the fight against inflation, signaling the potential for further rate hikes and higher-for-longer rhetoric, despite headline inflation peaking in most regions. As the energy crisis in 2022 drove up eurozone inflation at a quicker rate than in the United States, we expect to see disinflation occur in Europe more rapidly than in the United States, with energy prices continuing to decline. (They’re down nearly 50% from their peak last year.)
Further, thanks to lower inflation, real wage growth has turned positive in both the United States and Europe for the first time in nearly two years. This, in turn, supports domestic demand and consumption growth, which we expect will allow U.S. GDP growth to continue at current levels. While Europe is lagging the United States by a few quarters, the story is much the same there.
Within China, we expect the recovery to be slower than originally projected. The country lost some momentum shortly following its COVID reopening. The near-term outlook remains soft based on the slower-than-expected recovery in consumption (which is driven by low consumer confidence), continuously high youth unemployment, and the reduced wealth effect (due to the weak property market). While uncertainty remains, the potential for government stimulus and improved U.S.-China relations could drive equities in the near term. Performance has been primarily driven by state-owned enterprises (SOEs) and AI-themed names, but we expect this to shift as the economy recovers and valuations reset. The overall Chinese market remains inexpensive, but there is no improvement in clarity or timeliness.
Market Views
The narrowness of market leadership, or lack of breadth, has been a surprising phenomenon this year given our belief that a return to historical long-term interest-rate levels would suggest a continued broadening of growth and stock returns.
In reality, the uncertainty of economic outcomes this year has driven the market to safety or visibility of growth, which has favored some of the prior market leaders, including large-cap technology stocks, especially in the United States. Not coincidentally, some of these year-to-date leaders saw their multiple premiums contract considerably last year, so perhaps they were poised for some degree of re-rating.
Internationally, particularly in Japan and Europe, market performance has been more evenly distributed. Recently, the United States has begun to see a similar effect, with the breadth of market leadership broadening and a reversal away from large-cap technology to small cap and sectors that were left behind, as we had expected earlier in the year. This broadening effect is consistent with easing inflationary pressures and growth stabilizing.
Our portfolios remain focused on identifying a diversity of growth across regions, industries, and market caps. We believe the market is due for a shift in momentum, with contraction of relative multiples for the highest-valued sectors and companies. As a result, we continue to monitor these potential risks within our portfolios.
A Few Words About Artificial Intelligence
Returning to where we began, I’d like to say a few words about AI. The astounding launch of the generative AI application ChatGPT toward the end of 2022 brought unprecedented public attention to all things AI. While we have analyzed numerous AI and machine learning applications across a number of industries over the past several years, it is clear we are just now approaching the steep part of the “S curve.”
Our work of late has centered on organizing an AI taxonomy so as investors we can begin to assess the areas that could have the most impact on companies and even industries. The simplified beginning of the exercise is to focus on analyzing which companies or business models currently rely on people to perform tasks that AI can now, or will soon, do cheaper, faster, or more accurately.
We also wanted to highlight which functionalities we believe are done better by AI than a human. In the initial phases of our analysis, we found that vision, translation, and predictive analytics have potential for significant impact.
For example, in vision (which could mean physical, chemical, or molecular), AI could surpass the abilities of the human eye. In translation, AI could translate the English language to code or to other languages. And in predictive analytics, AI’s ability to identify peak sales, supply-chain management, peak pricing, or patterns are also areas of potential advancement. As expected, many companies we research and own are far along in a number of these practices.
Importantly, these are preliminary findings. The era of AI is just beginning, and the full realization of the technology’s benefits, limitations, and risks are still widely unknown in this emergent phase.
As growth investors, we are keenly focused on innovation and disruption cycles. While there is currently an abundance of hype built into a few key companies and stocks, we believe AI will likely play out as a collection of transformational technologies that will have broad impact on determining corporate winners and losers. Our portfolios will reflect this research, and we look forward to reporting back to you in future writings.
Ken McAtamney, partner, is the head of the global equity team and a portfolio manager for William Blair’s International Growth, Global Leaders, International Leaders, and Emerging Markets Leaders strategies.
