U.S. Equity Valuation Justified by Profitability and Policy; AI Drives Bond Issuance

Key Quotes

"But the way I approach it is like there are some very important differences from that time period, from valuations back then. First of all, I think companies in major equity indices are higher quality than the past. They operate more efficiently. They deliver strong profitability, and in general pretty solid free cash flow."

Serena Tang explains that current equity valuations are distinct from past bubbles by highlighting the improved quality and efficiency of companies within major indices. Tang argues that these companies demonstrate strong profitability and solid free cash flow, suggesting a more robust foundation for their valuations.

"I think we also need to consider how technology now represents a larger share of the index, which has helped push overall net margins to about 14 percent compared to 8 percent during that 1990s valuation bubble. And you know, when margins are higher, I think paying premium for stocks is more justified."

Tang points out that technology's increased weighting in current equity indices contributes to higher net profit margins. Tang suggests that these elevated margins, compared to historical periods like the 1990s bubble, make paying a premium for stocks more justifiable.

"And I think this combination, you know, monetary easing, fiscal stimulus, deregulation. That combination rarely occurs outside of a recession. And I think this creates an environment that supports valuation, which is by the way why we recommend an overweight position in U.S. equities, even if absolute and relative valuation look elevated."

Tang identifies a rare confluence of monetary easing, fiscal stimulus, and deregulation as a supportive factor for equity valuations. Tang concludes that this combination creates an environment justifying an overweight position in U.S. equities, despite potentially elevated absolute and relative valuations.

"Yes. We are expecting U.S. stock earnings to sort of broaden out here and it's one of the reasons why our U.S. equity strategy team has upgraded small caps and now prefer it over large caps."

Tang anticipates a broadening of U.S. stock earnings growth, which has led to a strategic shift. Tang notes that this expectation is the basis for the U.S. equity strategy team's upgrade of small-cap stocks, now favoring them over large caps.

"Now, part of it will be via private credit, part of it would be via Asset Backed Securities. But some of it would also be via the U.S. investment grade corporate credit bond space. So, add in financing for faster M&A cycle, we forecast around [$]1 trillion in net investment grade bond issuance, you know, up 60 percent from this year."

Tang outlines the diverse channels for financing significant AI-related capital expenditures, including private credit and asset-backed securities. Tang forecasts substantial net investment-grade bond issuance, projected to increase by 60% from the current year, partly due to financing needs for a faster M&A cycle.

"I think in the first half of next year that downward pressure on the dollar should still persist. And you know, as you said, we've had a very differentiated view for most of this year, expecting the dollar to weaken in the first half versus G10 currencies."

Tang predicts that downward pressure on the U.S. dollar will continue into the first half of the upcoming year. Tang reiterates a differentiated view held throughout the current year, anticipating a weakening dollar against other G10 currencies.