November 2024 Active Management Insights: The evolving AI opportunity set

Executive summary:

Manager preferences within the artificial intelligence (AI) opportunity set are continuing to evolve, with some managers now focusing on software and consumer technology plays.
In the wake of significant China stimulus, managers are turning more positive on China. However, many are waiting for consumer confidence to rebound before adding to their China positions.
Managers see continued value opportunities in Europe and the UK, especially among banks.

Broad global trends

Brightening outlook for China

The Chinese government unleashed substantial fiscal stimulus measures in late September, causing a sharp rally in Chinese equities that is expected to drive a continuing improvement in sentiment. Although many managers want to see additional improvement in consumer confidence before increasing their exposure, most are confident that there is limited downside risk from here.
Emerging markets specialists, broad global managers and long/short equity investors are increasing exposure to internet platform companies in e-commerce, advertising and gaming, which offer favorable growth prospects and reasonable valuations.

Value opportunity in Europe and the UK

Europe continues to provide opportunities for bargain-seeking investors. European banks offer significant valuation upside and increasing profitability stemming from greater discipline on costs and growing digital banking platforms. Return on equity (ROE) among banks in the UK is at a post-GFC (Global Financial Crisis) high, while price-to-book (P/B) multiples remain modest for the sector.

The AI-related opportunity set is evolving.

Manager preferences within the generative AI theme continue to evolve. Outside the obvious plays in semiconductors and data centers, managers are looking at software and consumer technology plays. Utilities and their suppliers are a related theme.

Optimism toward Japanese growth

Sustainable wage growth and a positive capital expenditures (capex) environment are expected to spur economic growth in Japan. Managers are shifting positions to companies with pricing flexibility that will be able to pass-on rising labour and raw material costs.

Global equities

Thinking harder about AI’s structural winners

Investors are focusing on the beneficiaries of AI adoption—mostly software and online-data platforms that optimise customer services and improve targeted advertising spending.
Semiconductor and hardware players expect to benefit from an AI-driven replacement cycle across consumer technology and new applications that require increased processing power.

Europe remains a bargain

Value managers continue to believe European banks are trading at discounts to their U.S. and Japanese peers. Consolidation in the European banking industry and a more favorable political environment is allowing investors to unlock greater value.
European airlines face a supply short-term disruption but are benefiting from industry consolidation and pricing power with stable demand.

China is at the early stage of a turnaround

Both growth and value managers are finding more opportunities in China. Consumer-oriented, e-commerce names are well-placed to benefit from a potential economic recovery and improving consumer sentiment in the wake of the announcement of ambitious policy stimulus.

Opportunistic healthcare ideas

The recent market correction in healthcare provided entry points into innovative market leaders whose cost and scalability advantages allow them to capture large addressable markets.

Overlooked sectors with attractive risk-reward

Defensive-quality managers are seeing opportunities to buy companies with stable growth that have been recently neglected by the market, such as utilities and consumer staples.

Pockets of commodities are rewarding

Deep value managers see strong upside in specific metal markets due to tight supply fundamentals and pricing pressure mostly supporting gold and platinum producers.

U.S. equities

Will valuations matter?

With the broader equity market near record highs, large cap active equity managers across the style spectrum are becoming progressively more cautious on their forward return expectations as overall valuations continue to rise.
Growth-oriented managers expect to take further profits in pricey mega-cap technology holdings while adding to lower valuation compounders within the industrial sector as interest rates fall.
Managers are broadly in agreement that smaller-cap stocks are relatively cheap and should benefit during the current interest rate cutting cycle, but are generally reluctant to further add to exposures ahead of a potential economic downturn.

Hidden AI beneficiaries

Markets and managers have (rightly) focused on direct AI plays like semiconductors, datacenter operators, and software service providers in recent years, but are now looking further afield.
Alongside the above-noted defensive plays, managers are adding to holdings within electric utilities, which are expected to benefit from supplying the soaring power demand from the ongoing AI-driven buildout in datacenter capacity.
Nuclear power is noted as a particular beneficiary, with builders and service providers of smaller, modular reactors seen as the preferred play.

Staying put

The accumulation of risk-induced uncertainty has rolled into the fourth quarter, with investors pointing to the ongoing wars in the Middle East and Ukraine and the U.S. presidential election as notable known risks.
Outside of the exceptions noted above, for the most part managers are sticking with their current positioning. Specifically, growth-oriented managers aren’t wanting to chase momentum-driven names higher while value-oriented managers are reluctant to add cyclical risk without evidence of a weakening economy.

Emerging markets equities

Shifting sentiment in China

Late in the third quarter was a pivotal moment, with the Chinese government appearing to draw a line in the sand around the macro slowdown by unleashing the largest wave of stimulus since the end of the COVID-induced lockdowns.
While investor sentiment remains mixed in the short term, with some questioning the adequacy of support measures and seeking further evidence of improving consumer confidence, the general agreement is that there is less downside risk from here on.
As a result, there has been a move by investors who have been underweight to reduce that risk by adding to their China positions.
Much of the marginal capital has been going into higher quality businesses with more visible cash flows, such as well-established internet platform companies—particularly in e-commerce, advertising, and gaming—as valuations remain attractive given current growth rates and profitability.
Some contrarian managers continue to be positive on the flailing real estate sector, focusing on companies with strong balance sheets and access to bank financing.

Investors remain positive on Brazil

Investors remain positive on Brazil given a strong macro backdrop, despite the country’s central bank raising rates to control for an unexpected uptick in inflation. The capacity to cut interest rates moving forward could benefit financial institutions and consumer-facing sectors such as retail and homebuilders.

Positive view on India persists but valuations remain elevated

While some managers have been taking profit and rotating toward China growth, investors remain bullish on India. In particular, growth managers continue to see a long runway, noting opportunities in the financial and telecom sectors. These views are supported by healthy consumer spending and ongoing infrastructure spending.

Long/short equity

Persistent preference for defensives over cyclicals

Defensive tilt: Hedge funds continue to show a clear bias toward defensive sectors over cyclicals, both in positioning and active flows.
Sector shifts: Hedge funds are continuing to buy in real estate, staples, and health care, while trimming exposures in consumer discretionary, energy, and industrials.

Technology and momentum moderation

Tech underweight: Net exposure to tech remains near 12-month lows after consecutive months of selling.
Rotating within TMT (technology, media, and telecommunications): There are early signs of rotation from semiconductors/hardware into software, though software positioning is still near multi-year lows.

Regional trends

Europe overweight persists: U.S.-based hedge funds are maintaining overweight positions in Europe, with renewed buying interest.
China re-engagement: There’s an increased appetite to participate in China rallies, primarily driven by Asia-based accounts.

Europe and UK equities

Banks still offer upside

European banks still offer scope for material upgrades to the skeptical expectations of investors. The industry is showing increased discipline and a focus on generating sustainably higher returns. With valuations remaining depressed, and many stocks still trading below book value, this has the potential to spur re-ratings in the sector.
The potential headwind from digital challenger banks has been slow to materialise. Simultaneously, digitisation is helping traditional banks control costs, not just by increased automation but also by an increased customer willingness to transact online. Some banks report up to three-quarters of sales and two-thirds of new customers are now transacted digitally. The per-customer cost for new customers is roughly half that of legacy customers.
A similar picture is visible in the UK, where bank ROEs have reached a post-GFC high. Banks have benefitted from higher interest rates and lower loan losses, though this has not yet been fully reflected in price-to-book multiples for the sector.

Japan equities

Mixed stance toward bank exposure

While many managers expect Japan's inflationary environment to persist, they do not foresee the Bank of Japan taking a hawkish stance given weak economic conditions. Consequently, managers on average have reduced their positions in banks after outperformance, although some have maintained their holdings, focusing on long-term trends and governance reforms.

Increased focus on stocks with high exposure to China

With the expectation of additional economic stimulus measures, many managers have begun reducing their underweight positions in cyclical stocks with exposure to China. They have added to chemical and machinery stocks with stock-specific advantages that are trading at attractive valuations, while avoiding purely cyclical-driven companies with no pricing power due to concerns over increasing competition with Chinese manufacturers.

Relatively optimistic view on domestic demand

Sustainable wage growth and increased capital expenditures are expected to contribute to Japan’s economic growth. In this context, many managers believe companies can pass rising costs on to sales prices.
As a result, they have been increasing positions in sectors affected by rising raw material and labour costs, such as consumer staples, services, retail, and IT service providers.

Canadian equities

Real estate strength expected to continue

Real estate was the top-performing sector in the third quarter. The declining interest rate environment in Canada will continue to be a tailwind. While managers remain positive on the sector, they prefer companies with high-quality assets in prime locations in case inflation resurges and drives a shift in the interest rate policy.
There is also interest in companies with exposures to areas such as storage, student housing, and other niche markets that offer diversification and potential growth.

Opportunities within financials

Interest rate cuts in the U.S. and Canada, along with the higher probability for a soft landing, benefitted the financials sector—particularly banks. However, due to deteriorating credit metrics and muted revenue growth, some managers are cautious on banks.
Investors favor less credit-sensitive financials, such as life insurance companies and alternative asset managers that benefit from structural tailwinds and capital-light business models.

Growth potential across industrials

Industrial stocks have rebounded as recession fears ease. Investors are focused on previously out-of-favor companies with strong growth potential given growing infrastructure spending and onshoring. Specifically, this includes areas like industrial leasing, hazardous waste companies, and lumber-based products.

Increased interest in biotechnology

The decline in interest rates has also fostered a more risk-on sentiment within the healthcare sector. At the margin, growth investors are exploring riskier growth areas, including biotech.

Australian equities

Small cap’s time to shine

In September, the S&P/ASX Small Ordinaries Index outperformed the S&P/ASX 100 Index by 2.22% following an extended period of underperformance. Small cap managers argue that an environment of falling interest rates is supportive for smaller capitalisation companies, who often have higher debt levels, longer dated growth, or are in cyclically exposed industries.
Brokerage firm Bell Potter found that over the last 30 years, the S&P/ASX Small Ordinaries Index has outperformed the S&P ASX 100 by roughly 8% on a 12-month total return basis once the U.S. Federal Reserve (Fed) initiates an easing cycle.
Australian small companies provide a favorable habitat for active managers to add value, with the index consistently below the universe median, and below the bottom quartile over longer periods. Over the past five years (dating to Sept. 30, 2024), the universe median outperformed the index by 4.9% annually.

Real assets

Listed vs. non-listed: Macroeconomic tailwinds

Listed REITs (real estate investment trusts) continue to trade attractively relative to private real estate, with cap rates that exceed private real estate by over 1%.
It’s widely believed private market re-pricing is done and borrowing costs are set to ease, but continuing economic uncertainty is contributing to defensive positioning in the short-term.
Development in industrial and multifamily real estate is set to cool off moving forward. The surplus of supply could increase vacancies in industrials in 2025.

Real estate: A rich opportunity set?

Secular growth trends are set to provide structural tailwinds to absolute returns, while economic uncertainty will likely lead to market volatility and a rich opportunity set for active managers.
Cashflow growth estimates remain strong for 2025, and there is potential for valuation expansion to serve as an additional return source for investors.
Balance sheets remain strong globally, but refinancing headwinds may negatively impact earnings, emphasising the importance of fundamental research and bottom-up selection going into 2025.
Data centers continue to see strong demand, but power constraints in new developments are holding back supply.

Infrastructure: Regulators sanction utility growth returns

There is a significantly higher future demand for electricity due to electrification and increased data storage. This will be a source of revenue growth for electricity utilities. However, the market has been concerned that regulators who determine the returns providers can earn will hold back this growth.
During the quarter, regulators in some U.S. states issued determinations that allow for a market return on capex to meet future energy needs. Managers are positive regarding the pragmatic approach of the regulators. They are selectively overweight utilities that are able to work with regulators to achieve required returns for new power generation.