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TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.
Welcome to the TCW Investment Perspectives podcast, where our investment professionals share their insights and expertise on how to make the most of your portfolio. I'm David Vic, Managing Director in Fixed Income at TCW. U. S. Equity markets have staged an impressive rally this year that has surpassed expectations.
David Vick:Despite widespread concerns about the state of the economy, tariffs, and ongoing global tensions, the S and P is up about 12% so far this year. That said, the environment is complex, as a handful of mega cap technology companies have driven much of those gains. For investors, the question now is how to find opportunities in a market that seems by many metrics to be expensive. Joining me today to help sort out this dilemma is Youssef George, a senior vice president and head of equity portfolio specialist here at TCW. Youssef, thanks for joining the podcast.
Yusuf George:Thanks for having me, Dave. It's very, very excited to be here today.
David Vick:Great. Let's talk big picture. So as you look today, what are the main factors making today's valuations what makes them so complex? What makes the the valuation landscape so difficult these days?
Yusuf George:That's a that's a it's a really interesting one. So, you know, as you've said, equity markets have had a sharp rise this year. I think if you look year to date, equities are nearly up 14 and a half percent off of, you know, the April Liberation Day lows, and the market has been primarily fueled by the AI landscape. If you think about the CapEx investments that the large hyperscalers are making into everything from training models and to to chips to power and infrastructure. And then we have the beneficiaries of these spending companies that are seeing an expansion of their earnings growth.
Yusuf George:There's a lot of real support in the markets. The rally that we've seen this year is also being driven by the Fed's easing cycle. Now if you think historically, you know, Fed easing cycles tend to coincide with equity market rallies, and the Fed started easing in September. So that plus the expectation of two more cuts continues to be a tailwind. Now there's continued conversation, and and what makes this landscape so complex is the strong divergence between the valuations of the AI mega cap companies, which are trading at sometimes twenty three and thirty times forward earnings versus the rest of the market trading at significantly lower earnings, sometimes single digit earnings growth.
Yusuf George:And there's been a lot of concern related to this divergence in the market. Right? In addition to this, you have geopolitical threats. I mean, just a few weeks ago, president Trump threatened increased tariffs on China, which sent the market to one of the sharpest daily drops that it's seen all year. I think the markets dropped two and a half percent on that day.
Yusuf George:The market shrugged that off, but there's other uncertainties, geopolitical tensions, macroeconomic ones, such as inflationary concerns. We're in earning season right now, so lagging corporate earnings during the season may remain a shock to the market. So when we think about all of these different factors put together plus the high valuations of these large mega cap companies, there's a lot of complexity in the market, and it's a moment where us as investors have to spend a lot of time thinking about the valuation landscape and the deep analysis that we need to do to look beyond sort of the headline noise and really understand the fundamentals of the market.
David Vick:Got it. Obviously, a variety of factors there, but let's take a deeper look at those, those AI mega cap companies. Obviously, they're in the news. They're driving growth. So how do you define or how do you describe their influence on the rest of the market?
David Vick:And what happens if their growth starts to slow, and maybe what is the likelihood, in our view, that that growth does start to see a more sort of a normalization?
Yusuf George:You know, we and others in the market tend to think about AI and speak about it with with a lot of ease. But I think that the market and the impact that these AI companies have had really can't be understated. They have dominated and have had an outsized impact on the markets due to both their rapid growth and their investments. Right? If you just take a second to think about the investment cycle and a little bit of context associated with it.
Yusuf George:Back in early twenty twenty four, the deals associated with some of the large hyperscalers, the big four to be precise, amounted to less than about a $125,000,000,000 in total. If you fast forward to earlier this year, the spend by the large hyperscalers was close to 300,000,000,000, tracking to well over that. Right? So there's been significant growth. And this is only the public companies.
Yusuf George:We're not even talking about the private ones yet. Right? If you think about OpenAI, just within the last two months, they've announced pretty significant deals with Oracle for $300,000,000,000 as an example, or NVIDIA mentioned that they would invest a 100,000,000,000 in OpenAI. So there is a good deal of spending that is already happening with these hyperscalers right now. This, though, points back to that conversation around the heavy concentration in the market.
Yusuf George:If you look at these large mega cap names, AI driven names, they're about 35% of the S and P 500. So people are obviously concerned about these companies and the undue influence that they have on the market. But if you think about the spending that has been happening, estimates are that over 1% of GDP growth has been a contribution by these large cap companies. So it's a really important factor not to diminish the amount of investments that they have had and the beneficiaries that are associated with it. Our equity CIO made a really important point.
Yusuf George:He mentioned that during COVID, some of the stimulus packages were adding about a half percent to 1% of GDP growth. Whereas, as I just mentioned, some of the spending that's happening by these hyperscalers are real money going into real projects right now. If I were to point to a few examples of this across different sectors, we can think about the real estate and data center markets. We can think about power and grid investments. We're seeing real money being driven into those areas.
Yusuf George:And I'm happy to dig into any of this, but I think the the main point is the demand that we're seeing associated with AI is currently very high and is only growing. And so there's a lot of support in the market for them, and we believe that this underlying investment is is necessary.
David Vick:I think there's widespread agreement out there that computing demand is poised to grow and AI companies are are expected to continue growing. But what happens if that turns out not to be the case? What happens if there is a slowdown and that market actually does the growth rates are slow, growth rates slow, demand declines. What what happens in that sort of environment?
Yusuf George:So there's a lot of conversation around if AI is a bubble or not. And we think for many reasons, it is not a bubble. We have already started to see a little bit of slowing of the earnings growth of these large mega cap names, which speaks to the broadening out to other names where there's value and opportunity. But it's really important to note how impactful these large hyperscalers are and the CapEx investments are as it relates to the market. If I were to talk about power demand, we often talk about a aging grid and infrastructure associated with it.
Yusuf George:We know that US doesn't have enough power to support demand. We know that the infrastructure of The US is really old, you know, in some instances over 40 years old, and the backlog is real. If you think about transformers, the backlog is about three years or so. I'm bringing up this point because there is strong demand associated with electrification, but CapEx dollars are being spent now to support the grid. So while we think about AI as a secular theme and a secular growth driver, the investments that are being made are actually exponential not only to the AI boom, but also to US infrastructure as an example.
Yusuf George:And many companies are willing to spend their capital in this moment that will continue to support the earnings growth profile of the beneficiaries of this. While there may be some impacts if these company don't hit the targets, if the ROI doesn't seem to come into place in the way that we believe, we still believe that this is a long term secular driver, and there may be a short term correction. But if you look at some numbers that our our PMs who cover the AI space have recently pulled out for us, if you look at the mag seven price earnings growth, right now it's trading around 1.6 times. The S and P is trading at about two times, and Russell one growth is about 2.1. So if you look at these numbers, the earnings growth of the MAG seven, while it may seem high, is reasonable.
Yusuf George:While it's trading at a high premium, it is reasonable considering the constraints associated with this demand and with the potential long term earnings growth power of this space. So things may slow. There may be a correction. But over the long term, we think that there is sustained evidence and demand that this will be a continued long term driver.
David Vick:Yeah. I think there's a lot of certainly a lot of demand, and the the need for computing power is not likely to go down anytime soon. I think everybody can agree there. But maybe let's let's downshift a little bit. Obviously mega cap is sort of driving the headlines, but what about sort of the lower end of the market?
David Vick:So the value stocks or mid cap stocks, they're trading at relatively steep discounts to their historical averages. Does that create opportunities or are there things happening in the lower end of the market that we should be thinking about as well?
Yusuf George:Yeah. And I I wouldn't categorize it as just the lower end of the market. I think when we look at value across the board, there's growing opportunity. Obviously, we talked about the concentration of growth in the AI names and and the outperformance that they've driven, but index valuations are stretched now, and value, in our opinion, continues to remain diversified. The market, if you look at the last few years, has been driven by momentum and size.
Yusuf George:And these have been two of the largest contributors. And the S and P 500 looks expensive on many different fronts. Look at price to book. If you look at market cap to GDP, it's trading right now at 23 times forward earnings. But if you look at it if you look at the S and P from an equal weight perspective versus the cap weighted perspective, equal weight is trading at a discount right now.
Yusuf George:So AI companies aside, the market is trading at around 17 times earning. And outside of the max seven, some of the names, the the other four ninety three, are seeing about four to six percent earnings growth. So there's opportunities in different sectors. If you look at energy, if you look at materials, if you look at health care, utilities, I think that there's a lot of opportunity when we think about value that's being created in this moment. Maybe to paint the picture a little bit more deeply.
Yusuf George:So if we go back to AI for a second, the top names are the focus right now. The the sort of Batman stocks. Right? You know, the the Nvidia's and the Broadcom's of the world. These companies obviously have the most direct leverage and the most exposure to this theme.
Yusuf George:But over time, that's going to expand to the second and third order winners, companies and industries that currently look like value. I can provide two really specific examples. One, telecoms. Right? So because of increasing AI adoption, end customers are then continue to drive greater data usage, right, on their personal devices.
Yusuf George:I use it a lot. I'm I'm sure you use your phone to chat GBT or source something. This growing demand is creating pressure on telecom companies, which have to expand CapEx to meet the demand. This is gonna fuel strong pricing power for the telecom tower industry. This sector is currently squarely in the value space and is trading at a steep discount to historicals.
Yusuf George:The other example I can provide is in the utility space. So utilities is trading around 18 and a half times earning, and it's about one standard deviation from above the fifteen year average. But if you compare it to the broad market, the sector is actually trading at more than a two standard deviation discount. When you think about some of the themes, these long term themes that we talk about often, you know, AI, reshoring, electrification, utilities is gonna benefit from the power generation needs for data centers. And as rates come down, there's gonna be lower financing costs, etcetera.
Yusuf George:So a sector like utilities, which is trading pretty cheaply, can likely post stronger earnings growth with a pretty low beta, which is a attractive risk reward. I guess the main point is there's potential for mean reversion as macroeconomic factors and the uncertainty around it diminishes as earnings growth potentially slows for some of the large mega cap names. And as market leadership becomes more distributed, value in mid cap names really have an opportunity.
David Vick:I agree. It's interesting as some of those same themes were you doing on the fixed income side as well. You look at infrastructure, digital infrastructure, power generation, those things are all consistent with what we're doing on the fixed income side as well. But maybe aside from AI, if we think about other maybe defensive sectors, consumer discretionary, maybe financials or healthcare, those look like a little more attractive these days. How do you evaluate opportunities in some of those sectors apart from the AI boom, given ongoing macroeconomic changes that are that are underway?
Yusuf George:Look. The macroeconomics are tricky, and I think they will remain to be. And this is something that I know you and and your team look at a lot. I guess when it comes down to it as active managers, we we focus on a bottoms up approach, and we look for the highest quality companies. When we look at some of the sectors that you're talking about, which are traditionally defensive, the most important thing is fundamentals.
Yusuf George:We start with that, and we end with that. Right? We look for companies that are resilient. Identify companies that have stable cash flows, pricing power, strong balance sheets. These are things that equip them to handle, shocks in the market or even economic downturns.
Yusuf George:We look to see if there's a growing TAM based upon some of the secular growth drivers. I guess if we were to point to a few sectors, health care, if there's biotech innovation, or in real estate, if we think about aging demographics and the increasing demand for senior housing, there's secular growth opportunities that exist across many of these different sectors. So we look at those things. Of course, we look at valuations on a relative basis. We look at what our current multiples look like in the sector versus historical averages.
Yusuf George:We look at peer groups to identify areas of untapped potential. We consider regulatory shifts, as I mentioned earlier, and some policy shifts. And if I get I guess, to point to a very specific sector, if you think about the health care sector, you know, throughout the year, it's been a really challenging one to invest in, you know, primarily because of navigating the tariff markets, navigating regulatory shifts, especially in China. But we've seen recently that investor sentiment has remained, I would argue, cautiously optimistic, despite all of the geopolitical tensions. And it seems like the stability around these have made that sector a lot more attractive.
Yusuf George:It's more stable. And that has if I look at something like drug pricing, that calm has really made investors refocus on fundamentals and the value associated with it. The point is that balancing these factors allows us to capitalize on defensive growth potential without taking on some of the undue risks of these macroeconomic shifts.
David Vick:Sure. Makes sense. So earlier, you talked a little bit about how we define quality. Maybe any other points on that you might like when you're looking for a quality stock, like what does that mean? What sort of things do you look for?
David Vick:And of those things, what's the most important today? You know, you had to pick one or two things to really drive our definition of quality, what would that look like to you?
Yusuf George:Well, quality can be defined by many factors. But, you know, just to to hit home on a few things that we we wanna reiterate, you know, strong balance sheets are essential. Liquidity, prudent capital allocation, earnings power matters. You know, we are in earning season in this moment, and so we look at companies that have predictable, sustainable free cash flow. They can weather volatility in a better way.
Yusuf George:Competitive positioning. We talk a lot about not only a growing TAM, but business model advantage. So differentiated products and services, defensible market share, and then, of course, management. Management with a proven track record that has good and sound corporate governance that aligns with shareholder interests. I think all those factors lead to long term value creation.
Yusuf George:So it is our disciplined bottoms up approach that lets us focus on rooting out the noise and really staying laser focused on earnings growth and fundamentals and, identifying strong opportunities in high quality companies.
David Vick:That makes sense. Thanks, Youssef. I think that's pretty much all the time we have today. So thanks, Youssef, joining me to look at the current equities market. For more information on TCW strategies, please visit our website at tcw.com.
David Vick:Thanks for listening, and we'll pick up next time exploring more trends and opportunities that are shaping global markets.
disclosures:Thank you for joining us today on TCW Investment Insights. For more insights from TCW, please visit tcw.com/insights. This material is for general information purposes only and does not constitute an offer to sell or solicitation of an offer to buy any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such, or be the basis an investment decision.
disclosures:The information contained herein may include preliminary information and or forward looking statements. Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results.