Why This Bank of America Strategist Sees S&P 500 Risks Ahead — Barrons.com

By Reshma Kapadia

Savita Subramanian is concerned about the broad impact of AI spending, and finds it "a little odd" that growth expectations for the S&P 500 are close to levels not seen since the 1980s.

Subramanian, head of U.S. equity and quantitative strategy for BofA, has told investors in recent weeks to lock in gains, going against the bullish tide washing over Wall Street.

Barron's spoke with Subramanian on June 29 about a range of issues, and she discussed why she doesn't want to own megacap tech stocks, and where she would park money now if she had "a bunch of capital."

An edited version of the conversation follows.

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Barron's: What's your outlook for the S&P 500?

Subramanian: Our target is still about 7100 for the S&P 500. We are neutral to negative equities at the index level, primarily due to a bearish call on the megacap tech cohort. I don't see any reason to continue to buy Magnificent Seven or megacap tech stocks that are the capex spenders.

If you had to pick what to buy among big-cap technology, semiconductors — even though they are quite expensive — seem like a cleaner story: They are getting the money (for AI) whereas the hyperscalers are spending the money. And while software has taken a hit, it isn't massively neglected as IT services were after ChatGPT was released.

What concerns you about the AI thesis?

The number one risk: If the hyperscalers or the AI capex cycle slows down. What we have heard from companies, if anything, is that they are speeding up AI spending. They aren't showing signs of hitting the brakes.

There's still a question of whether the build-out of capacity will be deflationary like in other cycles. I don't think that is factored in. In the telecom bubble, companies built the infrastructure we are using today but didn't survive long enough to reap the benefits. It was also massively deflationary.

With any physical build — like a home renovation project — it tends to take longer, and cost more than you think. We are watching if hyperscalers can spend this much money and shoulder the burden. The other thing we are watching is the impact on the economy in the process of building out AI capabilities.

What's the concern?

There are three drivers of revenue for technology companies: Spending from enterprise, corporate advertising and consumers. Ad spend doesn't really grow because of AI; it just gets diverted to the best provider. Folks are most bullish about enterprise spending on AI because there's a propensity for companies to spend zero to $200,000 to replace a person — a lot of cash. But the U.S. economy is 70% consumer oriented so how does that play out?

So far, we have seen a pause in hiring new, white-collar professional service employees — like college grads. What I worry about for the overall economy longer-term is that college grads have been a big portion of the consumer-driven economy. The source of all value add to the economy over the last 30 years is from white-collar professional services.

So you're worried that AI displacing these workers could hurt consumer spending?

Maybe skilled manufacturing or whatever new jobs are created by AI is going to fill that but we don't know what these jobs are. Right now, a lot of the good news is priced into the market but not necessarily the bad.

In the near-term, the other component that is worrying is that we are seeing middle-income consumers, which represent the bulk of spending growth, trading down. That's the other component that's troubling. And while some of the inflation triggers for lower-income consumers isn't accelerating as quickly, that's not the case for insurance and other bigger spend items for middle-income consumers. Higher income rental is rising faster than lower-income rentals. Now, there's a set of risks mounting for the bigger driver of consumption growth.

What is the outlook for the stocks beyond AI?

Every sector is seeing an earnings acceleration this year. Manufacturing, for example, is benefiting from this thesis of deglobalization and moving production closer to the consumer. Materials, energy and commodities are doing well because of this AI build-out and infrastructure spending, and these manufacturing-oriented companies haven't levered up — and have become much more disciplined around how they spend money. That's another sea change over the last 10 years.

But if we are returning to a more manufacture-intensive economy, I don't know if that's bullish for S&P multiples. One reason S&P multiples have been high is because businesses have been asset-light and less manufacturing intensive.

What would you want to own instead of tech stocks right now?

If I had a bunch of capital, I'd sock it in large-cap value. We are most bullish because of the total return prospects. Dividends and buybacks have slowed down for some technology companies that are spending more but have remained healthy in energy, financials and other areas of the market, including some of the manufacturing capex beneficiaries

You are seeing more red flags in the market. What stands out?

When there's massive outperformance of the high multiple, high expectation companies like we have seen lately, that tends to be a sign of speculation or FOMO. It's more psychological than fundamentals or valuation driven. On top of that, long-term growth expectations for the S&P 500, especially within technology and communication services, are close to record levels since the 1980s. That's a little odd because we just came out of a strong earnings cycle for a lot of these technology companies and folks expect them to still grow stronger.

Investors are paying close to the highest multiples for topline growth over the last 12 months so sales growth is really expensive.

Investors are supposed to be forward-looking. If we are in an inflation cycle, sales growth will be more abundant and you shouldn't pay for past sales growth because it's not scarce. Instead, the scarce resource may be margin stability, balance sheet strength or capital discipline.

What else are you watching?

Liquidity characteristics are also changing. After two bullish years of favorable equity supply and demand dynamics — with increased buybacks, privatizations and little equity issuance — it's now going the other way with initial public offerings and new equity issuances.

And you are seeing all these rule changes from the indicies [for new offerings like SpaceX], which always smacks of late-stage machinations.

Long-term interest rates, which have behaved relatively well. But if we go back to a 2022 [type scenario] when interest rates become unmoored, that could be a catalyst for a broader selloff.

What could be a trigger?

If there's no demand for long-term treasuries with continued sovereign risk in the U.S. and no attempt to solve the deficit problem, unless GDP accelerates. This environment of inflation, growth and maybe a little deregulation all push the long-end of the curve up. This is the environment where you want to think about companies throwing off cash instead of using cash, which gets me to large value.

Thanks, Savita.

Write to Reshma Kapadia at reshma.kapadia@barrons.com

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