U.S. Equities Are Back in Favor

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U.S. equities experienced a rough period relative to the rest of the world late in 2022 and into 2023. While U.S. equities moved mostly sideways, stocks in Europe and China pushed sharply higher. European stocks were buoyed by sharply lower energy prices amid a surprisingly warm winter, while the Chinese stock rally was driven by post-COVID reopening.

But that trend has reversed since January 18, with U.S. stocks gaining back more than half of that deficit as of June 23.

The primary reason for this reversal is that the market is anticipating an imminent fading of the two primary tailwinds that have driven European and Chinese stocks higher.

In Europe, energy price relief may be on the verge of reversing, as a relatively warm winter has been replaced by a warm summer, leading to an increase in energy needs. Additionally, the coming winter of 2023¬–2024 may not prove as comfortable as this past winter. As a result, futures markets are pricing in an unwelcome increase in energy prices.

Meanwhile, Chinese economic activity is expected to fade as the initial pop from reopening passes. The services industry remains robust, but activity may soon match the fade seen in the manufacturing sector. And while further monetary and fiscal stimulus may be forthcoming from the central government, it is unlikely to be as aggressive as the stimulus measures seen in the past. This is because Chinese priorities have shifted away from meeting specific economic growth targets in favor of policies that promote common prosperity and financial deleveraging.

Meanwhile, the outlook for U.S. company earnings has rebounded and is trending in a positive direction after an extended period of deterioration. The inflection has been particularly notable among growth stocks—especially technology stocks—as recent developments in artifical intelligence have provided a boost to estimates despite the broader economic slowdown. Industrials, as well as some other cyclical areas, are also benefiting from accelerating demand resulting from the CHIPS and Science Act and Inflation Reduction Act, as well as the increasing trend toward “reshoring”.

Of course, these smaller trends may ultimately be overwhelmed by broad economic weakness if the U.S. economy plunges into recession. But thus far, the economy has proven extremely resilient despite sharply tighter monetary policy.

Many investors will point out that, despite the diverging earnings outlooks between U.S. stocks and the rest of the world, the valuations of U.S. stocks are considerably more expensive. As of June 23, 2023, the forward price-to-earnings ratio of the MSCI U.S. Index stands at 19.2x, compared to 12.8x for the MSCI All Country World ex U.S. Index.

But it is important to understand that this difference can be justified by the similarly large difference in company profitability, as evidenced by comparing the return on equity of the two indices. The return on equity for U.S. companies stands at 18.1%, while the rest of world is at only 12.7% as of June 23, 2023. More notably, that gap has been gradually expanding for nearly 15 years. This means that while U.S. stocks are quite expensive relative to the rest of the world, they are expensive for a reason. And until the market begins to believe that the ongoing divergence in profitability has peaked, it is unlikely that valuation concerns will matter.

In conclusion, the outlook for U.S. stocks has recently improved relative to the rest of world. And while U.S. stocks may be considerably more expensive, this difference is driven by the equally large advantage that U.S. companies have enjoyed in profitability. As a result, our Asset Allocation Committee has recently eliminated its underweight position in U.S. stocks relative to the rest of the world.

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