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July 2023 / VIDEO

U.S. Equities Are Back in Favor

Earnings outlook for U.S. companies is trending positive.

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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In Europe, energy price relief may be on the verge of reversing, as a relatively warm winter has been replaced by a warm summer, leading to an increase in energy needs.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.


Key Insights

  • Tailwinds that have boosted equities outside the U.S.—including low energy prices in Europe and post-COVID reopening in China—are expected to fade.
  • Given the improved earnings outlook for U.S. companies, our Asset Allocation Committee recently increased the allocation to U.S. stocks from underweight to neutral.

From late 2022 into 2023, non‑U.S. equities—especially in Europe and China—significantly outpaced U.S. stocks. However, the tailwinds that drove outperformance in those regions may be peaking. Meanwhile, U.S. company earnings have rebounded after an extended period of deterioration. The gap in their performance relative to other global equities has narrowed by more than half (Figure 1).

U.S. Equities Bounce Back

(Fig. 1) U.S. equities vs. the rest of the world

Line charts showing that the MSCI All Country World Index ex U.S. has outperformed the MSCI U.S. Index for the period between November 1, 2022, and June 23, 2023.

November 1, 2022, through June 22, 2023.
Past performance is not a reliable indicator of future performance.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. MSCI Indexes. See Additional Disclosures.

European stocks rallied in early 2023, supported by sharply lower energy prices amid an unseasonably warm winter. But this price relief is likely to reverse as energy demand increases during the summer months. Colder temperatures in the coming 2023–2024 winter season also could boost energy consumption.

In China, robust economic activity driven by the post-COVID reopening appears to have faded, and stimulus measures to shore up economic weakness are unlikely to match prior levels given the government’s focus on financial deleveraging and ensuring that the benefits of economic growth are shared more widely.

Meanwhile, despite looming headwinds, the U.S. economy has remained resilient, and the U.S. earnings outlook is trending positive (Figure 2). U.S. growth stocks, technology stocks in particular, have been boosted by recent developments in artificial intelligence. Companies in the U.S. industrials sector also have benefited from higher demand spurred by the Creating Helpful Incentives to Produce Semiconductors (CHIPS) and Science Act, the Inflation Reduction Act, and corporate reshoring.

U.S. Growth Stocks Earnings Estimates Have Inflected Higher

(Fig. 2) Earnings outlook for U.S. growth stocks

Line charts showing earnings estimates for 2023, 2024, and 2025, and a corresponding bar chart showing earnings per share (EPS) growth for 2024 and 2025.

Actual outcomes may differ materially from estimates. Estimates are subject to change.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. FTSE/Russell Indexes. See Additional Disclosures.

Notably, valuations for U.S. stocks far exceed other global stocks. However, this valuation gap can be justified by differences in company profitability. U.S. stocks are more expensive because they have enjoyed a sizable advantage in profitability—a gap that has been expanding gradually for nearly 15 years.

Given this improved outlook for U.S. stocks, our Asset Allocation Committee moved its allocation to U.S. stocks from underweight to neutral relative to the rest of the world.

Additional Disclosures

MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2023. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.


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