Global equities have pushed higher since our June 30 quarterly asset allocation outlook. The global equity market is up a very solid 15% in US$ terms year-to-date (19% in A$ terms).
The US market has led the way, rising 16% year-to-date (20% in A$). With earnings stalling in CY23, the strong rally has meant the US market price to earnings ratio (PE) has risen this year from 17x to just over 19x, based on 12-month expected earnings. As confidence around a US soft landing has gained traction, market breadth has improved, although mega cap US tech has done a lot of the heavy lifting year-to-date.
An apparent levelling off in the previous sharp rise in long-term interest rates has helped the revival in long-duration US tech (figure 2). Better-than-feared earnings from the big US tech companies have also helped the sector revive, and excitement around the earnings upside of the AI revolution has further boosted US tech, particularly the dominant mega caps.
A key plank behind our constructive view of US/global equities at the start of the year was the view that positioning and sentiment toward equites was very cautious and indeed outright negative coming into 2023. This view was premised on fears the US would lapse into recession by around mid-2023. Lingering fears around sticky inflation also combined with recession fears to keep many investors on the sidelines.
Our own view was that a 2023 recession was unlikely and inflation was peaking. This tilted us to a positive view on global equities, particularly with a backdrop of cautious investor positioning. Positioning and sentiment are no longer cautious and US market valuations have expanded. This suggests global stocks would likely be vulnerable to any significant bad news, be it growth-, inflation-, or financial system-related.
To be clear, our core view is still reasonably constructive. On balance, we expect a continued slowing in US inflation and slower but not recessionary gross domestic product (GDP) growth, with a return to modest US earnings growth. However, after strong gains for the year-to-date, we expect at least a period of consolidation is due. In our base case, we still see moderate positive returns on a 6-12-month view, although the very strong returns witnessed so far in 2023 are likely behind us.
Are US Valuations Sufficient Reason to Be Bearish on Equities?
While recession and inflation fears have ebbed from the gloomy consensus predictions of 6-9 months ago, the issue of valuation is once again beginning to be advanced as a reason to be cautious on global/US equities.
Concerns around US market valuations in particular have been a recurring bear point for many commentators. Indeed, US overvaluation concerns date back to the “irrational exuberance” comments from former Fed Chair Alan Greenspan in 1996. While there have certainly been some periods of genuine “irrational exuberance”, most obviously around 2000 and in 2021, the US market has repeatedly defied the valuation bears. Importantly, superior US earnings growth has been an under-recognised driver, while the premium to rest of world has expanded rather than mean-reverted.
Our Current View
At current levels, the US market is not at a bargain level and is probably “mildly” expensive. As a result, our near-term view is that we see near-term consolidation and a moderate (fair) return on a 12-month view.
While we are cognisant of PE expansion in US equities, we note that the US market has looked expensive for much of the past 25 -30 years (particularly over the past 10 years), versus its own valuation history.
The move away from very low interest rates was supposed to spell the death knell for US tech and the high valuation of US equities. It was certainly a catalyst for a significant correction, but valuations have rebounded quite quickly. Interest rates are important to valuations, but so is return on capital and growth potential.
To our mind, the quick rebound in valuations suggests the natural level of US valuation is higher than a simple long-term average would suggest. The US mega caps (the magnificent 7) are trading on around 30x forward earnings (cap weighting this basket). We expect some consolidation in the mega cap advance and we are becoming more selective in this space, but we generally do not think the mega caps are outrageously valued given their strong growth prospects.
Digging deeper into the US market valuation and excluding the mega caps, stocks look less demanding at about 16x expected earnings. Valuations outside the US are much less demanding (the world ex US is trading on 13x), although there is likely more cyclical economic risk in Europe relative to the US. We believe that on a quality-adjusted basis the US should trade at a large premium to the rest of the world, although taking a strategic view, we feel the global market outside the US looks undemanding, even with some cyclical risk to earnings.
We retain a neutral to marginally positive view of global equities, although some consolidation looks likely. We are not particularly bearish on US stocks or mega caps, despite their strong run, but more stock-specific selectiveness is likely to be required going forward. At the global level, we remain diversified by geography and style (growth, value, quality). In addition we hold satellite investments in emerging markets and global small caps.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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