From the shadow of the 2008-9 global financial crisis, the S&P 500 has returned on average 13.5% per annum for a sterling-based investor. Over the same period the Japanese Nikkei returned 5.5% annually, with the FTSE 100 and Stoxx50 just 4.3% and 3.7%. respectively.
US corporate earnings have clearly been a key driver of US equity returns, growing by an average of 7% per annum, versus anaemic growth elsewhere. However, rising valuations on growing optimism have driven just under roughly half the returns, with the S&P 500 price earnings multiple 1 year forward rising from 14 to 21, representing a 40% valuation premium to the rest of the world.
As a result of this standout performance US equities now comprise around 70% of the global equity market, with the so called Magnificent 7 US tech behemoths accounting for 35% of US equity market capitalisation, having delivered 50% of the overall S&P 500 return from the end of 2022 to the market peak in February this year.
The catalyst behind the last two years’ performance and the aggressive narrowing in equity leadership has been the capex boom in artificial intelligence. During this period, investors have sought safety in quality growth mega-cap equities with strong fundamentals, pricing power, exceptionally strong balance sheets and wide competitive moats, while eschewing interest-rate-sensitive price-takers, on a reduced focus on fundamental value.
As a result, the market environment has been characterised by high levels of crowding in trend following, momentum-based strategies concentrated in US mega-cap equities and, as we have seen, in February this year it reached extreme levels.
This degree of market concentration is almost without precedent and over recent months we have been positioning for a broadening out in equity market returns by region and sector as the gap between earnings growth in the US and the rest of the world inevitably narrows. Even before the commitment by Germany to ramp up its spending on defence, investment and infrastructure it was apparent that earnings expectations outside of the US were inflecting higher. However, in the US the earnings outlook was deteriorating on elevated economic uncertainty driven by president Trump’s trade rhetoric.
Elsewhere, the US dollar underlined its status as the world’s reserve currency, appreciating 30% on a trade weighted basis since the global financial crisis. Furthermore, and as we have seen in the recent past, tariffs would ordinarily boost its value. However, over the long term we would argue that the gradual de dollarisation of global trade flows, the reduced appetite of central banks to hold dollars and Russia and China looking to develop alternatives to the SWIFT payments system combine to create a much more mixed outlook for the US dollar than has been the case in recent years.
As we look ahead, how the US equity market will evolve looks finely balanced. On the one hand the so-called AI ecosystem may deliver sufficiently strong earnings growth to justify the elevated valuations of the most highly rated technology companies. In this case the valuation gap between these and the broader corporate universe could begin to narrow as the latter play catch up.
However, and on the other hand, there is the risk of a lower adoption of new AI technologies, with companies less willing to invest in them. In this scenario this overinvestment on the part of the hyperscalers would see the valuation gap narrow via a de-rating of the most highly rated stocks.
In terms of the medium-term market environment, it is hard to say which way this will play out, but from a risk-adjusted perspective it supports a less US-centric equity allocation than a market cap weighting.
Outside of the US we like the UK equity market, reflecting attractive valuations and its defensive properties.
Elsewhere we are overweight to Japan, which in addition to a much more favourable domestic growth outlook is benefitting from long overdue corporate reforms to facilitate the unwind of cross shareholdings to enable businesses portfolio restructuring and increased corporate investment. This should help ensure that business and earnings cycles are less correlated with the rest of the world.
Finally, earlier this year we moved to a neutral stance on Europe, on the view that the markets were overly pessimistic on anticipated growth and corporate earnings delivery for 2025.
Jon Cunliffe is head of JM Finn’s investment office. The views expressed above should not be taken as investment advice.