Opportunities on the Horizon: Investing Through a Slowing Economy

Thematic updates | WEALTH OUTLOOK 2023 | MID-YEAR EDITION | 40 Through May, global equities have already matched a typical year’s annual return, up 7% year-to-date. But under the hood, the rally has been far from broad-based. 1 Of the $4 trillion in global market cap created so far this year, 89% can be attributed to just 10 companies, mostly US mega-cap tech names (there are 2,880 companies in the MSCI ACWorld Index). While these market cap-weighted indices have delivered solid gains, the average return across S&P 500 constituents is closer to flat. US small caps have also missed out on the rally. For many on the sidelines, the decision to buy equities or continue to sit in cash feels a lot harder. But the choice of whether to own the S&P 500 at 19x expected earnings or US T-bills at a 5% yield is an overly simplistic way of looking at the investment landscape. The global equity universe today presents us with plenty of compelling opportunities at reasonable valuations. Our Global Investment Committee recently added to shares in Asia, Europe, and Latin America which in aggregate trade at a 30% discount to the S&P 500. And given very top- heavy performance in the US, value is starting to emerge in profitable small- and mid-cap stocks as an additional alternative to expensive US large caps. Will the next cycle be different for non-US stocks? A common misconception among US-biased investors is that US stocks always have and always will trade at a premium to shares abroad. While this has certainly been true for the last decade or so, it is not a law of nature. In fact, for much of the last 100 years US equities have traded much closer to parity and sometimes even at a discount to their global peers ( FIGURE 7: EmergingMarkets Equities at Discount to US Equities in Currencies ). Over the past 15 years, however, US equities have gradually richened relative to international shares as America’s tech dominance offered investors a highly coveted segment of growth in an otherwise muted global growth environment. While global equities are unlikly to simply surge higher in the year ahead, we see both cyclical and structural tailwinds for non-US shares in the expansion that will eventually follow the present period of economic uncertainty. As we discussed in As US dollar dominance ends, currencies may drive returns , an eventual unwind of aggressive Fed tightening should take some steam out of the US dollar’s rally vs major currencies. As US interest rates fall, investors who flocked to higher-yielding US assets and high-quality US equities may need to look elsewhere in the world to find better value. Meanwhile, meaningful corporate governance reforms in Japan and Europe also look promising. Japanese financial authorities are actively incentivizing companies to return more cash to shareholders, catching the attention of some of the world’s largest investors. In Europe, conglomerates have been spinning off businesses at a premiumwhile simplifying their structures. Buybacks and M&A have also picked up this year. Lastly, long-term thematic trends can also explain US equity market dominance over the past decade. Growth in the major trends of the 2010s like social media, e-commerce, cloud computing, and smart phones were all dominated by US tech giants. But in the next decade, unstopable trends like global aging, electrification & decarbonization, and a rising Asian middle class may benefit more than just US firms. Pharmaceuticals, brands servicing emerging markets consumers, and clean energy leaders can be found across the global equity landscape. Investing with a US bias risks missing out on a key subset of these potential winners. Capturing improving value outside of mega-caps Aggressive monetary and fiscal stimulus during the pandemic was aimed at supporting businesses facing existential risks from the stay-at-home economy. This support helped smaller, riskier firms outperform the giants in the year following the 2020 COVID lows. But the side effects of that stimulus – surging inflation and sharply rising borrowing costs – have benefited large firms with scale and pricing power. Meanwhile smaller firms have lagged, giving up all of their post-COVID era gains. Small- and mid-cap stocks’ (SMID) tepid performance over the past two years means that valuations have improved, with profitable small cap names now trading at a 26% discount to larger peers. While large cap growth in particular has rallied in 2023, fast-growing small firms remain in the doldrums ( FIGURE 1 ) . Market expectations for a Fed pivot should change this paradigm, enabling a catch-up in small-cap