Four reasons why the odds are stacked against US equities

With US equities up 21.4% in 2020, outpacing the rest of the world for the third consecutive year, many investors have been reluctant to diversify their portfolios globally.

This isn’t just a recent phenomenon. For the past 10 years, US stocks have beaten non-US stocks by an average of 8.7% per year (MSCI All-Country World ex US $ Index).

However, we may have reached a turning point in this cycle. Since November 2020, non-US equities have outperformed by 5.2%, as the rollout of Covid-19 vaccines bolsters optimism for a global economic recovery.  

So, are we approaching the end of America’s stock market exceptionalism? Here are four reasons that suggest we might be.

1. Cyclical opportunities lie outside the US 

During the pandemic, investors have sought the refuge of defensive growth stocks, which make up a large segment of the total US stock market capitalisation. These companies have soared in value amid lockdowns and increased demand for digital services.

However, if you believe that an economic rebound is now imminent, then it makes sense to start allocating outside the US. That’s because non-US equities have far more exposure to cyclical sectors such as energy, industrials and materials, which tend to perform well in a recovery.   

For example, whereas the US equity market only has a 37% market cap weighting in cyclical sectors, the rest of the world has a 55% weighting. This lower cyclical exposure means US stocks are unlikely to rebound as much as their global peers once the pandemic has ended.

2. US valuations are at their peak

One consequence of US outperformance is that valuations are now stretched to levels that would have historically foreshadowed low returns relative to the rest of the world.

For example, US share prices currently trade at 33x their cyclically-adjusted historical earnings (CAPE) compared to 18x for global equities. That’s the most expensive they’ve ever been in relative terms in 50 years (see next chart below).

To be clear, equity valuations are expensive everywhere. But that doesn’t mean a global stock market crash is imminent. It just means future long-term returns could be lower. And even if that is the case, relative valuations suggest non-US equities are likely to perform better than their US peers.  

3. President Biden could prove to be a tailwind for emerging markets

Emerging market (EM) equities have suffered as a result of US-China trade tensions under former US President Trump’s tenure. But under a Biden administration, analysts expect economic relations to be less fractious and for alliances to be restored with US allies.

This improvement in international relations and its positive spill-over effect on global trade activity should support export-orientated emerging markets.

Corporate tax rates are also expected to increase under Biden, which may deliver a sizeable blow to US earnings.  

Against this backdrop, investors have started to favour overseas markets. For example, EM equities have now overtaken the US in terms of cumulative performance since January 2020, as shown below. 

4. Tech market concentration may hinder future US performance 

The largest US technology companies - Apple, Microsoft, Amazon, Facebook and Google (Alphabet) - known as the “FAMAGs”, have benefitted enormously from the economic fallout of the crisis, as more people rely on their technology to work and shop from home. 

However, their market capitalisations have become so large that they are essentially driving the market. Since January 2020, the MSCI USA Index has returned 23%, but only 15% if we exclude the FAMAGs.

The problem with such index concentration is that it can drag returns lower for the overall US market if confidence in Big Tech deteriorates for any reason. 

One of the ways this could happen is through regulation. The US Democratic Party, which now controls both houses of congress, has been especially vocal about curbing their anticompetitive practices and multiple antitrust investigations are already underway against Facebook and Google.
 
Although unlikely in the near term, new regulations could slow down future M&A expansion, which has been an important ingredient for their success.

The worst is probably behind us

While the last decade has belonged to the US, conditions now seem increasingly ripe for a reversal towards the rest of the world.

There is no guarantee this will happen. New strains of Covid-19 may undermine any nascent economic recovery and investors may continue to favour the US. 

But this is bound to end at some point. US cyclical exposure to a global recovery is limited, relative valuations look stretched, market concentration has increased and EM equities are playing catch-up.

With this in mind, investors may be wise to diversify their equity portfolio outside the US over the coming decade.