Despite a credit rating downgrade, the trading environment remains supportive of alpha
The decision by rating agency Fitch to downgrade the United States’ credit rating from AAA to AA+ on August 1 sparked a fresh round of debate about the economy and the outlook for U.S. stocks. Amid the din that ensued, it’s easy to forget that the U.S. economy isn’t the same as U.S. stocks.
For instance, the percentage share of revenue for the S&P 500 Index is evenly split between services and goods; however, U.S. GDP is made up of mainly services, at approximately 70%. Goods make up a 20% share of GDP, and the remaining 10% is from government spending.¹
Although current consensus thinking is that the U.S. economy is poised to decelerate meaningfully and may be heading into a recession, we think it’s incorrect to assume that opportunities can’t still be found within the U.S. markets. On the contrary, we believe the U.S. stock market offers compelling opportunities to investors relative to the rest of the world.
1 Favorable demographics
“Demography is destiny” is a saying widely attributed to French philosopher Auguste Comte that continues to ring true today, albeit in a slightly different form: Demographics are an economic growth driver. From that perspective, the United States does fare a lot better relative to its developed-market peers.
U.S. old-age dependency ratio is expected to be lowest among developed nations by 2075
Source: Organisation for Economic Co-operation and Development, as of August 3, 2023.
Research from the Congressional Budget Office suggests that the number of people in the country between the ages of 20 and 64 (i.e., those who are likely to be the most productive and economically active) is likely to keep growing until 2070 before the trend reverses.² Crucially, the old-age dependency ratio³ in the United States is expected to be one of the lowest among developed economies. This suggests that the U.S. economy is likely to remain strong and well positioned to outperform its peers in the years ahead.
2 A commitment to driving technological advances and innovation
The United States continues to be a leading player in pure-play technology and across the healthcare complex. In our view, this speaks to U.S. companies’ commitment to innovation and technology that’s going to be difficult to replicate elsewhere.
Many would agree that the country led the rest of the world during the pandemic with COVID-19 vaccines and therapeutics. In the midst of this calamity, U.S. healthcare companies persisted with unprecedented innovation and medical advancements that should continue to provide a fertile opportunity set for market-beating growth. Research suggests that patients recovering from COVID-19 infections could face an elevated risk of cardiovascular issues, diabetes, and central nervous system diseases—a development that would lead to a rise in demand for treatments.
Encouragingly, U.S. firms within healthcare are continuing in their quest to address urgent but as yet unmet medical needs. For example, type 2 diabetes (T2D) is recognized as a serious public health concern with a considerable impact on human life and health expenditure. Insulin, one of the most common treatments of T2D, increases patient weight and the potential risk of obesity, which can trigger other issues and diseases such as joint replacement and various cancers. A few pharmaceutical companies have recently developed a breakthrough drug that can treat both T2D and obesity. Once these treatments are commercially available, they could potentially reduce the incidences of cardiovascular death, heart attack, and stroke in overweight patients.
Research and development spending by country/region
Source: OECD Main Science and Technology Indicators, April 2023. EU-27 refers to the European Union. USD refers to the U.S. dollar.
On the technology front, many market commentators have noted that the bulk of positive U.S. stock market performance in the first half of the year has been driven by a small group of tech companies. While the rally may lack breadth, what’s impressive is that every single one of these firms is a U.S. company—each of them a global leader within their segment with a reputation for investing heavily in research and development. In our view, this speaks to U.S. companies’ commitment to innovation and technology that’s going to be difficult to replicate elsewhere.
It’s difficult to deny that our lives are becoming increasingly enmeshed with technology—what’s the likelihood that technology will play a smaller role in our lives five years from now? Probably very low. Roughly 28.0% of S&P 500 Index companies are tech firms, but the sector only represents less than 7.5% of the STOXX Europe 600 Index and the MSCI China Index. The picture’s slightly better in Japan, where the weighting of the technology sector stands at around 14.0%, but that’s still markedly lower than the S&P 500 Index.⁴
Ultimately, the million-dollar question is this: In light of our evolving relationship with technology, which market is most likely to provide the best form of exposure to the sector? The answer, in our view, is obvious.
3 Macro fundamentals
Uncertainty is rising—it’s a refrain that’s come to define the trading environment in light of the rapidly evolving geopolitical backdrop. However, if we were to go back to basics and just focus on key macro fundamentals, it’s clear to us that the argument for investing in the United States remains cogent and deserves attention.
- Demographics, again
First and foremost, the United States hasn’t lost its demographic advantage relative to its peers in the developed world; in fact, it also isn’t faring all that badly relative to emerging economies. News headlines about an aging population and declining fertility rates may spark concerns, but a detailed analysis shows that the country will likely retain an edge over its peers and rivals on this front.⁵
U.S. fertility rates may have fallen below the replacement level since 2009, but it’s a dilemma that Japan (1970s), Continental Europe (1970s), and Mainland China (1990s) have been grappling with for decades.⁵ In contrast, the United States’ total population and working-age population are expected to keep rising for the next 50 years or so. As mentioned earlier, this represents the peak spending years for consumers, therefore providing a positive macro backdrop.
The United States has been producing more energy than it consumes since 2019.⁶ Given the challenges that Continental Europe faced this past winter in the aftermath of Russia’s invasion of Ukraine, it’s undeniable that the United States is in a much better position on the energy front relative to many of its peers—at the very least, it’s less likely to be affected by attempts from players who might consider using energy products as a bargaining tool.
Despite the significant amount of investment that will be needed as the world transitions toward green energy, the global economy remains heavily dependent on traditional fossil fuels. While the United States is a leader in terms of that spend and has been clear about its desire to shift to more green energy sources, the country's status as a net energy exporter gives us confidence that it's well positioned to navigate the long transition period.
The transition to green energy is likely to take a long time
Source: Energy Institute Statistical Review of World Energy, June 2023. EU-27 refers to the European Union.
Mean reversion, or a continuation of the mean?
The mean reversion theory, which posits that asset prices tend to converge to the average price over time, is a persuasive one. It’s psychologically intuitive since it’s aligned with a maxim that many of us have been taught in school: What goes up must come down (and vice versa).
It’s often cited by investors who opted to increase their allocation to international equities and reduce their exposure to U.S. stocks. On the surface, this appears prudent: After more than a decade of underperformance against their U.S. peers, mean reversion must surely be on the horizon. But due to the factors outlined above, we don’t expect the trend of outperformance to change anytime soon.
As a bottom-up investment manager that focuses on company fundamentals, the team can’t help but feel that such an investment approach risks being overly simplistic. There’s little to justify the belief that stocks that have underperformed over a period of time (i.e., international equities) would inevitably catch up and ultimately outperform. In our view, we’re more likely to see a continuation of the mean (i.e., continued U.S. equity outperformance) as opposed to a reversion of the mean.
U.S. profit margins tend to lead other markets
Source: Bloomberg, July 2023. Past performance does not guarantee future results.
Markets have historically placed a higher multiple on companies with the best growth prospects and higher margin profile; based on the factors we’ve highlighted, we’re of the view that U.S. stocks are best positioned to deliver higher growth over a multi-year period. In addition, relative to country/regional-specific indexes, we believe that the S&P 500 Index offers one of the best returns to investors.
Risk factors to monitor
The trading environment is becoming increasingly complex. Investment managers can no longer stick to analyzing balance sheets and profit-and-loss statements—monitoring geopolitical developments has become a critical part of the job.
One key risk that we’re monitoring is the world’s access to leading-edge semiconductors, used for AI and quantum computing applications. More than 90% of leading-edge semiconductors in the world are manufactured in Taiwan, with the island producing more than 6 out of every 10 semiconductors used worldwide. The global economy can expect to be dealt a heavy blow should it suddenly lose access to Taiwanese semiconductors as a result of tensions in the Taiwan Strait.
We’re also wary of the creeping short-term mentality that’s become increasingly commonplace, with investors reacting to short-term narratives about specific companies that had dominated market chatter instead of drilling down into company fundamentals and taking the longer-term view. Several of the market’s top performers in H1 2023 were among last year’s worst offenders, mainly because investors bought into the narrative of the moment and punished these firms for investing heavily in research and development. It’s important not to lose sight of the bigger picture and instead focus on a multi-year investment horizon while keeping an eye on inefficiencies that can potentially lead to attractive investment opportunities.
We’d even go as far to say that we’re in one of the best stock picking environments since before the global financial crisis.
A stock picker’s market
All things considered, it’s fair to say that the outlook for the equities market is a little more mixed; however, we do find the return profile on individual stocks in the United States highly attractive, particularly in comparison to the rest of the world. We’d even go as far to say that we’re in one of the best stock picking environments since before the global financial crisis, and here’s the best part: We expect this environment to continue for some time to come.
1 Bloomberg, July 2023. 2 Congressional Budget Office, as of January 24, 2023. 3 The old-age dependency ratio is defined as the number of individuals aged 65 and above per 100 people aged between 20 and 64. 4 Bloomberg, as of June 2023. 5 “America Hasn’t Lost Its Demographic Advantage,” Foreign Affairs, May 24, 2021. 6 U.S. Energy Information Administration, as of July 26, 2023.
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