We favor U.S. stocks to their other developed market peers over the next six to 12 months. Why? The U.S. policy response to the coronavirus shock has been decisive and comprehensive, and has exceeded the scale of policy action in other major developed economies. We expect more to come. The relatively high concentration of quality companies in the U.S. market is also supportive, in our view.
We see the quality tilt of U.S. stocks as supportive in today’s uncertain economic environment. This is reflected in the outsized weight of U.S. companies in the MSCI ACWI Quality Index. U.S. stocks account for more than 70% of the index, nearly 14 percentage points higher than the weight they occupy in the parent MSCI ACWI Index. Other DMs and emerging markets are underrepresented in the quality index, as the chart above shows. The sector composition of the U.S. market may partially explain the quality bias. Information technology is the biggest sector on the MSCI USA Index, making up more than a quarter of its market value. The communication services sector – which includes top Internet and social media companies – takes up 11%. Health care, which tends to have a high return on equity, stable earnings growth and low leverage, makes up an additional 15%. These three sectors account for more than half of the MSCI USA Index, compared with 33% and 28% in MSCI’s Japan and Europe indexes, respectively.
U.S. stocks have rebounded more than 20% from the lows in late March, when decisive policy actions were announced to help bridge the economy through the coronavirus shock. This has helped them outperform other DM equities. We believe that the U.S. activity shortfall from the current economic standstill is initially likely to be more than twice as large as the global financial crisis. Yet over the longer horizon, the cumulative impact – the sum of activity lost every quarter relative to its pre-shock 2019 trend – will likely be less severe, as we argue in how large is the coronavirus macro shock? The reason is the historic U.S. policy response that includes a fiscal package of more than $2 trillion, and extraordinary measures from the Federal Reserve to cushion the economic and market impact of the coronavirus shock. The U.S. fiscal package is equivalent to about 10% of the U.S. gross domestic product (GDP), the largest among key DMs, and we believe there may be more to come. Overall, we see more policy room in the U.S. than in other DMs in coming months to help shore up the economy, but recognize that successful and timely execution of fiscal measures is a key risk everywhere, including in the U.S.
To be sure, the near-term picture for corporate earnings is dire as the first-quarter earnings season kicks off: Analysts expect Q1 earnings of S&P 500 companies to contract 7.3% year-on-year – the largest annual decrease since the third quarter of 2009 – according to FactSet. Yet earnings estimates for sectors with defensive characteristics or positive long-term growth prospects have held up much better than those of cyclical sectors. Q1 earnings of the communication services sector is expected to grow 8.8% on the year, versus a 41% decrease in energy, for example. Technology and healthcare are also among sectors with positive earnings growth estimates. In another sign of the defensive nature of these sectors, the dispersion of earnings forecasts across companies within them has risen much less than in many cyclical sectors.
The bottom line
We prefer up-in-quality and up-the-capital-structure exposures, especially those with strong policy support, over the next six to 12 months. Within equity markets, that means a preference for the U.S. market and the quality and min vol style factors. We also prefer credit over equities given bondholders’ preferential claim on corporate cash flows in a highly uncertain economic environment. We stay neutral on global equities on a tactical horizon, recognizing the wide uncertainties around the path of the outbreak in coming quarters, but see value for investors with long investment horizons.