Will U.S. Equities Continue to Outperform?

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Welcome to Advisor ToGo, brought to you by CIBC Asset Management. A podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Murdo MacLean. I’m a client investment manager at Walter Scott & Partners. 

The question as to whether U.S. equities will continue to outperform is an interesting one. 

I guess the question, first of all, is outperform what? And I suppose other markets is the suggestion there. I think that still is a dangerous thing to sort of predict, largely because the U.S. is home to a great many excellent world-class businesses, but there are also many excellent world-class businesses that exist outside of the United States, some of which we saw last year performing far better than a great many U.S. companies. 

I think historically, it’s been the case that for a while now, the U.S. markets have been stronger than most markets. But there are always, I think, possibilities where Japan or Europe or whatever will have a better year every so often. So I think, as bottom-up stock pickers like ourselves, we don’t really think about the global investment opportunity as a series of countries, but more a very broad set of opportunities that a stock picker can take advantage of. So, buy the best companies in the U.S., buy the best companies in Scandinavia, buy the best companies in Japan. And provided you don’t overpay for them, that tends to be a fairly successful recipe for delivering outperformance. 

The portion of the MSCI World Index that the Magnificent Seven, as they’re currently being called, was accounted for was really very significant. North of 20%, certainly, at points. The thing in the favour of these businesses being able to continue to outperform, or at least do well, is that they are good businesses operating, generally speaking, in healthy sectors of the economy, i.e., continuing to grow. They tend to be relatively asset-light given their technology sort of skew, which means that they’re highly cash-generative. 

All of these businesses have been around a while, which is good. They’re not startups, unproven and such. I think there’s good reason to believe that there’s a lot of favourable tailwinds for them to continue, certainly the long-term time horizon, to do a good job. We have exposure to a couple of them, them being Microsoft and Alphabet. The others that we don’t invest in, there are various reasons why we do not, but that’s not to say that they’re not good businesses. But over the long term, these businesses should continue to do well. 

Will they dominate to the extent they did last year? Perhaps that’s a little less likely. We’ve certainly seen signs this year so far that the likes of Tesla and Apple have folded a bit. Now, each business, it’s important to remember, is operating in its own sort of environment. There are a few things that bind these seven together, but not all that much. They operate in very distinct markets in different sectors, for that matter. So I think it’s risky to really make these sort of sweeping suggestions or assumptions around seven quite different businesses. 

I think the other thing to be mindful of is that all of them trade on slightly different valuations. And so on one hand, you have an Alphabet, for example, trading on a high price earnings multiple. And on the other hand, you have Nvidia, for example, which trades at a substantially higher multiple than that. And so the risk in each of those businesses will relate to the fundamentals of those companies stacked up against the valuation that stock trades on. The higher the valuation, the more good news is in the price. 

I think investors just need to be cautious that the Magnificent Seven are a diverse group of businesses thrown together to make a nice, neat, pretty acronym. And they all fill different models with different growth rates and different business sort of profiles. 

Our view at Walter Scott is very much that over a reasonable timeframe, several years if not longer, the sort of sectors that outperform are those that have companies that can generate higher levels of growth but also higher levels of profitability and returns. And there’s sufficient evidence over the past 15 years or so that those sectors with the highest return on equity have also delivered the best returns for investors. And equally, those sectors were the poorest ones. In some cases, might’ve even failed to keep up with the index. So, we don’t really think there’s any reason to change that view. 

In the short term, you could have a situation whereby, such as we had in 2022, energy was the only sector that was positive, and that’s highly unusual. And indeed, energy had really been coming off of a very long stretch of poor performance with energy prices being very low, and so there was a significant amount of upside for that sector. But longer term, you wouldn’t expect energy to outperform because many of the companies don’t generate sustainable, consistent levels of profits. 

And so you’d look at a sector such as technology, given the constant innovation there, and the continual sort of evolution in that space, and fairly high conviction that in the next five to 10 years, there will be a number of new businesses that come onto the radar in technology. And the whole space is growing, so there’s lots of opportunities for growth there. 

I think healthcare is really interesting, though, in the context of this year, albeit it is an election year. However, a lot of healthcare businesses have been struggling post-pandemic with labour shortages, with bottlenecks in hospitals, with budget constraints. All of these factors have meant that some very, very good businesses in the healthcare space have actually underperformed because of these factors. That has led to a number of them actually looking quite attractive on an evaluation standpoint. Should those bottlenecks and restrictions begin to ease more significantly, I think there’s a very good chance that healthcare could have a much better year, and so that’s certainly one to keep an eye on. 

I think in the industrial space, there’s some very good businesses. And the consumer space, as always, it’s such a mixed bag. It’s not just a bunch of supermarkets and fashion retailers. There’s a huge amount of different businesses within the consumer-discretionary and consumer-staples space. I think although the consumer is challenged right now, any signs that the interest rate environment may be beginning to be relaxed will be positive for the consumer as it is for businesses, and we may well see some stronger performance there. 

But I think it would be unwise to predict that the sort of long-term winners necessarily do anything different. But as I say, you have to caveat that with 12 months is not a very long period of time within equity markets, and so unusual things do and can happen. 

I think we are currently focused on a five to 10-year view here at Walter Scott. The fact that our exposures sectors currently reflects that technology and healthcare and the consumer space are likely to continue to do better, that is why we have a significant exposure to those sectors, and why we have less exposure to those sectors that are more cyclical and perhaps not capable of the sort of levels of returns that we would look for. 

A lot of excitement around Japan last year. If you were a yen-based investor, then it was a good year, but a lot of that was lost in the weak yen if you were not a sort of domestic investor. That’s worth keeping in mind. A lot of excitement around Japan relates to corporate governance reform, M&A, and also, of course, weak yen making these companies profits look better. But I would say that Japan, or many other countries, the outlook for those countries doesn’t change that quickly, and it certainly isn’t determined simply by the direction of the yen. 

I think Japan continues to have some very good businesses, no question, some of which we invest in, but their country also faces many challenges in terms of the highs or debt to GDP, the aging demographic, which they are very well known for, the inefficiencies within the corporate landscape, the long way to go before we still see tangible corporate governance reform. We see pockets of it, but is it still a long way to go? Given the fact that the [inaudible 8:28] sector continues to be laden with quite a lot of debt taken on in years where the interest rates were low, those companies are sitting on a lot of that debt, which is costing a lot more. 

Any company sitting in a sector that has too much debt relative to its capabilities to generate capital is a risk because at some point, they will have to refinance that debt, and that will be painful. But you must also consider the fact that where they got that debt from is typically lenders, banks. There is a lot of potential in the banking sector for nonperforming loans to escalate quite significantly if we do not see material rate cuts in the near future. I think it’s wise to be cautious, as we always are, on the financial space, particularly in the banking sector, because what we know to be true is that they make loans for a living, but the visibility around the health of those loans is often very difficult to get a handle on. 

We saw at the outset of last year the issues in the sort of regional banks, made most famous by Silicon Valley Bank, of course, and the fact that nobody saw that coming. Regulators didn’t see it coming. Investors didn’t see it coming. And so I think one must be very careful about the financial space, particularly in the banks, because of the low visibility and because of the dramatic shift in monetary policy. That’s why we don’t own any banks and haven’t for a while. I realize in Canada they’re very well-owned, but nonetheless, we have the whole world to choose from, so there’s a slight difference in the universe we’re talking about here. 

I think in terms of regions, China has really had a very tough period for several years, and understandably so. Very, very significant restrictions during the pandemic imposed on the people, a very slow reopening, and then a bit of a sluggish recovery. Certainly, if you were to take that, sort of most people’s views going forward, they might say, “Well, China, with all of its issues, looks like a bad place to invest.” 

I suppose, having visited the country twice last year, we have a slightly more constructive view of China. We don’t own Chinese businesses, but we do own companies with exposure to China. Those visits definitely highlight the fact that there is a recovery going on. The Chinese population are out and about, they’re consuming, and the government is very much incentivized to support that recovery. It may take slightly longer than the market would like, but it’s definitely underway, the real estate sector aside, because that certainly has issues to work through. 

There are, I think, still plenty of pockets where you can be relatively bullish on China, and particularly from a starting point where valuations are multi-year lows, if not record lows at some points so far in the last 12 months. 

On the face of it, it’ll continue to be risky, might well underperform, but there are grounds, I think, at least to be a little bit more optimistic about that market than that might be the case if you were to just look at the last couple of years of performance.