While rates may have already peaked, economic activity across regions remain uneven. The US is emerging as an economic leader within the developed world, which may benefit US large-cap equities over the coming months.
The correction in the S&P 500® Index observed since August created an interesting entry point as valuation multiples moderated, earnings and economic activity surprised to the upside, and disinflation is likely to continue.
The United States economy has been one of the brightest spots in 2023. The country was largely expected to be an epicentre of global slowdown — with just 0.1% GDP growth forecasted for 2023 at the start of the year — but has instead been the growth engine of the developed world. Economists are now pencilling in a 2.2% expansion for 20231. Economic activity continued to surprise to the upside in October with US Services PMI at 50.9 (versus 49.9 estimate) and Manufacturing PMI at 50 (versus 49.5 estimate)2. This stands in contrast with weakening prospects for European economies.
Inflation, which has been the key concern, has already significantly moderated with annual CPI at 3.7% and core CPI at 4.1% in September. The excess demand is gradually being drained by monetary tightening while supply chain pressures have also eased materially3. Higher oil prices pose a risk to the inflation path, although on a relative basis, the US is less dependent on imports compared to Europe or Japan.
However, the most remarkable part of the macroeconomic picture is that the battle against inflation is being won, but the labour market remains remarkably resilient with the unemployment rate at 3.8% and job openings at 9.6M. The low unemployment is not causing an inflation spiral, as wage growth moderated to +0.2% in both August and September.
The stock market is not the economy, but the US expansion is pivotal for US large caps as companies within the S&P 500 Index generate 59% of the revenue domestically, which is a relatively high proportion for a large-cap index; in comparison, the corresponding numbers for the MSCI Japan is 47% and just 42% for the MSCI Europe4.
While the EPS for the S&P 500 Index have been revised down throughout 2023, US large caps exceeded the lower hurdle in Q2 by 7.7%. The Q3 season has started strong with 146 companies reporting as of 25 October, delivering a 7.1% surprise5. While companies often note that there could be risks to demand stemming from higher interest rates, their earnings continue to beat expectations. From here, disinflation combined with a resilient US consumer is likely to drive a rebound in economic activity, translating into earnings growth next year. Indeed, 2024 S&P 500 Index EPS growth is expected to reach 12%6.
As of 24 October, the S&P 500 delivered a year-to-date gain of 11.7%, predominantly driven by the “magnificent seven” stocks. The pullback that began in August, combined with strong earnings prospects for 2024, brought 12-month forward price-to-earnings (P/E) multiples to 17.8x. This is close to the 10-year average and could offer a more appealing entry point for investors.
While we watch valuation multiples closely across regions, it is important to note that the US equity market is structurally supported by secular trends like AI, broad innovativeness and market position. This allows analysts to pencil in potentially higher earnings growth justifying, to a certain extent, higher P/E multiples compared to other regions.
S&P 500 Index Performance and Valuation
Equities in general, and the S&P 500 in particular, are very sensitive to yield. The primary implications of a higher yield on the S&P 500 are:
In our view, 10-year yields may have gone too far and with current levels became another disinflationary force. This may allow the Fed to start cutting rates in 2024 more rapidly than is currently priced in, supporting both the US economy and equities in the medium term.
Increasingly, investors are looking for exposure to the S&P 500 Index with an ESG lens. S&P 500 ESG Leaders applies a best-in-class ESG methodology to the S&P 500 Index. The range of ESG exclusions and selection based on ESG rankings results in an index of 200 stocks. On a sector basis, the largest sector differences are a 4% overweight to Consumer Discretionary, and a 3% overweight to Information Technology. Most of the other sectors are somewhat underweighted, with the largest underweight at -3% in Health Care. S&P 500 ESG Leaders has outperformed its parent index (S&P 500) by more than 6% in the last 12 months. It also has better returns on a 3-, 5-, and 10-year basis with very little additional risk, and a tracking error of 27.