Weekly ETF Brief

Equity Outlook: At the Turn of the Tide

The long-awaited Federal Reserve (Fed) rate pivot has finally arrived, with an outsized 50 basis point cut delivered on 18 September. US interest rates are now on an easing path, accompanied by a gradually slowing but still exceptionally resilient US economy and labour market. The soft landing continues — benefitting risky assets — but in our view some finesse will be required going forward, given performance, valuation, and concentration levels in tech-related stocks. Investors should search for opportunities beyond mega cap names.

26 September 2024 6 min read

Krzysztof Janiga, CFA

Senior Equity ETF Strategist

From Performance Concentration to Performance Broadening

The rally observed at the beginning of 2023 was extremely narrow, with the Magnificent 7 stocks — led by Nvidia — capturing a disproportionate share of the upside move. However, as Q3 unfolded market performance began to broaden, and tech giants underperformed. The challenge with a continued overweight in mega cap names is that their strong performance led to a significant rerating — making this segment of the market more vulnerable to any softening of elevated expectations related to AI monetization and growth. This vulnerability was clearly visible after Nvidia’s results. Investors may therefore search for opportunities in exposures with less expensive valuation levels.

US Exceptionalism Continues

The US economy and labour market have been remarkably resilient in the face of monetary tightening. Unemployment is low in many parts of the world but the estimated average US GDP growth of 2.1% in the next three years is expected to exceed other developed economies such as Eurozone or Japan, where growth is forecast to remain anemic at 1.2% and 0.7% respectively¹. Economic exceptionalism remains intact and is driven by consumer and fiscal spending. In this “soft-landing rate cut” environment we believe investors should search for opportunities within the US but with more attractively valued and more domestic exposures. The preferred play may differ depending on the market volatility investors expect.

US Small and Mid Caps: Risk On

A broad-based US equity rally is a likely outcome following the beginning of the rate cutting cycle. In this scenario the Russell 2000 Index or S&P MidCap 400 Index are particularly well positioned given these are domestic exposures generating from 76 to 80% of their revenue within United States². As such they offer exposure to US exceptionalism in a most direct way. The cyclicality of small and mid caps may be a tailwind as the growth rates in the US economy have been chronically underappreciated. The Russell 2000 Index offers perhaps the most upside while the S&P MidCap 400 Index is a more balanced option, bringing cyclicality, domestic profile, and undemanding valuations. It also offers exposure to companies with stronger balance sheets and higher earnings quality.

How to Access the Theme

US Dividend Aristocrats: Defensive Approach

Since the start of the third quarter of the year, market participants began to position for a broadening of equity market performance. Small caps and dividend aristocrats have both outperformed the Magnificent 7. It was not a smooth path as volatility rose in early August and early September. Against that backdrop the defensive profile of US Dividend Aristocrats offered much needed protection, outperforming the S&P 500 by a wide margin with lower drawdowns in days when markets sold off. Investors who expect volatility episodes to continue may find the S&P US High Yield Dividend Aristocrats Index to be the most appropriate tool in the current environment. Its significant underweight in technology allows investors to play broadening while its overweight in defensive sectors — and the ability to generate cash flows — provide protection against threats from slower growth or higher inflation.

How to Access the Theme

European Exposures: Opportunities in Dividends and Small Caps

The outlook for European equities is more mixed. European economies have avoided deep recession and central banks are already cutting rates hence this is a European version of a soft landing — but with much more sluggish growth. With that in mind, the medium term picture for European large caps looks grim — China’s economic slowdown and geopolitical stance are major headwinds for European exporting companies. Against this backdrop we would encourage investors to consider more exposure to domestic small caps or turn towards Euro Dividend Aristocrats which are underweight Technology and Consumer Discretionary. The latter is a sector which includes luxury goods and autos, the two areas which are most China-reliant.

How to Access the Theme

EM Small Caps: Embracing Opportunities, Avoiding Threats

Investors may want also to gravitate towards emerging market (EM) equities for reasons of economic growth, US dollar weakening or diversification. The elephant in the room is China, which represents 24% of the MSCI EM Index and remains the key performance detractor due to its geopolitical stance, weakening domestic economy, and uncertainty around its regulatory stance towards its own technology sector. The MSCI EM Small Cap Index offers a simple solution to that challenge, as it is heavily underweight China which accounts for only 8% of the index. Instead it overweights India which represents 30% of the index, and is an economy that expanded by 8.2% in FY23-24 and is expected to grow by ~7% over the next two years³. Beyond India, two important components are Taiwan (22% of the index) and South Korea (12%), both high quality emerging markets that remain indispensable parts of the semiconductor and broader electronic equipment supply chain. This country mix has led to significant outperformance of EM small caps over large caps since late 2020 and we continue to see it as a tailwind. Valuations do not look stretched.

How to Access the Theme

Footnotes

Disclosure

Marketing Communication
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