US Equities: Flight to Quality amid Elevated Uncertainty
US equities could offer a degree of protection against current geopolitical uncertainty, notably given their lower dependency on Russian resources.
Strong earnings growth combined with challenged performance to start 2022 have led to improved valuations for the S&P 500, the bellwether US large cap equity index.
Investors who prefer a more domestic and cyclical mix could consider S&P MidCap 400 or Russell 2000 exposures.
Amid geopolitical uncertainty, investors may seek less impacted parts of the market, such as US equities. While global growth may deteriorate due to the implications of the Russian invasion of Ukraine, for now a recession is not priced in, especially in the US economy. Indeed, the US economy is not heavily dependent on Russian natural resources, including oil and gas. We believe that in the current environment US large cap exposures, such as the S&P 500, may be the optimal choice as they combine robust earnings and relative resilience to the crisis.
The S&P 500 index rebounded sharply after the initial shock of the COVID crisis thanks to immediate monetary support. However, the relative outperformance of US large caps, compared to other regions, was driven by a strong US economy and the company mix within the index. Indeed, the S&P 500 has a large weight in technology companies from various sectors. These tech giants look set to continue growing in the longer run, benefitting from structural mega trends. Their strong performance in the COVID era was often attributed to the long “duration” nature of companies within the large cap index.
However, amid uncertainty, the strong demand for products and services of companies within the S&P 500, coupled with a robust US economy, have been equally important. We believe that the S&P 500 may yet again offer a level of protection against this new geopolitical uncertainty, which, unfortunately, may persist longer than necessary.
Until recently, the biggest challenge facing investors looking to add to US large cap equities was elevated valuations. However, strong earnings from US large caps and poor performance so far in 2022 significantly improved the 12-month forward price to earnings multiple, which now sits at a relatively undemanding 18.6x, below the level of 20 February 2020 (as presented in Figure 1).
Although monetary policy tightening remains one of the challenges to navigate and a rate lift off in March of 25bps minimum is fully priced in, the path and the pace thereafter are more uncertain, particularly when it comes to quantitative tightening. US 10-year treasury yields remain anchored around 2% for now, providing support for the increasingly attractive relative valuations.
Figure 1: S&P 500 Performance and 12-Month Forward P/E
How to play the theme
Investor can access S&P 500 equities through the SPDR® S&P® 500 UCITS ETF. To learn more about the ETF, and to view its full performance history, please visit the fund page.
More domestic and cyclical alternatives for positioning with US equities
Investors could also consider adding US equity exposures beyond large caps. Both US mid and small caps offer distinct features not only due to their smaller size and more domestic profile but also given their more cyclical sector split relative to S&P 500 (see Figure 2). The S&P MidCap 400® Index, with a 12-month forward P/E of just 14.4x, could be a preferred strategy under a scenario in which the US Federal Reserve tightens monetary policy more aggressively. The less demanding valuation of the index would then serve as a cushion against expanding yields.
On the other hand, the Russell 2000® Index, or small cap index, represents a higher risk-reward exposure that is best suited to play the upside scenario of continuous cyclical recovery but with a milder yield expansion.
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