Move Up in Quality in the US and Rotate Overseas

Despite a softening US economic outlook and elevated macro risks, equities have posted gains to start the year. But the path has not been linear or balanced.

Broad market gains in the US have coincided with narrow leadership, but better than expected Q1 earnings results.¹ Yet full-year 2023 estimates are still lower today than they were to start the year, as earnings revision trends remain skewed to the downside. The weaker earnings picture and increasing prices have pushed US valuations above averages.²

Overseas markets, in particular Europe, don’t have these fundamental risks. There, earnings sentiment has been more positive, with full-year estimates increasing on the year.³  And valuations are far more attractive, both on an absolute and relative basis.⁴

Even with gains to the start the year, US stocks continue to be exposed to earnings risk this late in the cycle, leaving risk/reward skewed to the downside.

To help bolster a portfolio’s strength given concerns over US fundamentals and an improving outlook overseas, investors should consider:

• Moving up in quality to own US firms with more repeatable cash flows and durable balance sheets, trading at inexpensive valuations
• Targeting international markets to capitalize on developed ex-US stocks’ relative regional attractiveness

Markets Disconnected from Macro Outlook

Even though Q1 GDP growth was positive, the US economic outlook remains tenuous.

• Leading economic indicators continue to roll over into deeply negative territory.⁵
• The probability of a recession in the next 12 months predicted by Treasury spreads has spiked to near 70% — the highest level since 1983.⁶
• Bank lending conditions have tightened to their highest level since the pandemic.⁷

But equity markets seem disconnected from this negative backdrop.

The S&P 500 Index has zigzagged upward year-to-date as a result of companies beating earnings expectations by wide margins. Traders’ forecasts for rate cuts later this year, which could ease funding pressures and increase liquidity, also have added to the market’s gains.

But the S&P 500’s strong performance has been driven primarily by a few mega-cap growth names, evidenced by the S&P 500 Equal Weight Index underperforming the market-cap weighted version by 8% over the past three months — a level ranking in the bottom 1 percentile over the past 30 years.⁸

And, the better-than-expected earnings results need to be viewed with some cynicism. The S&P 500 reported negative year-over-year growth in Q1 and is on track to report negative earnings again in Q2 — marking the third consecutive quarter of declines.⁹

Engineered Earnings Surprises Give False Hope

Those upside surprises in Q1 earnings? They were engineered by analysts continually slashing earnings estimates ahead of the reporting season (estimates fell by 6% leading up to the quarter).¹⁰ In other words, companies simply cleared a bar that had been reset lower.

Combine artificially low earnings estimates with better-than-expected results and it’s easy to see how investors have false hope that earnings have already hit rock bottom.

Despite these fundamental risks, US equity valuations remain stretched — creating another headwind to sustained market stability. The S&P 500 Index currently trades over 19x the next-12-month earnings (equal to 5.2% earnings yield) — above its 30-year average.¹¹

With 10-year Treasury yields at ~3.5%, the US equity risk premium is well below its long-term average, indicating a poor risk/reward trade-off,¹² as shown in the following chart.

Move Up in Quality Without Overpaying

With such fragility at the center of US earnings, it becomes even more important to add fundamental strength to portfolios by looking to higher-quality firms with durable balance sheets and stable cash flows. Historical trends support this view.

As a factor, Quality has outperformed the broader market in seven out of eight economic slowdowns, and by an average of 6.5% during those periods on a cumulative basis since 1988. Following Quality, Minimum Volatility outperformed on four occasions by an average of 3%,¹³ as shown in the following chart. Quality’s consistent track record of outperforming the broad market in every recession since 1988 highlights its ability to reduce equity downside risks.

After lagging the broader market for most of 2022 due to expensive valuations and aggressive rate hikes, Quality has made a comeback this year as economic weakness has come into focus. Quality now leads factor performance on a trailing six-month basis and is outperforming the broad market by 6%.¹⁴

Valuation concerns remain, however. Quality’s forward P/E valuations still sit 21% above their pre-pandemic average.¹⁵ Given the weakness in earnings trends, paying a premium for broad-based quality firms may be warranted. But focusing on inexpensive Quality names may be the most beneficial tactic to add fundamental strength to US equity portfolios.

Get Quality Dividends at a Reasonable Price

Financial strength and discipline enable companies to reliably increase their dividends for years, or even decades. More specifically, companies with a long track record of increasing dividends exhibit higher Quality characteristics, such as lower financial leverage and more stable earnings than the broader market.¹⁶ This stable source of income — return of shareholder value — is particularly valuable in today’s uncertain environment.

While dividend strategies have reduced drawdowns and lowered volatility during periods of market stress,¹⁷ dividend payers with many consecutive years of dividend increases have been less likely to cut their dividends in low-growth economic environments.

For example, while 36% of the S&P 500 High Dividend Index, an index tracking high dividend-yielding companies, cut full-year dividends during the pandemic, just 7.2% of the S&P High Yield Dividend Aristocrats Index — an exposure that screens for companies with at least 20 years of consecutively raising dividends — made dividend cuts.¹⁸

And the S&P High Yield Dividend Aristocrats Index has outperformed the broad market by an average of 78 basis points a month when the broad market posted a negative monthly return, outperforming more than two-thirds of the periods.¹⁹ Its performance advantage was even stronger — 146 basis points of outperformance — during the broad market’s 20 worst-performing months.²⁰

Compared to the stretched valuations of the broad market, the S&P High Yield Dividend Aristocrats Index is trading at a discount ranking around the bottom quintile since 2005.²¹ This creates an attractive entry point for investors to add quality dividend exposures without overpaying.

Look to Attractively Valued Developed ex-US Opportunities

While US equities have seen negative EPS revisions for 2023, developed ex-US stocks have witnessed an increase in earnings estimates, stronger growth, and broader earnings upgrades. Supported by the improving economic backdrop in Europe, developed ex-US earnings are expected to grow 3.9% for 2023 — two percentage points more than December’s estimate, outpacing the US by 2.8%.²²

In the Q1 earnings season, non-US companies are delivering both higher EPS growth (13.2%) than the US (-1.9%) and exceeding earnings expectations by a larger margin (12.3% vs. 6.6% for the U.S).²³

Better earnings prospects have bolstered the strong price momentum in international developed equities that emerged late last year. Developed ex-US stocks have returned 15.6% — their second best six-month relative performance since 2000 — and outperformed the S&P 500 in five of the past six months.²⁴

Despite double-digit gains, the price-to-forward-earnings multiple for non-US equities has recovered only to the level it was right after the Russia-Ukraine war began. And it is still below its 20-year average. Relative to the US, developed ex-US stocks are trading, on average, in the bottom 13th percentile versus the US over the past 15 years based on four different metrics: price-to-book, price-to-earnings, price-to-next-12-month-earnings, and price-to-sales,²⁵ underscoring their inexpensive valuations.

Strong earnings sentiment and price momentum, alongside constructive valuations, underpin the rationale to rotate broad-based US allocations overseas.

Focus on Europe: An Underdog Awakens

Since the Global Financial Crisis, Europe has struggled with lagging development in new technologies and challenging demographic trends. The Russia-Ukraine war exacerbated post-pandemic inflation pressure and added energy security and geopolitical uncertainty to Europe’s long list of headwinds.

But the eurozone economy’s resilience over the past three quarters has surprised investors and economic forecasters. Excess savings from the pandemic along with government subsidies to help households cope with high energy prices have contributed to strong consumer spending, which has helped avoid recession.

The decline in energy prices has led to a decline in headline inflation and China’s reopening has supported export demand and tourism. Against this positive economic backdrop, European equities are leading the charge in terms of macroeconomic and earnings fundamentals in international developed markets.

European Equities: Growth and Earnings at a Good Price

European companies have outperformed their US peers in terms of earnings growth and surprises over the past two quarters.²⁶ They also have led positive earnings revisions globally, with upgrades exceeding downgrades, as shown in the following chart. European equity’s 2023 growth estimates have been revised upward from 2.0% to 3.8% over the past three months, compared to downgraded US growth of 1.0%.²⁷

Despite double-digit gains over the past six months, European equities are still trading close to their lowest level in two decades — around a 30% discount to US equities based on forward P/E.²⁸

Admittedly, Europe still faces headwinds from restrictive monetary policy. If the global economy experiences a deep recession, which is not our base case scenario, Europe’s greater exposure to cyclical sectors — like Industrials, Materials, and Financials — poses downside risks.

For now, European stocks’ strengthening fundamentals, supportive price momentum, and large valuation gap with their US peers, should continue to generate positive interest from investors.