2023 Midyear ETF Market Outlook
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:
Even though Q1 GDP growth was positive, the US economic outlook remains tenuous.
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
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.
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.
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.
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.
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 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.
To increase the fundamental strength of US allocations and target attractive opportunities in overseas markets, consider the following ETFs:
1 FactSet, as of 5/19/23.
2 Bloomberg Finance, L.P., as of 5/19/2023 based on the price-to-next-twelve-month earnings ratio.
3 FactSet, as of 5/19/2023 based on the MSCI EAFE Index.
4 FactSet, as of 5/19/2023 based on the MSCI EAFE Index versus the S&P 500 Index.
5 Based on the Conference Board of Leading Economic Indicators per Bloomberg Finance L.P. as of May 19, 2023.
6 New York Federal Reserve Bank, as of 5/12/23.
7 Federal Reserve, Senior Loan Officer Survey, April 2023.
8 Based on the S&P 500 index and the S&P 500 Equal Weighted Index trailing 90-day returns from 1994-2023 per Bloomberg Finance. L.P.. as of 5/18/23.
9 FactSet, as of 5/18/23.
10 FactSet, as of 5/18/23.
11 FactSet, as of 5/19/23.
12 FactSet, as of4/28/23.
13 FactSet, as of4/28/23. For the period between June 1988 and December 2022.
14 FactSet, as of 4/28/23.
15 FactSet, as of 4/28/23.
16 FactSet, as of 4/30/2023. Based on weighted average long-term debt to capital and average earnings growth variability of constituents of the S&P High Yield Dividend Aristocrats Index.
17 Kenneth French Data Library, State Street Global Advisors, as of 09/30/2022. Low and high dividend stocks are represented by the bottom and top quintile groups based on dividend yield.
18 S&P Dow Jones Indices, A Case for Dividend Growth Strategies, 2022.
19 S&P Dow Jones Indices, for the period from November 2005 to March 2023..
20 S&P Dow Jones Indices, for the period from November 2005 to March 2023.
21 FactSet, as of 4/28/23. Based on the price-to-forward-earnings and price-to-cash-flow ratios.
22 FactSet, as of 4/28/23. Developed ex-US markets are represented by the MSCI EAFE Index.
23 Credit Suisse, as of 5/12/23.
24 FactSet, as of 4/28/23 based on the MSCI EAFE Index and the S&P 500 Index.
25 Bloomberg Finance, L.P. as of 5/18/23 based on the MSCI EAFE Index and the S&P 500 Index
26 Barclays, as of 5/5/2023.
27 FactSet, as of 4/28/23. EPS growth estimates are based on Consensus Analyst Estimates compiled by FactSet.
28 FactSet, as of 4/28/23.
Dividend Equity Investing
A style of investing focused on owning companies or a portfolio of companies that make distributions and, in turn, reinvesting those dividends regularly with a view to slowly accumulating wealth over the long term.
Earnings Per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
Global Financial Crisis
The economic crisis that occurred from 2007-2009 that is generally considered biggest economic challenge since the Great Depression of the 1930s. The GFC was triggered largely by the sub-prime mortgage crisis that led to the collapse of systemically vital US investment banks such as Lehman Brothers. The crisis began with the collapse of two Bear Stearns hedge funds in June 2007, and the stabilization period began in late 2008 and continued until the end of 2009.
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
A system of ranking scores that shows the percentage of results that are lower than the benchmark or fund in question for the most recent three-year period. Every year, each score is updated with the most recent year’s percentiles.
Price-to-Book Ratio (P/B Ratio)
A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). A high P/B means either that investors have overvalued the company, or that its accountants have undervalued it.
Price-to-Cash-Flow Ratio (P/E Ratio)
A stock-valuation measure that is calculated by dividing a firm’s cash flow per share into its current share price. Financial analysts often prefer to value stocks using cash flow rather than earnings because earnings are more easily manipulated.
Price-to-Forward Earnings Ratio
The price of a security per share at a given time divided by its projected earnings per share over the coming year. A forward P/E ratio is a way to help determine a security’s stock valuation — that is, the fair value of a stock in a perfect market. It is also a measure of expected, but not realized, growth.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
S&P Equal Weight Index
An index whose constituents are members of the S&P 500 Index and follow the eligibility criteria for that index, which measures 500 leading companies in leading U.S. industries. The S&P EWI measures the performance of the same 500 companies, in equal weights. As such, sector exposures in the S&P EWI will differ.
S&P 500 High Dividend Index
The index is designed to measure the performance of 80 high yield companies within the S&P 500 Index and is equally weighted to best represent the performance of this group, regardless of constituent size.
S&P High Yield Dividend Aristocrats Index
An index designed to measure the performance of companies within the S&P Composite 1500® that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 years.
Upside Capture Ratio
A statistical measure of an investment manager's overall performance in up-markets. It is used to evaluate how well an investment manager performed relative to an index during periods when that index has risen.
The process of determining the current worth of an asset or a company.
One of the basic elements of “style”-focused investing that focuses on companies that may be priced below intrinsic value. The most commonly used methodology to assess value is by examining price-to-book (P/B) ratios, which compare a company’s total market value with its assessed book value.
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini, and Anqi Dong through the period ended May 19, 2023 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
Past performance is not a reliable indicator of future performance.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
Investing involves risk including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
Dividend paying securities can fall out of favor causing securities to underperform companies that do not pay dividends. Changes in dividend policies of companies may adversely affect fund performance.
There is no guarantee that the stocks in the portfolio will continue to declare dividends and if they do, that they will remain at current levels or increase over time.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
A “value” style of investing emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market.
Low volatility funds can exhibit relative low volatility and excess returns compared to the Index over the long term; both portfolio investments and returns may differ from those of the Index. The fund may not experience lower volatility or provide returns in excess of the Index and may provide lower returns in periods of a rapidly rising market. Active stock selection may lead to added risk in exchange for the potential outperformance relative to the Index.
A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Foreign (non-U.S.) securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
There can be no assurance that a liquid market will be maintained for ETF shares.