The dominance of the US stock market relative to other equity markets over the past 15 years is an enigma for many investors who were taught to believe in international diversification. As shown in the accompanying chart, US equities have outperformed international equities in most years since the 2008 Financial Crisis. In the process, the US market’s capitalization has gone from being on par with that of both Europe and Asia to being roughly three times greater.
US Equity Performance Relative to EAFE, annual returns in local currency
A Top of Mind commentary by Goldman Sachs (October 30) interviewed leading researchers to glean their insights about whether US outperformance is at a turning point. A diversity of opinions was presented, but there was widespread agreement among the participants that the technology sector was an important factor contributing to the US market’s outperformance. The reason: Tech is by far the most important sector in the S&P 500 index — representing 28% of the weight — versus 7% for the MSCI Europe and 13% for the Topix.
David Kostin, Goldman’s chief equity strategist, observes that this compositional difference has benefitted the S&P 500, because tech stocks have posted faster sales growth during the past 50 years and have much higher profit margins than other sectors. Furthermore, he believes the greater dynamism of the US index as reflected in its high constituent turnover helps to explain the US market’s outperformance. By comparison, the indices for Europe and Japan are dominated by legacy companies.
Over the past decade, Kostin finds that return on equity (ROE) for the S&P 500 increased by 480 basis points (bp) compared with 370bp for the European STOXX index and 310bp for the TOPIX. He attributes the ROE expansion in the US to an emphasis on maximizing shareholder value by US companies that have deployed a myriad of tools to boost profit margins. Accordingly, Kostin believes investors should overweight US equities in global portfolios.
Peter Oppenheimer, Goldman’s chief global strategist, acknowledges that the US remains at the cutting edge of technological innovation. However, he thinks it is unlikely the US can outperform much longer and believes investors should diversify into international markets that are considerably cheaper than the US. He argues that the US market has greater concentration risk than other markets and the stock market capitalization relative to GDP is at a very high level.
Oppenheimer, however, does not believe that the rally in tech stocks is comparable to the tech bubble in the late 1990s: “The seven biggest US companies seen as the leaders in the race to commercialize generative AI technology have an average P/E of 25. That compares with a P/E of 52 for the biggest companies at the peak of the internet bubble.” When these outlier companies are excluded the overall performance of US companies is more in line with international companies.
Looking ahead, the ability of the US market to outperform will hinge in part on how AI evolves and the impact it has on boosting productivity.
McKinsey & Company defines generative artificial intelligence (Gen AI) as algorithms (such as ChatGPT) that can be used to create new content, including audio, code, images, text, simulations and videos. Researchers at the firm believe it is poised to unleash the next great way of productivity, and they estimate it has the potential to generate between $2.6 trillion to $4.4 trillion in value to the global economy annually. The main areas they see being impacted are customer operations, marketing and sales, software engineering and R&D.
Goldman’s economists also believe breakthroughs in Gen AI have the potential to bring about sweeping changes in the global economy: “They could drive a 7% (or almost $7 trillion) increase in global GDP and lift productivity growth by 15 percentage points over a 10-year period.” Analyzing databases detailing the task content of more than 900 occupations, Goldman’s economists estimate that roughly two thirds of US occupations are exposed to some degree of automation by AI. They further estimate that of those occupations that are exposed, roughly one quarter to one half of the workload could be replaced.
These findings are consistent with conclusions of researchers at an investment conference sponsored by the University of Virginia’s Darden Business School. While the adoption of AI techniques is expected to be broad-based, the sectors that are likely to be most impacted are healthcare and financial services according to Professor Daniel Rock of Wharton. One of the main conclusions of Professor Anton Korinek of Darden is that the extent of productivity enhancement depends on how rapidly GEN AI evolves and is diffused into the global economy.
While there is still considerable uncertainty about how this will play out, the US is widely recognized as the global leader in AI whereas Europe is a laggard. This shows up as a significant outperformance of the tech sector in the US relative to that of Europe this year. Wolfgang Munchau of Euro intelligence observes that Germany has excellent scientists and engineers, but it has over-specialized in pre-digital technologies. He contends that Germany and other European countries have missed out on the digital revolution.
Rebecca Patterson, former Chief Investment Strategist of Bridgewater, concludes that Gen AI will play a key role in extending US outperformance. She cites a study by Cliff Asness et.al, which shows that over a 10-15 year period, domestic growth is the dominant driver of equity returns. She also sees AI as playing a critical role in boosting productivity as the working-age population shrinks in many countries. When Patterson was asked if all the good news about AI was priced into markets, she responded: “history has shown that structural changes in the economy tend to be priced in over many years.”
Weighing these considerations, my take is that the period of US stock market dominance may be nearing an end for two reasons. First, with US profit margins at record highs, there is limited scope to increase them further especially with increased impediments to globalization. Second, the cost of capital in the US will be higher than in the past decade, when it was unusually low due to unorthodox Fed policies.
That said, the US economy is inherently resilient and better positioned for the future than Europe and Japan owing to the role that technology and AI can play in boosting productivity. Also, US equity market valuations based on P/E multiples are not unduly high considering the higher ROEs of US businesses. Consequently, while the gap in performance between US and international markets could narrow in the coming decade, investors should not expect full mean reversion.
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