Can US stocks keep on growing?

US markets have tended to return well above global averages across long, medium, and short-term time horizons. In 2023 the S&P 500, taken as an index of large-cap US stocks, returned around 24 per cent. The MSCI World ex USA Index, representing global markets aside from the US, returned around 12 per cent.

The S&P 500 has delivered 13.06 per cent annualized returns on a ten-year basis, 15.22 per cent returns on a five-year basis, and 10.18 per cent on a three-year basis. The MSCI World ex USA offers 5.34 per cent, 8.04 per cent, and 5.49 per cent annualized returns across those same time periods.

The point is perhaps best demonstrated by comparing the MSCI World Index — which includes US markets — and the MSCI World ex USA index. As of March 29th, 2024 the MSCI World has returned 25.72 per cent in the past year. The MSCI World ex USA has only returned 15.92 per cent. US markets have historically delivered.

But after years of outperformance some are asking if US stocks have become too expensive, too concentrated, or lack the same opportunity set going forward. Much of the recent growth in US stocks has been driven by a few select mega-cap names, which has introduced concentration risk. The US is also in an election year, adding more short-term uncertainty. Can the US equity allocations which have done so well for institutions and pension funds sustain their performance going forward?

“Sometimes compositions adjust, but a new player inside the US always seems to be emerging, and I think that is unlikely to change,” says Sadiq Adatia, Chief Investment Officer at BMO Global Asset Management, when asked about if the current US equity performance is sustainable. “Because of the global presence that many of these companies have, you still want to own US along the way.”

What makes US equities so strong?

Adatia highlights scale and diversity in US markets as drivers behind their ongoing performance. Contrasting US equity markets against Canada, he notes that Canadian markets offer strong exposures to energy, financials, and natural resources. The US, however, has world-leading companies in virtually every sector as well as unmatched names in sectors like technology and healthcare.

Kate Lakin looks at earnings growth to back up her bullish view of US markets. Lakin is the Director of Equity Research at Putnam Investments, part of Franklin Templeton. She noted that over the past decade S&P 500 companies have offered around 11 per cent average earnings growth, which is only slightly behind its annualized rate of return. More recently, S&P 500 companies have generated significant earnings growth despite a global pandemic, the onset of record high inflation, and one of the sharpest rate hiking cycles in recent memory.

Lakin attributes some of that resilience to the strength of US-listed mega caps. Both she and Adatia highlight how performance in 2023 was driven largely by the “magnificent seven” stocks: Tesla, Microsoft, Meta, Amazon, Alphabet, Nvidia, and Apple. This year, performance has bifurcated somewhat but Lakin and Adatia both highlight that some of the trends behind that performance in 2023 should keep driving equity returns from US markets in 2024 and beyond.

What might drive US equities forward?

“I get excited about further growth because of AI, reshoring, antiobesity drugs, and a little bit of ‘who knows what else could come next,’” Lakin says when asked about what could drive US performance in the future.

AI (artificial intelligence) tops her list for somewhat obvious reasons. Exposure to AI in 2023 was a major driving force behind each name in the magnificent seven. As the magnificent seven split somewhat in 2024, the names with better exposure to AI — Nvidia, Meta, Amazon, and Microsoft — have outpaced their competitors.

Lakin explains that AI offers positivity because hyperscaling companies spend big on AI. In a drive to revolutionize their productivity through AI and automation, these companies are increasing their total capital expenditures at a compound annualized growth rate of around 20 per cent. Putnam estimates AI capital expenditures are doubling every year.

Adatia shares Lakin’s optimism around AI, though he notes that some element of investor hype may see the largest AI market leaders correct slightly in future. While he notes that the current run in US tech names is backed by some strong earnings growth, he compares this moment to how tech stocks corrected in the 1990s and have since climbed back beyond those pre-crash valuations.

Both he and Lakin noted their excitement about some of the downstream impacts of AI, which could see the broader US equity market catch up against its mega-cap leaders. Lakin noted, for example, that AI could represent a paradigm shift in utilities. The computing behind AI requires a huge amount of electricity, resulting in a demand growth profile that US utilities companies have probably never experienced.

While AI has been the headline grabber in recent years, both Adatia and Lakin emphasize the range of other themes and innovations that could push the global economy forward, from GLP-1 obesity drugs, to automated cars. In almost every one of those trends, there is a leading company based in the US or listed on a US exchange.

What risks are out there for US stocks?

Despite the high valuations we now see on US markets, both Lakin and Adatia argue that the prices are largely justified. Earnings would have to come down significantly among leading US names for their multiples to hit ‘unreasonable’ territory. That said, there is already some degree of divergent performance among the US stock markets’ biggest winners. That may justify more of a stock picking approach going forward as valuations adjust on specific names.

One area that may impact valuations, according to Adatia, is interest rates. While the bond market has largely priced in US interest rates staying higher for longer, he notes that equity markets have been more reticent to price in the likelihood of only one or two interest rate cuts this year.

Another significant area of risk, Adatia says, is geopolitics. The biggest issue he foresees is if US election rhetoric elicits any kind of retaliatory action by China. Restrictions against massive companies like Tesla or Apple doing business in China could have huge detrimental impacts to US stock performance.

The significant run in mega-cap stocks has raised the issue of concentration risk on US markets, whether the S&P 500 is too heavily weighted to a small group of largely tech names. The magnificent seven, for example, represent over 25 per cent of the S&P 500’s market capitalization. Both Adatia and Lakin note that there could be corrections in some of those mega-cap names, but the sheer range of other leading companies listed on US markets should continue to drive overall long-term performance. 

“When you have a few names that come up short-term you need to be cognizant of that, but when you have these industry leaders that have been around for decades or longer, I think you’re okay in those areas,” Adatia says. “And you have lots of leaders in large-cap names, the JP Morgans and Eli Lilly’s of the world, and lots of great sectors where you can find good opportunities to move and rotate along the way.”