The dominance of the U.S. stock market relative to other equity markets over the past 15 years can be an enigma for any investors who were taught to believe in international diversification. As shown in the accompanying chart, U.S. equities have outperformed international equities in most years since the 2008 Financial Crisis. In the process, the U.S. market’s capitalization has gone from being on par with that of both Europe and Asia to being roughly three times greater.
An October 30 Top of Mind commentary by Goldman Sachs interviewed leading researchers to glean their insights about whether U.S. 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 U.S. 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 index and 13% for the TOPIX in Japan.
David Kostin, Goldman’s chief equity strategist, observes in the October 30 Top of Mind piece 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 U.S. index as reflected in its high constituent turnover helps to explain the U.S. 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 for the S&P 500 increased by 4.8% compared with 3.7% for the European STOXX index and 310bp for the TOPIX. He attributes the ROE expansion in the U.S. to an emphasis on maximizing shareholder value by U.S. companies that have deployed a myriad of tools to boost profit margins. Accordingly, Kostin believes investors should overweight U.S. equities in global portfolios.
Peter Oppenheimer, Goldman’s chief global strategist, acknowledges that the U.S. remains at the cutting edge of technological innovation. However, he thinks it is unlikely the U.S. can outperform much longer and believes investors should diversify into international markets that are considerably cheaper than the U.S. He argues that the U.S. market has greater concentration risk than other markets and the stock market capitalization relative to gross domestic product 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,” he said in a September Goldman piece. “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 U.S. companies is more in line with international companies.
Looking ahead, the ability of the U.S. 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 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 generative AI have the potential to bring about sweeping changes in the global economy. In an April report, they wrote that these technologies “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 U.S. occupations are exposed to some degree of automation by AI. They further estimate that of those exposed occupations, roughly one quarter to one half of the workload could be replaced.
These findings are consistent with conclusions of researchers at a November investment conference sponsored by the University of Virginia’s Darden School of Business. 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 Daniel Rock, a conference speaker and professor at the Wharton School of the University of Pennsylvania. One of the main conclusions of Professor Anton Korinek, also a conference presenter and a professor at UVA Darden, is that the extent of productivity enhancement depends on how rapidly generative 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 seen as laggard. This shows up as a significant outperformance of the tech sector in the U.S. relative to that of Europe this year. Wolfgang Munchau, a columnist at Eurointelligence observes that Germany has excellent scientists and engineers, but it has overspecialized in predigital technologies. He contends that Germany and other European countries have missed out on the digital revolution.
Rebecca Patterson, former chief investment strategist of Bridgewater, concluded in the October 30 Goldman piece that generative AI will play a key role in extending U.S. outperformance. She cites a 2011 study by Cliff Asness, Roni Israelov, and John Liew, which showed that over a 10- to 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 U.S. stock market dominance may be nearing an end for two reasons. First, with U.S. 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 U.S. will be higher than in the past decade, when it was unusually low due to unorthodox Federal Reserve policies.
That said, the U.S. economy is inherently resilient and better positioned for the future than Europe and Japan, thanks to the role that technology and AI can play in boosting productivity. Also, U.S. equity market valuations based on price-to-earnings multiples are not unduly high considering the higher ROEs of U.S. businesses. Consequently, while the gap in performance between U.S. and international markets could narrow in the coming decade, investors should not expect full mean reversion.
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