The Investment Strategy Group Answers Four Key Client Questions

While the markets have recovered their losses from earlier in the year, clients are asking our Investment Strategy Group (ISG) several questions. At a recent client forum, Sharmin Mossavar-Rahmani, chief investment officer for Wealth Management and global head of ISG, addressed these questions.

1. Is US Preeminence Intact?

While US economic policy uncertainty index has eased from its peak levels in April, it remains elevated compared to history. This, alongside the relative underperformance of US equities year-to-date compared to major non-US equity markets, has raised a key question among clients: Is ISG’s US Preeminence investment theme intact? 

ISG’s answer is a resounding yes. Their investment theme of US Preeminence is built on enduring economic, financial, and geographical advantages. These factors include: the superior size and strength of the US economy and capital markets; human capital and labor productivity advantages; the resilience of US institutions; and an efficient private sector. Because many of these advantages can be seen as both significant and structural, they cannot be easily compromised by the policies or actions of any one administration.

The benefit of these advantages is evident in the dramatic outperformance of US earnings since the global financial crisis (GFC) trough in 2009. The strong upward trend of US earnings is important given equity prices ultimately follow the trajectory of earnings. ISG expects US earnings growth to continue outpacing other regions, underpinning their recommendation to stay invested in an overweight position in US equities. 

2. Has the Safe Haven Status of the US Dollar Deteriorated?

In conjunction with market participants questioning the durability of US Preeminence, clients have also asked whether the US dollar’s 8% year-to-date decline and underperformance versus other developed currencies marks the end of the US dollar’s status as the world’s reserve currency.¹

While the dollar has underperformed this year, it still remains 11% above its pandemic low and 39% above its global financial crisis (GFC) low.² ISG places a negligible probability on any currency or asset being able to replace the dollar as the leading global reserve currency in the foreseeable future because the factors that underpin its dominance cannot be easily displaced. More specifically, the US dollar:

• Comprises the majority of international official reserve holdings, reinforcing its role as a reliable store of value
• Remains the predominant currency for global trade invoicing and cross-border payments 
• Provides unmatched access to deep and liquid capital markets
• Is anchored by a large, diversified economy with liberalized capital markets and full exchange-rate convertibility

3. Are Valuations High or Too High?

Investors are concerned that current stock prices—especially in the technology sector—have outpaced what is justified by the underlying fundamentals, reminiscent of the dot-com bubble.  However, unlike the dot-com era when returns were driven by speculative increases in valuations, recent technology sector returns have been largely driven by earnings and dividends. 

Earnings strength is also broad-based. S&P 500 profits—even excluding major technology stocks— are still significantly outpacing those of the rest of the world. The composition of the S&P 500 also supports more resilient earnings. Across all 11 sectors (e.g. Healthcare, Financials, Industrials, etc.), the median profit margin of the largest 5 companies exceeds that of the sector as a whole. As a result, the S&P 500’s capitalization-weighted structure systematically overweight’s these large firms with superior profitability, which structurally supports index-level earnings growth over time. More durable earnings also help S&P 500 valuations, as investors are typically willing to pay a premium multiple for it.

4. What are the Risks to the Outlook?

There are numerous risks to the economic and financial market outlook. Earlier this year, ISG highlighted that China poses the greatest risk through three main channels: 1) Economic and trade tensions; 2) Geopolitical threats and military buildup; 3) Cyber attacks. Other notable geopolitical risks include the ongoing war between Ukraine-Russia, concern that Russia will continue to escalate its hybrid war campaign more broadly in Europe, conflict in the Middle East, and US military build up in Latin America.

Within financial markets, ISG continues to monitor recent events in the credit market, having recently hosted a client call on the topic in October (read the takeaways for more information: ‘Recent Bank and Credit Concerns: Canary in the Coal Mine or Contained?’). They are also closely monitoring recession risks, the rule of law, the US debt trajectory, and the implications of several circular financing deals announced between various tech companies. More details on the assessment of these risks will be available in ISG’s upcoming annual Outlook in January.

As investors navigate this elevated risk landscape, ISG recommends portfolios be positioned at their customized strategic asset allocation. These strategic portfolio allocations are designed to ride out volatility and provide staying power in the event of market disruptions and volatility.