Finding Balance in US Equities as Macro Threats Mount

In a market burdened by uncertainties, a flexible approach can help equity investors strike the right balance between short-term risks and long-term opportunities.

Stubborn inflation, high interest rates and recession fears have persisted through 2023, but you wouldn’t know it from looking at the US stock market through the lens of the S&P 500 for much of this year. The broader market, however, tells another story. Equity investors can navigate the uncertainties with a flexible approach that acknowledges real risks and by holding positions in companies with positive earnings revisions and attractive valuations.

Macroeconomic uncertainty seems to be on everyone’s mind these days. In the US, even though inflation has started to decline, the Federal Reserve is struggling to quell rising prices. As a result, monetary policy remains tight, and interest rates are likely to be stuck at higher levels for longer than expected. At the same time, the S&P 500 has gained 13.1% so far this year through September 30.

Despite weakness in the third quarter, with the S&P 500 returning a negative 3.3%, the market has looked surprisingly resilient. However, beneath the surface, performance has been mixed (Display). Technology and consumer-related stocks have led the gains, driven by a small group of companies seen to be big winners from artificial intelligence (AI). Excluding technology, earnings revisions for the market have fallen by 2.4%, implying weakness across much of the rest of the market. 

Rising Rates Haven’t Had the Usual Effect
 

Stocks are behaving in unusual ways. Typically, higher interest rates tend to put pressure on long-duration stocks, which have cash flows further in the future. That’s because higher rates increase the discount rate used to calculate the present value of future cash flows, which makes those cash flows less valuable, weighing on share prices. Yet technology stocks, which are generally considered longer-duration equities, have skyrocketed.

Why has tech defied expectations? Enthusiasm over generative AI offers an appealing source of optimism, particularly as investors search for companies with business growth drivers that can overcome potential macroeconomic difficulties. In fact, 2024 earnings revisions for technology stocks have outpaced all US sectors (Display). But since tech stocks have risen even more than their EPS revisions, valuations in the sector have climbed sharply, too. When we strip out technology stocks, the valuation of the S&P 500 actually looks quite reasonable, in our view. 

The technology-driven market has been extremely narrow, with the 10 largest stocks driving a disproportionate amount of the market’s gains so far this year. Even though the AI revolution will create some big winners—and some technology mega-caps offer strong growth potential—we think it is short-sighted for investors to pile too heavily into the technology sector because of a single theme.

Beyond technology, some sectors have performed as you might expect in a higher-rate environment, while others have not. Consumer-staples and utilities companies have underperformed, as expected. Yet more cyclically-sensitive sectors such as industrials and financials, which would typically be expected to do well in a higher-rate world, have underperformed. Healthcare stocks, which are often prized for their defensive characteristics, have also lagged.

Prepare for a Broader US Market
 

Some investors may feel flustered by these conditions. Portfolios that aren’t heavily weighted toward the 10 largest stocks that dominated in recent months have lagged the market. However, we believe that a broadening of market performance is possible in the coming months, and equity portfolios should position accordingly, looking toward parts of the market that have strong underappreciated return potential.

As the earnings revisions data above show, US companies across many sectors have experienced an earnings recession over the last year. But worst-case fears haven’t materialized. Earnings, like the US economy, have been largely more resilient than feared. If inflation continues to cool, and a big economic contraction is avoided, we believe these conditions should support stronger fundamental and stock price performance of a wider range of stocks beyond mega-cap technology.

Flexible Strategy for Near-Term Risks
 

In such fluid market conditions, we think a flexible equity strategy can be very rewarding. Healthy consumer spending should help ensure that an economic slowdown will be mild, in our view. If the economy holds firm, we believe the energy, financials and industrial sectors deserve closer attention. Since stocks in these cyclical sectors have faced downward pressure this year after outperforming in 2022, their valuations are relatively attractive. Within these sectors, investors can find reasonably priced shares of companies that offer solid earnings-growth prospects and capital-return potential.

Select technology companies do have a role to play in equity portfolios today, in our view. Even among the mega-caps, in some cases, valuations can be justified based on the durability of businesses, balance-sheet quality, margin resilience and long-term growth potential.

Identifying defensive sectors also requires flexibility in our view. At the moment, we believe quality stocks in utilities and consumer staples—traditional defensive sectors—are less appealing, given their stable but slower growth profiles, against a backdrop of higher interest rates and economic resilience. Should economic conditions deteriorate, we would expect defensive quality to come back into vogue. So, investors should be prepared to shift toward these areas if warranted.

Flexibility can be a virtue in equity investing. Today, with so many near-term risks looming—and the possibility of increased volatility, equity investors must stay on their toes, avoid being swayed by thematic exuberance and focus squarely on long-term company fundamentals. When markets appear to be complacent about macroeconomic concerns, striking the right balance between near-term risks and long-term opportunities is the key to positioning for a wider-than-usual range of expected market outcomes.