Global Weekly Commentary: Downgrading U.S. equities to neutral
Downgrading U.S. equities
We downgrade U.S. equities to neutral after a strong run amid surging COVID-19 cases and risks of fading fiscal stimulus.
Containment and mobility
We are tracking the interplay of containment measures and mobility changes on activity as economies have started to reopen.
Markets this week will expect to see improving U.S. non-manufacturing and services purchasing managers’ index data for June.
We have downgraded U.S. equities to neutral on a tactical basis, after a strong run of outperformance versus global equities since the March trough. We see a surge in COVID-19 cases in the U.S. potentially slowing the activity restart at a time when fiscal stimulus is at risk of waning. Yet the quality bias of the U.S. market lends some support and keeps us from turning negative.
Chart of the week
Selected regional equity market performance, year-to-date 2020
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute with data from Refinitiv, as of July 1, 2020. Notes: The lines show the performance of U.S., developed markets outside the U.S. and emerging markets, rebased to 100 on Jan. , 2020. The indexes used are the MSCI USA, MSCI World ex-U.S. and MSCI emerging Markets indexes.
U.S. stocks have outperformed in 2020, with a sharper recovery from the troughs of late March. See the chart above. This follows a multi-year stretch of outperformance of U.S. equities, driven by strong earnings growth as well as investor preference for tech and quality stocks. We now see a risk of more muted performance in line with global equities on a tactical horizon. New COVID-19 cases in the U.S. have been surging, prompting some states to roll back or pause their re-openings. This is potentially setting the U.S. on a very different activity restart path than most Western countries and much of Asia. Whether or not governments reimpose lockdowns, individuals may respond by reducing their mobility – as we observed at the onset of the pandemic. We view mobility as a key indicator of activity as economies restart, as detailed in our Midyear Outlook. As a result, failure to contain the virus may threaten America’s activity restart.
The outperformance of U.S. stocks in recent months has largely been supported by the historic policy response. The U.S. has so far delivered coordinated fiscal and monetary support sufficient to offset the estimated initial shock from the pandemic and spillovers to the full economy. Yet the resurgence of the virus is taking place just as Congress and the White House face a critical decision over whether to extend a number of crisis measures, including additional federal unemployment benefits set to expire at the end of July. Any premature reduction of stimulus in July, and as the shock persists, would increase the risk of financial vulnerabilities among businesses and households facing cashflow stresses. The risk of retrenching fiscal policy too soon in the U.S. comes as the euro area has been galvanizing its policy response to the coronavirus shock.
A slower economic restart could further dampen the earnings prospects of U.S. companies. Earnings per share of the benchmark S&P 500 Index are expected to decline 44% in the second quarter from a year earlier. That follows a 12.7% fall in the first quarter. Consensus estimates suggest U.S. corporate earnings will return to their 2019 levels by 2021, but we see downside risks given the likely slower restart. Renewed U.S.-China tensions and a looming presidential election with a historically wide gap between parties on policy add to the uncertainty.
What’s stopping us from turning negative on U.S. equities then? The U.S. market has a high concentration of quality companies – especially in technology and communication services – that are set to benefit from structural trends accelerated by the pandemic. We have upgraded the quality style factor in our Midyear outlook to a strong overweight, preferring it as the most resilient exposure against a range of potential outcomes. And U.S. equity valuations do not look substantially out of line to us, with the equity risk premium above its long-term average.
Bottom line: The resurgence of COVID-19 cases in the U.S. threatens the restart of activity, and has prompted us to downgrade U.S. equities to neutral over our six-to-12 month tactical horizon. Yet the relative quality bias of this market keeps us neutral overall. We prefer European equities, which we have upgraded to a tactical overweight. The region offers more attractive cyclical exposure than emerging markets due to its public health measures and ramped-up policy response, in our view.
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