Global Weekly Commentary: Upgrading U.S. equities
Overweight U.S. equities
We upgrade U.S. equities to overweight, expecting this market to benefit from both structural growth trends and a potential cyclical upswing during 2021.
Vaccine hopes amid virus surge
Surging Covid cases and new restrictions in the U.S. have weighed on markets even as positive vaccine news points to an accelerated restart during 2021.
This week’s purchasing managers’ index data could help gauge the impact from lockdowns in the euro area and UK, and show signs of softening U.S. activity.
We upgrade U.S. equities to overweight, with a preference for quality large caps riding structural growth trends – as well as smaller companies geared to a potential cyclical upswing. We prefer to look through any near-term market volatility as Covid cases surge. Positive vaccine news reinforces our outlook for an accelerated restart during 2021, reducing risks of permanent economic scarring.
Chart of the week
Sector composition of MSCI regional indexes, October 2020
Sources: BlackRock Investment Institute, with data from MSCI as of Oct. 30, 2020. Notes: Information technology, healthcare, consumer discretionary, communication services and financials are top five sectors on the MSCI ACWI Index by weight. Others include industrials, consumer staples, utilities, real estate, materials and energy.
The pandemic has accelerated some key structural trends, such as increased flows into sustainable assets and the dominance of big tech companies. The U.S. market has a favorable sector composition compared with other major equity markets. It boasts a higher share of quality companies – those with strong balance sheets and free cash flow generation – in sectors backed by long-term growth trends such as tech and healthcare. Information technology and communication services represent nearly 40% of the market value of the MSCI USA Index, compared with just 11% in Europe. See the chart above. The U.S. tech sector is about more than just the handful of mega caps that have led market performance in recent years and face heightened regulatory scrutiny. Semiconductor and software companies, for example, face few regulatory risks and enjoy long-term growth trends. The financial sector – under pressure from the low interest rate environment globally – represents a relatively small slice of the U.S. market in comparison to Europe.
Markets have been weighing a near-term resurgence in Covid cases against advancing vaccine development. We expect rising infections and new restrictions to cause activity contraction in Europe in the fourth quarter, with the U.S. close behind. Meanwhile China is set to return to its pre-Covid growth trend thanks to better virus control, boding well for the rest of Asia and emerging markets (EMs). The challenging months ahead in the U.S. and Europe could support the case for further outperformance of large-cap tech and healthcare companies. At the same time, prospects for an accelerated economic restart during 2021 could favor more cyclical exposures. Should investors stick to quality – a perennial recent winner – or rotate into beaten down cyclical exposures?
We believe this is not an “either/or” question – and advocate a more nuanced approach. A “barbell” strategy that includes allocations on one side to quality companies benefiting from structural growth trends; and on the other to selected cyclical exposures. This can help achieve greater portfolio resilience amid still high levels of uncertainty about vaccine deployment and the prospects for further pandemic relief, we believe. Our tactical upgrade to U.S. equities and long-held preference for the quality factor are how we choose to gain exposure to structural growth. We take a selective approach to cyclical exposures, with overweights in EM equities; Asia ex-Japan equities and the U.S. size factor, which tilts toward mid- and small-cap companies. EMs should benefit from a global cyclical upswing in 2021 as well as more predictable U.S. trade policies under President-elect Joe Biden. The size factor is geared to a U.S. cyclical upswing.
We prefer avoiding more structurally challenged cyclical exposures. We have downgraded European equities to underweight and hold an underweight in Japanese equities. The European market has a relatively high exposure to financials, which we see pressured by low rates. Japan may not benefit as much as other Asian countries from a cyclical upswing, and could see its currency driven up by a weaker dollar – a result of monetary easing and more stable trade policy under a Biden administration. Bottom line: We see the vaccine development providing a constructive backdrop for risk assets as we approach 2021, but advocate a balanced approach: quality companies that should outperform even if fiscal support disappoints; and selected cyclical exposures that are likely to thrive as the timeline for widespread vaccine deployment advances. A key risk to our U.S. equities view: The winding down of key Fed/Treasury emergency support facilities by the U.S. Treasury highlights risks ahead for overall U.S. policy support, especially on additional fiscal relief.
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