Diversify beyond the US and growth

We expect US stocks to underperform global markets. The probability of a hard landing for the US economy is rising, we expect earnings to contract, and valuations are expensive in both absolute and relative terms. The MSCI USA index is trading at 18.7x P/E, a 17% premium to its 20-year average (16x) and to the MSCI All Country World Index.

Within US markets, we recommend being selective and defensive and diversifying beyond technology. Our most preferred sectors are consumer staples, industrials, and utilities. Our least preferred sectors are consumer discretionary, financials, and information technology.

We also have a cautious view on growth stocks, even if we see some pockets of opportunity (e.g., Asia’s semiconductor industry and in cybersecurity). Consensus expects flat earnings for the MSCI ACWI Growth Index for the next 12 months. US growth stocks trade at particularly lofty valuations, yet markets are underappreciating risks to their earnings. In our view, the market has yet to fully accept that the largest technology companies cannot perpetually grow at the same pace as they did in the past decade. We believe that high-quality stocks with lower valuations, and stocks that provide shareholders with sustainable income, are likely to perform more strongly.

We expect MSCI Emerging Markets to deliver low-teens positive returns this year. Emerging economies should have little exposure to the specific challenges of the US regional banks; the dollar should weaken on declining  US growth and rate differentials to the rest of the world; and China's economic reporting provides a tailwind. Altogether, we expect earnings growth of 1%, and valuations are attractive with a 40% price-to-book discount relative to developed markets.

Within emerging markets, we prefer Chinese equities, Asian semiconductors, and sustainability-focused investments. MSCI China is off its February highs, but the market's current valuation of 10.7x P/E with 14% expected earnings growth provides a solid platform for a further uptrend. We believe Beijing's supportive policy stance and the expected earnings recovery in Chinese stocks have yet to be fully factored into valuations. Meanwhile, we think margins at Asian semiconductor companies are likely to recover as supply-demand dynamics improve in the second half of the year. Excess supply is being eliminated as companies reduce prices to bring inventory levels down, and as supply growth adjusts to recent capital spending cuts. We also expect demand to rise with a new product cycle.

Various European economies moved faster into a downturn last year, partly due to their heavy reliance on Russian natural gas. But as gas prices have fallen, sentiment should start to improve. Also, given already-tight regulations for the banking sector, Europe is unlikely to see a significant downshift in bank lending in the months ahead. In this context, we see select early-cycle opportunities such as the German market, whose valuations are attractive, in our view: MSCI Germany is trading at 11.5x forward P/E, a 9% discount to MSCI EMU.

We also expect European consumer stocks to perform well, in part due to China’s recovery. European stocks have the second-highest exposure to China compared to other regions, generating 8% of sales from the Chinese market. This is especially so for luxury brands, which should additionally benefit from a return of Chinese tourists to Europe. Chinese consumers accounted for one-third of global luxury-brand sales prior to the COVID outbreak, but only 17% last year.

The VIX Index has fallen to 17, below this year’s high of 29 and below its long-term average of 19. We expect volatility to pick up as markets reprice turning points in growth, inflation, and rates. For more defensive positioning, capital preservation strategies can allow investors to maintain upside exposure while protecting against potential downside.