Beyond US large cap: Where now for equity investors?

As we move toward the second half of 2024, expectations of a hard landing have shifted to expectations of a soft landing, and perhaps no landing at all. However, market concentration remains a challenge. Global equity markets are not only increasingly concentrated by name, but also by sector and factor, prompting concerns around diversification and risk management. 

How should investors navigate a narrow market? Looking beyond a long-only approach may be one way to mitigate high concentration. In this environment, we also continue to believe that quality matters. In the meantime, we are keeping a close eye on the factors that could improve market breadth and the opportunities that may materialize if and when this happens. 

Looking ahead to the rest of the year, Macro Strategist Nicolas Wylenzek examines the structural backdrop and Equity Strategist Andrew Heiskell shares his views on equity opportunities to watch. 

Regional roundup

Global

In the first half of the year, global equities delivered strong positive returns, with most markets participating in the rally. Most of this can be explained by a recovery in global growth, with global composite purchasing managers’ indices (PMIs) showing that business conditions for both the services and manufacturing sectors have meaningfully improved. 

The US was the major global growth driver in 2023, but in the first half of this year, PMI data showed that economic momentum widened beyond the US to include Europe and China, as illustrated by a broad rebound in both services and manufacturing new orders. Over the course of the rest of the year, this trend is likely to continue and could provide global risk assets with a positive backdrop. Areas that have so far lagged behind the rally over the last two years could be particularly attractive, including capital-compounding stocks and sectors with stable and growing dividends, as well as more “early-cycle” areas, such as small caps and emerging markets. 

US 

US equities delivered another six months of global outperformance as US indices continued to benefit from significant exposure to AI. However, this also meant that performance remained highly concentrated. Looking ahead, we think the most attractive risk/reward balance may be found in overlooked areas of the market, such as small caps, dividend stocks, and value stocks. In the event of a more meaningful slowdown in growth momentum, more defensive areas of the market — again such as sectors with stable and growing dividends — could provide an attractive hedge. 

Japan  

Strong performance in the Japanese equity market remained broad-based as global investors continued to buy into the structural change story. Given low valuations relative to US peers, Japanese equities continue to look attractive in the medium term, especially as corporate reforms remain ongoing. However, some uncertainty in the near term is likely to continue as policymakers struggle to stabilize the yen.

Europe 

While Europe has very little exposure to the AI theme, European equities benefited from a Goldilocks scenario of accelerating growth momentum and disinflation. If Europe remains in this environment, the region should continue to offer upside, and a very focused European strategy could offer the potential for attractive risk/reward. However, France’s upcoming parliamentary election is creating major uncertainty for European risk assets. 

UK

Sticky inflation and an uncertain rates path continue to put pressure on the valuation of UK equities. However, UK equities are now among the most inexpensive globally. While the risk/reward ratio is currently high, any moderation in investors’ economic fears could lead to meaningful near-term upside, especially if the upcoming election provides some political stability. 

China 

Chinese equities disappointed throughout 2023 and in early 2024 on the back of the country’s tepid economic rebound and growing concerns around the property market. More recently, investors reengaged in the hope that supportive measures by policymakers would finally stabilize the housing sector and trigger a recovery. However, for now, a real recovery has not materialized. As with the UK, the risk/reward ratio is high but is balanced somewhat by depressed investor sentiment. Given economic and geopolitical risks, we believe China warrants a higher equity discount rate than other regions. 

Emerging markets (EM) ex China 

After 15 years of relative underperformance versus developed markets, we think EMs are worthy of investor attention. Based on our analysis, EMs have tended to perform best during the early cycle after a US-led developed market recession. China could remain a drag on EM equity performance this year, but we believe relatively low inflation, improving fundamentals, low valuations, and high market inefficiency could create attractive opportunities for active managers.

What we are keeping an eye on 

1. The stickiness of US inflation — The US economy is clearly slowing, but the path of inflation is less clear. If inflation slows in line with economic momentum, the market should take this as a positive as investors will price in earlier and faster rate cuts. However, if inflation remains sticky, the US Federal Reserve’s ability to cut into a slowdown will be limited, which markets will take as a clear negative.
2. Sustainability of European Goldilocks — The European Central Bank recently delivered its first rate cut as European growth continues to recover. The combination of disinflation and accelerating growth is a major tailwind for European equities. However, May’s inflation print was the first significant upside surprise in months and markets will be closely watching Europe’s inflation trajectory from here. 
3. Developments in China — Chinese economic data has recently proved more mixed after three months of recovery. Monitoring Chinese growth momentum will remain extremely important as a sustained recovery will be the most important catalyst for international investors to re-engage with Chinese equities. 

Where are the opportunities?  

As we approach the second half of the year, a number of investment themes come to mind. 

1. Breadth may not yet be back but is poised to return

S&P data for June shows market concentration now standing at a 50-year high, with the largest six stocks in the S&P 500 now comprising over 30% of the index. However, while year-to-date returns have again been quite concentrated in these mega-cap stocks, breadth could be on the verge of returning. We are observing reduced correlations both across and within sectors, as well as increased dispersion, potentially creating opportunities for stock picking. As macro uncertainty abates, we expect to see breadth improve as 2024 progresses, largely through improved returns for the “S&P 493” along with small- and mid-cap stocks. This may be an ideal time to consider extending equity allocations, with the flexibility to neutralize risks posed by concentrated markets should breadth take time to unfold fully.  

2. In the US, small is big again 

We are forecasting a combination of modest growth and moderating inflation and interest rates. That should be an increasingly favorable environment for small- and mid-cap stocks, which dramatically lagged in 2023 and have materially lagged index returns for most of the past 13 years. Small caps have not been this undervalued relative to large caps since the dot-com bubble.

Furthermore, the small- and mid-cap universes have become increasingly inefficient given less sell-side coverage, more ETF trading, and the rapid increase in unprofitable small caps in the Russell 2000 following the boom of 2020 – 2021 in special purpose acquisition companies (SPACs). The upshot is that not only do we believe small- and mid-caps are on the verge of a period of outperformance, but we also think these conditions will be favorable for active managers.