US equities: Testing new highs or testing the limits?

Key takeaways

• With the US economy likely to re-accelerate this year and the Federal Reserve likely to begin cutting rates, US equities remain an attractive asset class.
• US market leadership is likely to broaden beyond the “Magnificent Seven” mega-cap stocks to include areas such as small caps and value stocks.
• Market volatility may increase during the US election campaign season, although the outcome of the election is unlikely to change the economy’s trajectory. 
   

Introduction

US equity markets have continued to test new highs and break through new barriers in the first half of 2024, but how long can this leadership last? The “Magnificent Seven” mega caps that have led the market are already dwindling in number, and what is likely to happen if their earnings ever disappoint the market? The concentration of the S&P 500 Index in mega caps appears to be a source of risk.

To answer questions about strategies for US equities, Franklin Templeton offers a roundtable Q&A with three of our investment professionals moderated by Business Development Director Colette Corveste.

Section 1. Macro conditions

Colette Corveste: What do the latest key indicators tell us about the state of the US economy, and what is the likely outlook for central bank policy and rates?

Jeff Schulze: Our proprietary ClearBridge Recession Risk Dashboard made a major move in June. It uses a traffic light design—green means expansion, yellow means caution and red means recession. It contains 12 individual indicators. In June alone, there were three improvements: wage growth and profit margins moved from yellow to green, and money supply moved from red to yellow. In 2024, the dashboard saw eight individual indicator upgrades. With the June changes, the overall dashboard signal has turned from yellow to green, signaling expansion. It’s a positive development. It's a faint green, but it comes at a point when we are expecting a soft patch in economic activity in the United States. Many people might think the soft patch is a potential recession, but we consider it a normalization after elevated post-pandemic growth levels.

If you look at the labor market, for example, the US June jobs report missed consensus expectations. With revisions made to the prior two months’ payrolls, the three-month average payroll creation stood at 177,000, which is the lowest since June of 2021. At the same time, that level represents 77,000 more jobs per month than what is needed to keep pace with population growth.

So, our expectation is for a soft patch that may create a little bit of a growth scare for some investors. But ultimately, we think that this will lead to a Federal Reserve (Fed) interest-rate-cutting cycle, starting in September. That will likely start to kick off an acceleration in US gross domestic product (GDP) growth in 2025. So that long-awaited cutting cycle is finally near, we believe.

Colette Corveste: In your view, are we late in the cycle? Early in the cycle?

Jeff Schulze: I would say we're at the later end of this cycle, but I see at least one more cyclical re-acceleration before there is an economic downturn. With the US unemployment rate at 4%, it's hard to say that we’re in an early cycle. But there is a high level of immigration to the United States, strong labor demand, and a relatively healthy consumer, despite some strains for the lower-income consumers. We probably have at least a couple of more years in this cycle until a recession, in our view.

Colette Corveste: Frank Gannon, given that Royce is a fundamental manager rather than a macro manager, what are you hearing about the economy when you speak with small companies?

Frank Gannon: Companies view the current earnings season as unusually important. Earnings are likely to be key in the broadening of overall market leadership. But some of the things that we've been hearing are a degree of slowing, especially on the consumer side.

The slowing goes beyond discretionary spending, which I think is important. Industrial businesses are starting to see demand wane a little bit. Pricing power is coming down, which is a big difference from what we heard in the middle of 2023.

Several companies have used the word deflation on their earnings calls. So, it wouldn't surprise us if things slowed down a little bit. At the same time, there's an enormous amount of spending taking place in the economy. In the United States, it is an election year, and the government is spending an enormous amount of money these days, which is benefiting companies across the board.

Colette Corveste: Is there anything that would derail your outlook? What are you looking at most closely going forward that could change this outlook?

Frank Gannon: I don’t see anything that could derail the economy at the moment. Of course, the US election will cause some volatility, and we have seen some of that over the past couple of weeks. The energy story deserves attention, too. If the Fed makes an interest-rate cut in the late third quarter or fourth quarter, it could help sustain the expansion that has been going on now for about 49 months.

Jeff Schulze: To add to that, the consumer really propels the US economy. There has been a dramatic rise of delinquency rates for credit card and auto loans. Although delinquencies are above pre-pandemic trends, this is mainly due to pandemic stimulus programs. A lot of loans originated in 2020 and 2021, when subprime borrowers had their credit profiles boosted artificially by government stimulus, rent and mortgage forbearance payment programs, and strong wage growth. While the trend of delinquencies is moving higher, the pace of acceleration peaked about a year ago. Most bank and consumer finance companies expect the trend could plateau and roll over in the coming years.

We are watching pockets of the economy for signs of strain, such as low-income consumers. But ultimately, as long as the top 20% of earners continue to spend—which is our expectation—the trajectory looks positive. Top earners are experiencing healthy asset appreciation. They are still earning attractive income on their fixed income assets, and they also have relatively low debt loads. We think strength among higher earners will offset any weakness among low-income consumers.

A recession happens when many people lose their jobs. That's when there is a strong change in consumption patterns. While initial jobless claims have moved a little higher, they are nowhere near the level that would make us concerned about an economic downturn. The most recent numbers are about 230,000 claims per week, and we would be concerned at a level of 275,000.

Section 2. Market outlook

Colette Corveste: What does the macro backdrop mean for US equities? Can US equities continue to lead other regions? Can mega-cap technology stocks continue in the forefront? Or are US valuations too stretched?

Marcus Weyerer: We expect a reacceleration. When you look at flows relative to US history, it shows a lot of confidence in the US economy. The expectation is that this reacceleration will sustain itself.

Where we have caution is in the monetary policy outlook: There may be one or two rate cuts later this year. The current expectation is lower than it was at the beginning of the year, when markets expected six or seven cuts. Lower rates could be beneficial for mega caps. They tend to be long-duration assets, with their growth and earnings extending out more into the future.

I would have expected mega caps to suffer more from the decrease in the number of expected rate cuts—but they have not suffered so far. This resilience suggests the mega-cap momentum might sustain itself. The companies within this space are continuing to meet sky-high expectations. Still, the danger persists that when earnings disappoint, market reaction might have a severe impact on the price-earnings (P/E) multiples. If a recession happens earlier than we expect, then current P/Es probably could not be sustained. But for now, we think valuations can be sustained. 

Aside from return expectations, we also consider volatility and risk. For now, market volatility, as measured by the CBOE Market Volatility Index [VIX]¹, is at a multi-decade low, but it's also at a low point for this year. The transition in rates alone could cause volatility—it often has historically.  I would argue that a higher VIX would be justified. In election years, the VIX often goes higher, although I would add that 2008 and 2020 were election years when other crises pushed the VIX higher.

Colette Corveste: Jeff, what are your thoughts on volatility and valuations? Do they increase the risk of a correction in US equities?

Jeff Schulze: If we're likely to have a growth scare, it will cause some concerns about the earnings that are embedded in the S&P 500 Index. The index has had a tremendous run since its October lows. A digestion period is probably needed. As Marcus noted, it's really common for volatility to rise in August and September, especially as we get closer to the election. Some pre-election jitters will likely come to the forefront. So again, I'm expecting a choppy couple of months. We could see a 5% or 10% equity market correction. Many investors may be looking to buy the dip, so the correction might be relatively small. From a valuation perspective, we have less concern. Small-cap and mid-cap valuations are in line with their historic averages. For the S&P 500 Index, the forward P/E is higher than the average P/E since the mid-1990s. However, if you look at a layer down in the index, beneath the top 10 companies, the story is different; the top 10 trade at a much higher forward P/E than the bottom 490, which are closer to long-term averages.

As active managers, we have an opportunity to sidestep some of that valuation risk that's embedded in the largest constituents.

Colette Corveste: Marcus, we're increasingly seeing some clients thinking about equal-weighted indexes as a way of avoiding that concentration risk. What do you think of that approach?

Marcus Weyerer: Equal weighting is one approach to manage concentration risk. Consider the effective number of stocks in an index. This number is a measure to determine the effective diversification of an index. That is, how many stocks would an equal-weighted portfolio need to match the diversification of the S&P 500? Currently, the number is just 60 stocks. In other words, the S&P 500 today has a diversification level that is equal to an index of 60 stocks due to the high concentration in the mega caps. That is an all-time low level of diversification; usually it's higher. And so, while an equal-weight approach reduces the mega-cap overweight, it does not solve for factors other than size. The approach to size is random, and it doesn’t consider other measurements like quality.

If you look at performance, an equal-weighted portfolio has recently lagged behind the S&P 500, which is to be expected because top-weighted stocks like the Magnificent Seven² have been driving returns. But in the last five major drawdown periods as well, when the market declined over 10%, an equal-weighted S&P 500 strategy has not outperformed the S&P 500.³ In other words, equal weighting does not reduce downside risk, and there is typically lower performance in the long run. So, that suggests to us that it's not a valid long-term investment strategy. Equal weighting works in the short run to reduce concentration risk, but there are other strategies, such as fundamentally weighting a portfolio, which may do better over the medium and long run.

Colette Corveste: Frank, let’s talk about US small capitalization (small cap) stocks following a sustained period of underperformance. What might be the trigger for a lasting run? And how much do themes like artificial intelligence (AI) and technological advances feature in the small-cap space?

Frank Gannon: If you look at the three-year return of the Russell 2000 Index through the end of the second quarter, it is negative—down about 2.6%.⁴ Three-year returns have been negative only six times in the history of the Russell 2000.⁵ It doesn't happen that often, and I think we will see market performance broaden out. I believe a year from now that broadening is one of the major themes we will be talking about.

Average Annual Total Returns through June 30, 2024

	One year	Three years	Five years	10 years
Russell 2000 Index	10.06%	–2.58%	6.94%	7.00%

I should note that there's nothing wrong with the mega-cap stocks—it’s just the pricing that we think is way too inflated on some of them.  

The question is, what is the trigger that can help small caps start to move up? I think part of the answer is earnings, which should drive the broadening of the market. We have some key pieces of legislation that impact on the economy and the market—the CHIPS Act, the Infrastructure Act and the Inflation Reduction Act (IRA), which are driving onshoring of manufacturing, for example.

Earnings may start to re-accelerate in the second half of the year and into 2025. If there is a Fed cut or two, and GDP accelerates, it will be interesting to see the earnings story outside of those mega-caps we have talked about.

Colette Corveste: Another extreme dislocation is the underperformance of value stocks versus growth. If we see broader leadership in US equities, how are value stocks likely to perform within that?

Jeff Schulze: If the Fed starts to cut interest rates, economic activity accelerates and earnings rotate, we are likely to see a broadening out in the market to include value stocks as well. When you look at expected 2025 earnings, the current earnings advantage of the Magnificent Seven really dissipates, not only relative to small caps but also relative to the other 493 stocks in the index.

Section 3. The US election

Colette Corveste: As we approach the US elections in November, what market impact do you see?

Frank Gannon: We are probably going to see some more volatility around the election. On the question of what a Democratic or Republican victory means, I don’t think either outcome would change much regarding the Infrastructure Act or the CHIPS Act. If Trump becomes president again, he will probably reduce the regulatory burdens in the CHIPS Act. This issue brings me to AI. One of the big questions for AI will be its energy demands, and what that means for the electrical grid in the United States and around the world. If Republicans win the election, they will probably try to make the United States more self-sustaining from an energy perspective. That would be helpful given the expected demands on the energy grid and could also help bring more liquid natural gas to Europe. There are many interesting themes that could play out.

Colette Corveste: Jeff, what differences do you see for markets after the election depending on which candidate wins?

Jeff Schulze: I don't see a very big difference in the market impact of the candidates. No matter who wins, there is a strong possibility there will not be a governing party majority in Congress. The government could be divided, or even if there is a sweep, the majority could be slim. Given that there are many individuals on the far right and the far left, there might not be much ability to pass legislation.

The real impacts are likely to be in areas where a president can act without Congress—namely, regulation and tariffs. A Democratic administration would probably be somewhat more supportive of green energy at the expense of traditional energy, and there would probably be more regulation of big pharmaceuticals companies, financials and industrials. A Republican administration would be the exact opposite.

Although regulation could be the source of small headwinds or tailwinds for those individual sectors, most of the time markets are more dependent on the broader economic environment. For example, energy and financials were expected to do well under the first Trump administration, but it was an unfavorable macro environment, and both of the sectors turned out to be laggards. Conversely, when President Obama was in office, health care was supposed to face a big headwind, but the sector ended up doing quite well.

In terms of trade and tariffs, both parties would likely be tough on trade, but Republicans would likely be tougher. They have talked about instituting a 60% tariff against China, compared with 19% currently, and an across-the-board 10% tariff on all imports from all US trading partners. However, this is not likely to be an issue this year. The process is long and there would be direct negotiations with China before anything goes into play. So that would take at least a year to come to fruition, if it even does.

Regarding a potential 10% across-the-board tariff, there is a lot of legal uncertainty around it and the potential for litigation. It probably would not be a story for the markets until 2026—and likely a tactic to negotiate better trading terms. So, talk of tariffs could cause some small motions in the market and favor more domestic companies over multinational companies. But the bigger issue is how healthy the overall economy is. Our base case is for a soft patch followed by a reacceleration of growth. We believe US equities are going to be able to move forward.

Colette Corveste: What impact would a Republican administration have on the continuation of the Inflation Reduction Act?

Marcus Weyerer: The IRA would be under threat if Republicans win both the presidency and Congress. In the example of Obamacare, the threat of repeal existed when Republicans won the 2016 election, although they never made much progress. Like Obamacare, the IRA is also entrenched in state law and in the actual economy.

Companies have made investment plans, and they are not going to change course simply based on an election. We would have to consider the outlook for the green energy transition that the IRA supports if Republicans control both branches of government. But for now, the election looks like it could come down to a coin flip, and it will take time for the likely outcome to take shape. It brings up our earlier issue—uncertainty for markets, which can contribute to volatility.

In terms of actual policy, the election will have some sector impacts, but on a broader level, policy does not determine that much. To give you an example, California has often led in climate investment. But today, Texas—a Republican state—is basically on par with California. Economic needs often direct investment more than policy does.

Colette Corveste: Marcus, for investors interested in the green transition and renewable energy in the United States, what approach do you suggest?

Marcus Weyerer: It could be risky to try to focus too much on the US green energy transition because the industry is exposed to policy and sector risks. However, tilting a portfolio could make sense. That means taking into account those economic changes and the economic risks, as well as physical risks. There has been much more discussion of those risks in Europe in the past couple of years than in the United States. From an investor's point of view, tilting toward green-oriented companies could make sense rather than going all in. If you have a view about the election outcome, it might be different, but we think the outcome is unclear at this point.

Section 4. Other considerations

Colette Corveste: With AI and electric vehicles [EVs] driving a sharp increase in power demand, could other energy issues play a major role in the next market cycle?

Jeff Schulze: We see a potential opportunity for utilities over the next 6-12 months for a couple of different reasons. First, utilities usually do well in a disinflationary, slower-growth environment. It's really a sweet spot for that particular sector. Given the soft patch that we're anticipating and the rate-cutting cycle, the yield on the 10-year Treasury could decline, something that also usually benefits that sector. This sector also has some secular tailwinds, such as demand for grid reliability, the clean energy transition and increased demand for electricity, creating the opportunity for a generational boom in capital expenditure (capex).

For a sector that typically doesn't have tremendous growth prospects, forecasted earnings growth over the next five years is supposed to compound at close to 8%, which is really unheard of for utilities.⁶ We think that this sector is attractively valued right now and in the sweet spot not only for the slowing growth backdrop that we’re expecting in the near term but also for the secular tailwind from the expected increase in electricity use.

Colette Corveste: Are you seeing any early signs and changes in the outlook toward technology companies?

Marcus Weyerer: In 2025, we might be in for a surprise on the inflation side, with the possibility of tariffs and with interest rates that might stay relatively higher for longer. These factors should have an effect on tech companies, although they did not have an effect when rate cut expectations declined from 6 cuts to 1 in the first half of the year. So, mega caps might again remain resilient against inflation, but it’s something I'm a little concerned about.

Frank Gannon: There's this idea that innovation is only in the large-cap space, but many small-cap technology companies are also really benefiting from what's happening with AI, and the overall market just hasn't recognized that yet. I would say that the outlook for many small-cap companies is quite positive.

To build on the case for energy, many small-cap companies outside the utilities sector are likely to benefit as the pressure on the US grid continues to grow. These are “picks and shovels” companies that supply equipment to a lot of the utilities and energy companies, and they will likely benefit amid growing energy demand, the growing use of AI, and continued system stress.

Colette Corveste: Frank, could you expand a little bit more on what types of companies and sectors you think will benefit from the onshoring and reshoring trend in the United States?

Frank Gannon: The industrials sector within the small-cap space is a major one. Industrials is a very large sector, but it encapsulates a lot of different sub-industries that are benefiting from onshoring. Many semiconductor plants are being built in the United States right now—in Tennessee, Kentucky and Ohio for example. These are all because of the CHIPS Act and the IRA.

Onshoring is happening for national security, and that's a major difference from past efforts. That’s why this trend is likely to continue to play out; more businesses are moving operations back to the United States. This is a significant theme, and we think the onshoring trend will contribute to the earnings expansion we expect to see in small caps in the latter part of this year and into 2025.

Colette Corveste: Should we be worried about the debt ceiling in the United States?

Jeff Schulze: The debt ceiling has been raised until 2025. There is a lot of political grandstanding, but it always gets raised. It just happens at the very last minute as concessions are made to the other side. While it seems like the process comes down to the last minute, there is no real limit to where the debt ceiling can go, and it can be raised in perpetuity. The key question behind that is how much higher can US debt levels go before you see materially higher interest rates in the United States?

It’s likely that we can accumulate debt in the United States for a longer period of time before the bond vigilantes come back and force higher rates and discipline on the United States. I don't see a situation under either potential administration after the election bringing down the deficit in a material way. Unless there is a recession, debt-to-GDP levels are likely to rise one or two percent each year for the next couple of years.

We may start to see some real issues with debt when we get into the next decade—it is really more of a problem for the United States in 2030.

Colette Corveste: What are your final thoughts on US equities?

Marcus Weyerer: US equities remain front and center. The key consideration at this point is how you can diversify a little with quality companies in the second and third tier, perhaps. This doesn't mean that one has to completely exclude the Magnificent Seven, but just consider it from a risk management perspective. Also, we see potential for higher volatility for the remainder of the year, which is as much a normalization of volatility levels as anything else.

Frank Gannon: I want to reiterate that I think one of the biggest themes we think will garner attention in coming years is the broadening of the US equity market. We believe small caps are going to be a big part of that. Right now, we see a good investment opportunity in small caps but focusing on quality will be important.

Jeff Schulze: We think that an economic soft patch is coming, but it is just normalization from the elevated growth of the post-pandemic cycle. The silver lining is that it's going to invoke a Fed rate-cutting cycle. After the first rate cut, we think it can make sense to move out on the risk curve—out of cash and into US equities as well as fixed income.