US financial market dominance can't last indefinitely: MSCI

The US stock market has returned nearly twice as much as international markets since the Global Financial Crisis, which subsequently resulted in its share of global equity market capitalisation approaching almost 70% by the end of last year. History, however, suggests that this dominance is bound to wane, according to MSCI chief research officer Ashley Lester.

The rise of US financial assets relative to the rest of the developed world "is a clear story," Lester told Financial Standard. During that time, the US experienced solid earnings growth, while the rest of the developed world saw effectively zero earnings growth.

It's also true, he said, that the multiples of US mega-cap stocks - of which there are fewer than 40 companies, including the Magnificent Seven, have traded at more than twice that of emerging market and developed stocks outside the country, as of the end of 2024.

The rationale for that premium is tangible, he said, because AI-related firms account for over 60% of US mega-cap segment's weighting, which helped jack up that group's returns to almost 40% last year - roughly double that of other segments - and are also expected to deliver earnings growth more than 30% above the broader market this year.

And so, for the largest institutional investors and individual wealth managers looking to move substantial capital, seeking regions with not only the capacity to absorb it but also a track record of delivering earnings growth, he said, in global markets over the past 16 years, "there's only been one game in town," and that's the US.

"Sixteen years of financial history says that the place to go is the US. Sixteen years of sales growth, 16 years of all of the most innovative and largest growing companies are in the US," he said.

By contrast, Europe hasn't managed to produce a single company from scratch in the last half century that's reached a market capitalisation of over €100 billion, according to the recent Draghi report on EU competitiveness.

The first quarter of 2024, however, marked a "massive reversal" in fortunes for US stocks.

After trouncing European equities by more than 20% in 2024, US stocks surrendered a similar margin in the opening months of this year amid heightened uncertainty about its institutional backdrop.

Over much of the past 16 years, particularly during last year's dramatic outperformance, Lester said, "the question of geographic diversification almost started to get set aside."

But now, even long-term investors, he said, are asking themselves whether they want to devote so much of their asset allocation to a single market - albeit one that's been successful historically - when its financial weighting far surpasses its share of global GDP, and when other opportunities are emerging elsewhere.

"We've seen over recent years, the rise of markets like India. This year, a rebound in Chinese stocks, perhaps driven by policy actions and optimism about DeepSeek," he said.

"In Europe, positive equity market performance may have been driven by a sense among some investors that Europeans were willing to break free of some of their self-imposed shackles of the last 16 years, whether that was a relatively heavy-handed approach to regulation, or a constraining approach to fiscal policy, especially by Germany."

The clearest evidence of that, he continued, may be the surge in European defence stocks, which have increased around 30% in the first quarter following JD Vance's speech at the Munich Security Conference, where he emphasised the Trump administration's view that Europe must materially raise its defence spending and shoulder more of its own security.

"The response from European nations, Germany in particular - with the change in their fiscal rules - really led investors to believe they might see sales growth in European stocks," he said.

A broadly similar story has played out in private markets. The US has been the epicentre of the global private equity ecosystem, supported by a vibrant private credit market, he said.

Lester said the headline story in private assets is a widespread structural belief held among institutional investors, including sophisticated Australian investors, that, over the long run, private market investments hold the promise of above-market returns. Yet, there's also a recognition that private markets face some significant headwinds at the moment.

Chief among them is a steep decline in private equity distributions over the past few years, following post-pandemic interest rate increases.

Distributions to investors from recent vintages of private venture capital funds are around one-fifth of their historical average, he said, while buyout funds are distributing at around 20% to 40% of typical levels. Private credit, meanwhile, has held up somewhat better, distributing at around 40% to 60% of historical levels, helped by the fact that loans naturally mature.

Lester said that "real slowdown" in distributions reflects that many assets are being held - let's say, private equity positions - at valuations investors are struggling to find buyers for.

"At the start of this year, there was a lot of optimism that there would be a revival in deal making in the sector - both on the sales side, perhaps because quite a lot of private asset investors in the US, in particular, felt some Biden administration policies, especially around competition law, were holding them back from selling portfolio companies - and also on the buying side, because, after all, there's US$2 trillion in dry powder sitting in private equity coffers," he said.

Although data reporting for private assets tends to lag, he said there may've been "some uptick" in deal activity in the fourth quarter of last year. But early signs suggest this hasn't continued - something he said was not "unreasonable to connect with the rise in uncertainty in markets."

"That overall picture means that if you're a sophisticated investor looking to deploy capital now, you might just be a bit cautious. There are a lot of assets that look richly valued relative to their market clearing price, and a long queue of investments that are still waiting to be made, that many institutional investors have already promised to devote capital to but haven't deployed," he said.