US exceptionalism: is era of strong returns over?

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The US stock market has delivered stellar returns over the past 15 years, which has led to the country becoming a larger part of the global stock market, meaning it now has greater influence over its performance. 

But several factors, including high valuations, a concentrated market, and geopolitics, could spell the end of US exceptionalism.

To examine the outlook for US exceptionalism, and consider whether investors should be casting their nets wider, Kyle is joined by Richard Saldanha, who manages the Aviva Investors Global Equity Income fund.

Saldanha also discusses the opportunities he’s seeing, explaining how the fund invests and his approach to investing in dividend-paying companies.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to the latest On the Money podcast episode, a weekly look at how to make the most out of your savings and investments.

Today’s episode focuses on whether investors have become too reliant on the strong returns of the US stock market.

Joining me to discuss this topic is fund manager Richard Saldanha, who manages the Aviva Investors Global Equity Income 2 GBP Acc fund.

So, Richard, we’re going to be talking about lots of different topics associated with the US stock market today, including whether it’s overvalued, concentration risk, political risk, and then we’re going to focus on the areas that you’re investing in, and where you’re seeing better value opportunities outside the US.

Let’s start off with the term ‘US exceptionalism’.

In financial circles, US exceptionalism is term that’s been coined to describe how extraordinary the US stock market has been for investors over the past 15 years.

However, for around the past year or so, more fund managers and commentators have questioned whether the exceptional returns of the US stock market can continue. What are your thoughts on US exceptionalism?

Richard Saldanha, manager of the Aviva Investors Global Equity Income fund: It’s a good question, Kyle. I think in some ways talking about US exceptionalism misses the point and that from our perspective, the US very much still remains an exceptional place to invest, right?

You think about the companies there, the levels of cash generation, capital allocation. You think about the returns on capital these companies generate, which typically for the US have been in excess of other regions historically. There’s plenty of exceptional companies there.

What’s interesting from our perspective, particularly when you think about the composition of global indices is that the US is huge. It’s almost two-thirds of the global equity benchmark now. So, from that perspective, from an investor standpoint, it makes a lot of sense to think about other regions and areas.

It’s been interesting if you think about certainly equity market performance – last year was a case in point – where, if you look at it in dollar terms, you had significant outperformance from regions such as Europe, Asia and emerging markets.

I’d almost say investors are already thinking along those lines. Yes, the US has been an exceptional place to invest, its delivered phenomenal returns, but, actually, it makes a lot of sense now to look at other regions as well.

Kyle Caldwell: Due to the phenomenal returns over the past decade, 15 years, the percentage weighting of the US stock market in global stock market terms has gone up a lot – you’ve mentioned that already, that [the US is] around two-thirds. If you look at the MSCI World Index, the US accounts for over 70%.

So, as global fund manager, you manage a fund, you have a certain remit, but ultimately, you want to beat the alternative. You want to beat a global index fund or a global exchange-traded fund (ETF). How do you think about the sheer size of the US stock market?

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Richard Saldanha: You’re absolutely right. Certainly the composition within the global benchmark, as I said earlier, two-thirds of that index is now one country alone.

I think history is an interesting barometer. When you think about times in the past where you’ve had these levels of concentration, whether it be countries or even within stocks themselves, you tend to have a reversal of that. Something happens and actually that changes over time.

I think what’s quite interesting is that, as I said, the US still remains an attractive place to invest. But certainly when you think about it from a valuation perspective and you look at valuation metrics, whether it be price-to-earnings (PE), or cyclically adjusted price for earnings, where you take the PE ratio and adjust it for where we are in the cycle.

The US market certainly looks a lot more stretched on that basis relative to other regions. I think that should also focus investors’ minds when they come to thinking about that diversification aspect.

So, if you look at the global equity income fund that we manage, we’ve got, give or take, 45% exposure to the US. It’s still an attractive place to invest. We can find plenty of companies there that are paying attractive dividends and growing those dividends and cash flows over time.

But to us, it makes a lot more sense to be looking outside the US because the valuations, as I said, are certainly more attractive. But, also, you can take part in in a lot of the dynamics that are driving US stocks, whether it be themes such as artificial intelligence (AI), energy efficiency, etc. So, to us, that makes a lot of sense over why you would look outside the US as well.

Kyle Caldwell: In terms of valuations, is the US stock market pricey as an aggregate, or is it the top end of the market? The so-called Magnificent Seven stocks, are such a big part of the US stock market, are they the ones that are the most expensive and then that’s pushing up the whole average?

Richard Saldanha: Yes. So, one of the themes you definitely are seeing this year is what we’d call a broadening out effect. If you think about what’s been driving a lot of the returns that we’ve been talking about, there’s exceptional returns in the US market, but it has come from quite a concentrated cohort. As you said, those Magnificent Seven companies, and we understand what’s been driving that around the themes of AI.

But what is also quite interesting is that you’re definitely starting to see that broadening out taking effect. Think about 2024 as an example, a lot of those US market returns were dominated by those Magnificent Seven companies. Now last year, it might surprise you to know, only two of the Magnificent Seven stocks actually outperformed the broader index.

So, that’s telling you in many ways that the equity investors are looking outside those stocks. Because, to your point, valuations do matter, and it is quite interesting that you’re starting to see that whether it be elements within the small-cap area, where the Russell 2000 this year has actually outperformed the S&P index.

Now we’ve had false dawns in the past year around small caps outperforming large caps, etc. But I think that’s also quite interesting that investors are starting to look outside that very concentrated cohort of names.

Kyle Caldwell: You’ve already mentioned that you’re underweight the US stock market. I think you’re also underweight the Magnificent Seven stocks. Could you talk through your current positions?

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Richard Saldanha: In terms of the Magnificent Seven companies, we own three out of those seven names. So, Microsoft Corp (NASDAQ:MSFT), which we’ve owned for well over a decade. From an income standpoint, Microsoft’s been a very consistent dividend payer. It’s not far off being what we would call a dividend aristocrat.

So, a dividend aristocrat is a stock that’s increased its dividend every single year for the past 25 years, and Microsoft is actually very close to that. It’s done that for over 20 years now. So, we’ve owned that for a long time, well before the theme around AI really took hold there.

Alphabet Inc Class A (NASDAQ:GOOGL) we also own in the portfolio, and that’s an interesting one, but they only recently initiated a dividend last year. So, you had the first dividends coming from Alphabet and Meta Platforms Inc Class A (NASDAQ:META) last year.

So, it’s quite interesting what you’ve been seeing in terms of the tech landscape and more and more companies paying dividends now, which actually means, from an income standpoint, there’s a lot more opportunity there. So, yeah, we took that opportunity, and started a position in Alphabet last year, which worked pretty well.

We also own a small position in NVIDIA Corp (NASDAQ:NVDA), which does pay a dividend as well. But if you look in aggregate across our exposure, it’s around 10% of the portfolio. If you compare that to a global benchmark where those Magnificent Seven stocks are almost 25% of the benchmark, you can see we own relatively less certainly compared to the global benchmark.

Kyle Caldwell: Going back to valuations, history shows valuations are key for long-term returns. Given the PE ratio on the US market - I think it’s around x30 at the moment - does that inform investors that over the next 10 years, returns are going to potentially be lower than they have been over the previous 10 years?

Richard Saldanha: Yes. So, history is an interesting guide here because, again, taking the point around PE ratios, if you look at that cyclically adjusted, that cape PE that we talked about earlier, typically, when you get to levels that are quite elevated that tends to mean the future returns tend to be lower.

Certainly we’re coming off the back of a period where you’ve had post-2022, three years of exceptional returns. Even global stock markets are up 20% in US dollar terms every year for the past three years now, which is quite exceptional in that sense.

When we think about it from an investor standpoint, are we going to be able to sustain those levels of returns? Quite unlikely, I’d suggest. Now, that doesn’t mean that equity markets can’t continue to remain buoyant. There’s lots of themes that are driving markets over the long run [and] that broadening out will help somewhat when you think about other parts of the market that perhaps haven’t necessarily participated as much in that strong performance.

But I think the reality is that investors should be mindful of the potential for lower returns and even drawdowns in markets, let's not forget. So, that should also focus investors’ minds when they think about constructing portfolios as well, to be mindful of some element of downside protection as well, I’d suggest.

Kyle Caldwell: I wanted to next ask about political risk. Last year, from around mid-February to mid-April, US and global stock markets suffered quite heavy falls in response to it becoming clearer [what] the US tariff policy would be. Then, from around mid-April onwards, when there was a 90-day pause in US tariffs, that settled markets. Since then, we’ve seen a very strong recovery play out.

I think a lot of investors were hoping US tariffs would be in the rear-view mirror this year, but we have the proposed threat of tariffs being introduced on several European nations in response to US President Donald Trump’s plans to try and take over Greenland.

What are your thoughts on how political risk could spell the end for US exceptionalism?

Richard Saldanha: To your point on geopolitics, that’s something that’s been in the background for quite a while.

It’s intensified, if anything, this year when you think about what’s happened, particularly aspects around the events in Venezuela and Greenland that you highlighted as well there.

From an investor standpoint, the reality is that you have to deal with that somewhat.

We put out a thought piece last year [noting] the amount of headlines and political noise that you’re seeing. I’d argue, certainly in my 20 years as a fund manager, that I’ve never seen it at such a high level.

The reality is as fund managers, our job, is very much bottom-up focused when we think about what we’re looking at whether it be the kind of drivers at the industry level or even at a company level. It’s focusing on the fundamentals, the earnings, the cash flows, and obviously the valuation context there. But the reality is the geopolitics certainly has an impact. We’ve seen that in terms of the volatility in the market.

But companies have shown that they’re pretty resilient in many ways to a lot of these geopolitical events happening right now.

In terms of the political side of things, sometimes it can throw up opportunities, which are quite interesting to us. Last year was a case in point, and the healthcare sector is an example. There’s a lot of political noise whether it be around tariffs, elements around drug pricing, or healthcare reform, etc. You saw that impact the sector massively when you think about the derating in the healthcare sector.

As investors looking at the bottom-up fundamentals and taking a slightly longer-term view, we felt that it was almost peak fear. Like a lot of the downside was in the share price, as it were, or priced in. That’s when you can take a more constructive view from an investment standpoint and take that longer-term lens and step in.

The point I’m trying to make is that the political noise does create opportunities, but you also have to have a bit of a thick skin and think about it over the long term because, certainly over the short term, it does create a lot of volatility.

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Kyle Caldwell: As you’ve already noted, around 45% of the fund’s in the US and you’ve got a global remit. Where’s the rest of the fund invested?

Richard Saldanha: Good question. When we think about the regional allocation from an income standpoint, certainly you tend to find quite attractive dividend-paying companies in Europe.

Obviously, the UK is part of that, but across Europe, there tend to be companies that are paying quite attractive dividends and growing those dividends.

Asia and the emerging markets have certainly been a fertile hunting ground in many ways from an income standpoint.

Obviously the US has delivered really strong levels of cash flows, and these companies have, certainly from a capital allocation standpoint, done exceptionally well. But I think you’re starting to see a lot of these elements, particularly outside the US. So, particularly in Europe, but also in Asia, you’re starting to see companies that are generating healthy levels of cash flow, growing those cash flows, and some pretty attractive industry growth drivers as well.

The context again with the valuations is certainly what really attracts us there because certainly on a relative basis, it’s more attractively valued.

So, again, you think about our exposures, whether it be in Europe and in Asia, that’s something that we can see persisting for quite a while.

Kyle Caldwell: How much percentage exposure do you have to Asia? I know that some global funds just invest in developed markets. Whenever I see any global fund with exposure to Asia or emerging markets, I think that’s more unusual these days.

Richard Saldanha: Yeah. You’re right in some ways. The way we think about it is that we try and understand the business models, and these are big global companies in many ways. You’ve obviously got the likes of Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM) in Taiwan, and if you think about some of the companies in pockets of Asia - AIA Group Ltd (SEHK:1299) is a good example in the insurance space.

There’s some interesting demographic shifts. So, to take AIA as an example, when you think about the protection gap that exists right now, whether it be in health insurance, life insurance, etc, you’ve got companies that are addressing that.

Even the consumer staples landscape is quite interesting because you’ve got companies that aren’t listed in Asia but are listed in areas such as Europe and the US. Companies such as Unilever (LSE:ULVR) are benefiting from some of the trends that you’re seeing in emerging markets, whether it be the strength of the end consumer, etc.

So, you can definitely play into some quite interesting demographical shifts that are taking place there right now. As I said, you’ve got companies with pretty good track records when it comes to paying dividends and growing that income stream over time. For us, that tends to be what piques our interest, when we can see companies that have done that over cycles, consistently growing that income over time. Asia certainly offers that right now to investors.

Kyle Caldwell: Do you have exposure to our own home market, the UK?

Richard Saldanha: Yeah, we do. It tends to be with companies that have quite a global footprint. When we look at our exposure from a UK context, we highlighted Unilever as an example, but also across other parts of the complex as well. We’ve got companies such as Experian (LSE:EXPN) in the credit bureau space as well, which is quite an interesting company from a cash-flow standpoint.

The UK still remains an attractive place to invest. From a capital allocation standpoint, you’re seeing companies deploy some of that capital, whether it be buying back their own shares. If you’re looking at the level of share buyback in the UK market, it’s increased quite materially over the last few years.

So, it’s an interesting case study where global companies are benefiting from a lot of the trends that US companies are benefiting from. But the valuations are certainly not as extreme.

Kyle Caldwell: You’ve mentioned cash flow a couple of times. When you’re scanning the global universe for income opportunities, is there a certain level of dividend growth that you’re looking for? Is there a certain dividend yield? Is there a low threshold that a company has to meet?

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Richard Saldanha: Yeah. For it to come into the portfolio, the company has to pay a dividend. That’s the starting requirement. We don’t invest in companies that don’t pay a dividend. But where we source that income from is pretty diverse.

We tend to think about it in terms of what we call income buckets. We have three buckets of income where we source from. The first one is what we call mature-yielding companies. These are companies that tend to pay quite high yields. Often, the headline dividend yield would be 4% or even higher.

That tends to focus on certain sectors. Pharma would be a good example. Telecoms, utilities, some of the staples companies as well, which fit within that bracket, some financials too.

Then we have what we call our core yields. These tend to be companies that can compound that income stream over time. They are very consistent, almost steady Eddie-type business models. You are getting a nice compounding of the cash flow and income stream over time. Typically, those yields tend to be around 2%, 3%, but there’s a very consistent level of income growth that you’re getting.

Finally, we have what we call our income growth bucket. These are companies that tend to operate in industries where you can see pretty attractive structural growth prospects. Technology would be a prime example. Some industrials that are playing into the AI theme would also fit into that bucket as well.

Now, typically, with the income growth bucket, those dividend yields are actually quite low. So, sometimes, they might be 0.5%, 1%, etc.

But what we really like about that bucket is the levels of income growth [are] actually pretty high. Typically, income-growth types of businesses will be growing their income stream at well over double digits, so mid-teens annualised growth or even higher. That’s thanks to the level of cash-flow growth these companies are generating.

So, the key for me from a portfolio construction standpoint is making sure we combine those buckets together because they offer you quite different qualities throughout the cycle. So, those mature-yielding businesses tend to be quite defensive [and] offer you that downside protection. Contrast that with the income-growth types of companies that tend to do quite well in periods where the market is buoyant. So, being able to source income across a wide range of yields and industries is quite beneficial.

Kyle Caldwell: Particularly with those companies that have higher yields, how do you make a judgement call that a company is not over-prioritising a dividend, since there’s been various instances over time [showing that] when a company does tend to overprioritise, that can really impact the growth of a company very negatively?

Richard Saldanha: Yeah, absolutely. The sustainability of the dividend is something that we are really focused on. Because, to your point, we’ve certainly seen periods in the past where what might look like an attractively high yield isn’t sustained, and you get companies that cut their dividend, whether it be the cyclical types of businesses or those that are actually allocating too much to increasing the dividend, not thinking about other parts of their business model.

There’s definitely a fine balance between paying an income, which we like and think is attractive, and also thinking about investing in your business, growing your business over time because, ultimately, that’s what drives the dividend growth.

It’s the ability to grow those cash-flow streams over time. That’s something we’re really almost laser-focused on when it comes to thinking about investing.

We’ve certainly seen episodes in the past, Covid being a prime example, where a lot of companies cut their dividends. If you look to the portfolio, I think only one of our companies suspended its dividend out of the 40 names that we held in the fund then.

So, it is something we absolutely do consider when it comes to investing. We want to be able to think ahead and think, are these companies going to be able to sustain those, if they are high yields, going into the future?

Kyle Caldwell: Richard, thank you very much for your time.

Richard Saldanha: Pleasure.

Kyle Caldwell: That’s it for our latest On the Money podcast episodes. We love to hear from listeners, and you can get in touch by emailing: OTM@ii.co.uk.

In the meantime, you can find plenty of insights and practical pointers on the interactive investor website, ii.co.uk. I’ll see you next week.