Why Morningstar thinks the US stock market is looking cheap

On the surface, the US equity market has had a blazing year. But we all know the reason. The magnificent seven have averaged returns north of 90% so far this year and represent significant portions of both the S&P 500 (29%) and Nasdaq 100 (49.2%).

Whilst average valuations would suggest that the US market is expensive, that far from the full story. Big tech has distorted the data and Marta Norton, chief investment officer – Americas for Morningstar, argues that outside of the big tech companies, the market is looking cheap. Morningstar now has one of the largest exposures to US equities it has had in some time.

It's not the only big idea to come out of Morningstar’s 2024 outlook webinar, with Norton and Matt Wacher, Morningstar chief investment officer – Asia Pacific, but it may be the most unexpected.

In this wire, I’ll summarise some of the key themes and outline where they are seeing opportunities.

The base case for the global economy

Norton tips inflation to continue to fall in 2024, along with lower growth and a hold on rates (if not potential cuts later in 2024). She expects the US to experience a soft landing.

Australia, on the other hand, is around 3-6 months behind the US and has a higher potential for recession, with interest rates finally hitting consumer confidence and retail sales.

The key known risks for the market are as follows:

• The ongoing Ukraine/Russia conflict
• The Israel/Gaza conflict
• China’s secular growth
• Potential recession
• Concerns in commercial real estate
• Elections in the US, UK and India
• Looming US deficits and disappearing demand
• Any resurgence of inflation and future rate hikes.

Morningstar notes that there are ways to consider offsetting some of these risks into 2024. For example, using cheaply priced energy assets like energy infrastructure could assist with concerns over the ongoing Ukraine/Russia conflict, while long-term, high-quality government bonds could offset equity market volatility caused by any heightened tensions between the US and China.

Morningstar’s investment ideas for 2024

From an equities perspective, Morningstar views defensive and cyclical sectors as looking most undervalued in the current market.

Financials stand out within cyclicals, with regional banks in the US particularly attractive.

“The price for these more than compensates for any impairment we’ve seen from leverage to commercial real estate,” says Norton.

“Within the big 4 Australian banks, ANZ, Westpac and NAB are looking reasonably attractive but we view Commonwealth Bank as looking overvalued at current prices,” says Wacher.

In terms of cyclical sectors, both healthcare and utilities look promising.

“We think concerns around leverage in Utilities are overdone. Many of the stocks in this sector have good earnings expectations and dividend growth,” says Norton.

Morningstar also has a positive view on small caps – particularly value stocks in the US market. Their outlook notes: “This is consistent with our US Equity Outlook, offering a large discount to “fair” which is considerably better than the large-growth counterparts that have dominated 2023 leaderboards.”

As mentioned earlier, Morningstar view much of the US market as undervalued, if you take a bottom-up approach. Bigger companies are dominating the view and making the market otherwise look expensive. They are taking the opportunity to increase US exposures and currently have the largest exposure to US equities in some time.

Morningstar also sees opportunities in emerging markets, though notes there is vast dispersion in activity and valuations. China, Korea and Brazil show the most promise for differing reasons.

“Brazil is great for banks and miners at better prices than in Australia,” said Wacher.

While China has had a challenging year, Morningstar also notes that healthy companies have sold off on investor concerns, and China will continue to have a dominant role in the global economy, even with slowing growth. Korea, on the other hand, has been a hotspot for AI exposure for Morningstar.

The topic of AI is hard for any investor to ignore. It is, after all, behind the tremendous returns of The Magnificent Seven this year. Morningstar argues that the opportunities on this front lie in what they term “second-derivative AI plays”. What this means is those companies that are effectively embedding AI into their workflows to drive new revenue growth opportunities - think champions of integrated AI, such as utilities companies, rather than the creators of tech, like Nvidia.

Morningstar also believes in government bonds for 2024. As per their 2024 Outlook: “We like government bonds more than we have for at least a decade, but we are prepared for surprises, which is why different duration profiles still factor into portfolio construction.”

Overall, bond yields are better than average and looking more attractive than they have in years, courtesy of rising interest rates. Even with the potential for cuts, Morningstar believes they can support diversification in the coming year.

You can find more ideas from Morningstar on Australian value picks of the last quarter here. 

You can read the full outlook here. Or to read a variety of views on 2024, please visit this wire from my colleague Glenn Freeman.