The end of US exceptionalism: Myth or reality?

EDITED TRANSCRIPT

Lukasz de Pourbaix (LDP): Today I am joined by Co-Portfolio Managers for the Fidelity Global Future Leaders Fund and Active ETF (ASX:FCAP), James Abela and Maroun Younes.

There's a lot happening markets at present, and one of the key things a lot of people are really focused on is volatility, which we've seen spike up quite aggressively. There are different reactions to volatility. If you think about behavioural investing, there are people that will be conservative and might take money off the market, others that will buy into the market, and finally, there are people paralysed by the market.

Both of you are very experienced investors, how are you navigating this volatile period?

Maroun Younes (MY): It's fair to say, the overarching theme of what we've been doing is really just to maintain cool, calm heads, which we think is the most important thing. However, we’re fortunate to have built a portfolio that’s set up to weather the storm.

One of the benefits of being invested high quality businesses is that they tend to be quite resilient to a lot of the macro shock. That gave us a decent level of cushioning to enter volatility episodes. At present, the landscape is very fast-moving, so it's difficult to make a lot of predictions as to how things are going to shape up.

We've been making some small changes around the edges, certainly not panicking, and waiting to see how it all unfolds from here. I think it can go one of two ways:

1. This is the end of it, the uncertainty around the tariffs is resolved, we avoid a recession, and things start to grind back up higher again; or
2. This uncertainty around tariffs and what that means shakes confidence and fundamentals, like spending and capital expenditure, down to a level where we start to see a recession, in which case there's more pain to come.

Trying to make a call now, one way the other, I think is premature. We're taking a wait and see approach and like I said, we’re very fortunate to have a well-positioned portfolio so we haven’t been required to do a whole lot of reactive changes on the fly as things were developing.

James Abela (JA):

In the second half of last year (around August), we trimmed very high price/earnings ratio (P/E) stocks because we noticed like 70-80% of our top 20 names were up between 20-40% just on P/E expansion, so that's something to be aware of. Furthermore, we started to trim technology names and US industrials, which had had really high P/E expansion. Also, we're not massively exposed to things like manufacturing. These decisions have put us in a good position so we’re not feeling panicked.

I think it’s all about keeping a cool head. What tends to happen in markets like this is that high P/E, high quality, high momentum stocks tend to come off quickly. Sectors like defensives, gold, real estate, utilities, low beta, and value do well. So, we've started tilting towards those the last six months and also tilting away from the US in favour of Europe, where the valuations are a lot more appealing. We’ve gradually taken these steps in the past 6-9 months based of what we’ve observed and what the Fidelity analysts are seeing.

LDP: It's testament to your investment process. Investing in quality companies and sticking to your discipline is quite interesting.

JA: Those people know our QTVM (Quality, Transition, Value, Momentum) strategy: Quality was pushing over 50% and these stocks had really high P/E expansion in the last six, 12, to sometimes 24 months - two years of P/E expansion! So, we know that when Quality is pushing 50%, we're at the point where it has given us a lot of alpha but that it maybe needs to be retested and checked again. This is why we’ve started to drift towards more Value at present.

LDP: The US tariff policies are very fluid at the moment. It seems that every day it's changing and shifting, stirring market volatility, and causing markets to react.

You own a lot of companies in the portfolio, attend active meetings with these companies, speak daily to Fidelity analysts on the ground around the globe.

From a bottom-up perspective, what are some of the initial reactions from companies and what may some of the potential impacts be on your portfolio?

MY: Fortunately, there hasn't been a huge amount of impact on the US stocks we own. Industrials that we hold do a lot more of the manufacturing and distribution in the US, so they're not super reliant on importing things from, particularly, China. We've seen a rollback on all the tariffs apart from China. So even those companies that we had four or five years ago, either through COVID or through the increasing geopolitical tensions between the US and China, had started to move some production away from China into places like Vietnam or India. Having the tariffs in those jurisdictions come down to 10% still makes those manufacturing hubs viable.

I think companies that are heavily reliant on importing from China are going to have to very quickly reorientate their entire supply chain and figure out whether they can bring the manufacturing back home, pending whether they have the right skill set and money to do so, or if instead they need to go to a different jurisdiction to do so.

So, whilst there's quite a bit there, thankfully for us, not a huge amount is within our portfolio, and therefore, the companies that we hold haven't been panicking or doing a whole lot in reaction to this.

JA: US exceptionalism, that really high return in the US market, is something that's been talked about for at least six months. The US is still the highest return on capital markets that we have in the world. The tariff announcements have tainted that view, suggesting the end of US exceptionalism.

But the reality is, for now and for the next couple of years, the US market is still very attractive in terms of returns on capital. As Maroun rightly said, we haven't had a huge impact in the portfolio. In the US, we are reducing our weight, but the US return on capital as a marketplace is still very attractive.

LDP: It’s been interesting to see, particularly in the media, that this end of US exceptionalism and we might see a rotation to Europe or maybe other geographical areas.

But you're suggesting that actually, net-net, the US is still an attractive investment destination?

MY: From the fundamental perspective, absolutely. Now, whether it remains the most attractive destination of capital, that's a different argument. But in terms of the strength of the underlying companies, it's still by far the most attractive market from a return on invested capital perspective and profit margins, so we’re continuing to focus on seeking companies with those characteristics.

LDP: Year to date, if you look at the performance of the US market, the S&P500 is down ~12%. If you look at some of the performance particularly some of the Mag 7 stocks like Nvidia, for example, which is down ~30%. So, some of the “golden child’s” over the last couple of years which have really driven the market performance of the US have come off quite heavily.

Interestingly and historically, these big, mega-cap names are often considered by investors to be considered the safe havens as you see the small-caps and maybe mid-caps that sell off.

How has the mid-cap market fared in this environment?

MY: It's been surprising that the mid-cap space has held up quite well and fallen a lot less than the Mag 7 names. It's also a unique sell-off because, as you mentioned, in a typical recession the larger companies with typically stronger balance sheets, stickier revenue streams, and more diverse revenue streams tend to be the areas that investors gravitate towards, and they tend to hold up a little bit better. As you move down the cap spectrum, typically you see businesses that are bit more cyclically exposed, higher beta perhaps and don't have the same balance sheet strength, so they tend to suffer a lot more.

This particular sell-off is very different to that. The Mag Seven has been hit by a double whammy. If you go back to January or February 2025, the first wave was really DeepSeek, which is so far in the region era now. Up until that point, the narrative had been that the Mag 7 pretty much had a monopoly on AI and then DeepSeek came along and changed that. That was the first round where their share prices were impacted quite significantly.

Rolling forward into the last month or so, we’ve seen more issues around the geopolitics of things and because the US runs trade deficits with a lot of countries around the world, how can other countries reciprocate? There are discussions around perhaps taxing some of the Mag 7 names. Too there is discussion around if the US want to shore up government finances, are they going to close some of these tax loopholes for some of these Mag 7 names who, given their size, are able to move money around to different low tax jurisdictions and not pay the highest marginal tax rate.

So, what you're seeing is definitely a challenge to the narrative. In hindsight, we found out these foreign investors, places like China, Japan, etc., have been running large trade surpluses with the US. They've been recycling money back into US assets. That's either been treasuries, or what appears to be the case of the last four or five years, US stocks. Now, if the US is really serious about cutting back some of the trade deficits it runs with some of these countries, perhaps they don't need to hold anywhere near as much by way of US dollar assets. So, we've seen treasuries sell off.

We've also seen some of the Mag 7 names sell off. So perhaps there's also a bit of flow repositioning taking place there. What it has meant is that the Mag 7 and the top end of town hasn't fared, driving some movement into the mid-cap space. They're also global in nature, so it's hard for them to avoid any tariff impacts tit for tat, whereas the mid-cap names, if they're domestically focused, can sidestep a lot of the collateral damage.

LDP: The mid-cap part of the market, in terms of valuations, have been trading within 30-year averages which is not rich in terms of pricing, whereas some of those mega cap names are priced for perfection.

MY: That's right. If you go back to February 2025, the MSCI World Index was trading probably in its top 10 percentile trading range over the past 30-years. The only time it eclipsed that was the COVID scenario, where you had rates basically go to zero, whereas the MSCI World Mid-Cap Index, which is our universe, in February was trading in line with 30-year averages, i.e., the starting point in terms of how much stocks could sell off.

JA: We saw movement in momentum thematics generally, so data centres came off hugely. Virtus, a stock in our universe, fell a long way. But also, anything that's energy related into AI has also come off quite a lot. So not only has quality moved down in terms of multiples, but momentum stocks and momentum thematics have also come down.

In the last two years, the market was very confident, and risk was very cheap. There was not a lot of attitude or pricing for risk. So that has really come out because risk has come into the market. People's duration was very long and now, it's become shorter because people are more concerned about economic recovery. This means momentum just doesn't work as well as a thematic. Things like data centres, energy related to AI, etc., have started to slow down in terms of multiple expansion or go the opposite way.

LDP: When you get market dislocations, and again, this comes with experience, and obviously, both of you have been in the markets for a while, it can be an interesting period for investment opportunities.

Despite the expectation of more volatility and more tariff news, what are the things you’re focussing on and where are these potential opportunities?

MY: I made a comment earlier on about whether we morph into a recession or not. I think that really is the key. We're at a point in time now where a lot of the consumer sentiment, business, capital expenditure, expectations - they're all quite soft. They tend to lead the hard data, but they don't always give you a perfect reflection.

In 2022 when the market sold off, we saw the soft data come down quite substantially, but the hard data held up, so we avoided the recession where we are now, we're seeing the soft data coming off quite substantially. Now, whether that's a repeat of 2022 and we don't get a recession, if that's the case, then we're probably somewhere towards the bottom.

If you start to see businesses delaying investment plans or laying off workers because they need to cover their tariff costs or anything like that, and that starts to feed into like a wage price spiral where people get laid off, spend less, start to fall back on their mortgage repayments - it may be morphing into something more sinister. It impacts the entire economy because if you look at the average magnitude of a recessionary bear market, normally, they are typically down 30-35% on average, peak to trough, and we've only seen peak to trough somewhere around the 18-20% mark. If we do morph into a recession, we're probably only halfway through what we could typically experience.

I think we really need to remain vigilant for the next few months and understand whether the uncertainty remains contained or whether it's actually developing into something worse than that. If you do get a recession, then it's likely to be towards the second half of the year. You're at this fork in the road, and you just need to decisions pending how things develop in the next 1-3 months.

LDP: What are some examples of hard data you mentioned and what are the key ones you'd be looking at?

MY: The key one is probably the employment numbers. If you remain employed, you maintain an income, then you can continue to spend. You can continue to service your mortgage etc. Once that starts to disappear, you spend less, you fall back on your mortgage repayments. Your spending is impacting that business's revenues, which then has to do a round of layoffs. That's how it all ripples throughout the entire economy.

The key thing is looking at the employment numbers, because once that domino falls, the rest typically follows quite quickly thereafter. If you had to distil it down into one thing to look at, it would be the either employment numbers or unemployment rate in the US, but looking at a broad range of things, basically assessing things like consumer spending, GDP - although it's quite lagging, but things like GDP growth etc., they would be the key.

Then in terms of opportunities to wrap it up, because what you don't want to do is find opportunities in cyclically exposed names which look quite attractive now from a valuation perspective, and you start to invest in those and then a recession comes, and that second leg down impacts those companies disproportionately. So that's why getting the answer to that first question is important, because then it can give you a good guide in terms of what areas to narrow your focus on, in terms of where to invest going forward - whether you go more defensive or whether you start to add risk back on into the portfolio, is really determined by that single question.

LDP: From what you’re both saying, it feels like you have made a couple of conscious moves before this recent volatility happened?

It feels like you've got a bit of room to move should opportunities or the market environment change?

JA: We're sitting and waiting for now until we have more certainty over what the next year or so is going to look like. We're looking at quality stocks that have fallen because valuations are more attractive. Cyclicals are probably holding off for a little bit more. We’re cautious of where leverage or exposures are - into consumer, market and cyclical leverage. If your exposures are in those three areas, which, if the recession or even economic weakness starts occurring or becoming a bigger mindset for the market sentiment, multiples will shift down lower, and you need to be careful of that.

There are opportunities out there, but you want to make sure that you're moving in one direction, not having to chop and change. That's what our experience tells us. You don't want to go too far down in terms of being defensive, but also you don't want to also jump in too early when you're not as confident, or you don't have the data to give you the confidence, which will give you visibility and therefore ability to think longer duration.

Remember what we've just gone through: high inflation, low price of risk. Now we're going into an economic concern, inflation's coming down, rates are maybe going down. We're still in an environment which is a little bit more uncertain than it has been, so you need some time for that to clear.