The strong US equity run since April has continued through the second quarter earnings season. Most of the constituents of the S&P 500 have now issued their second quarter updates, and this helped the US large-cap index extend its recent gains.
The rally in US stocks reverses the underperformance seen in the first part of 2025 as concerns about the valuations placed on some US companies, as well as questions about the durability of US economic growth, caused US equities to lag global developed markets.
After the surprise of Donald Trump’s Liberation Day tariffs, US equities sold off heavily as investors weighed the potential damage to US corporate profits and global growth. But the rally since then has seen the US return to favour, and enthusiasm for AI-linked tech stocks has since lifted US equity markets back to record highs in dollar terms.
However, there are reasons to remain wary of the recent enthusiasm for US equities.
Concerns about the high valuations placed on many US stocks haven’t gone away, and the increase in US tariffs since then adds to the pressure on US corporate profits. Although it is a blunt measure, the P/E ratio of the S&P 500 is around 27, considerably above the long-term average. To put this into context, the P/E ratio of the S&P 500 hit 25 in the dot-com bubble in 1999.
An argument in favour of US equities is the country’s economic growth and this remains far higher than other developed economies
The earnings updates from tech stocks like Microsoft, Meta and Alphabet have more than kept up with aggressive targets, but other companies are beginning to feel the pressure of higher costs and lower consumer demand.
Car makers, retailers and electrical goods producers have been the most noticeable in their warnings about the cost of higher tariffs, but concerns about the cost of tariffs are widespread. The KPMG Tariff Pulse Survey of US companies found that almost 60% of firms have reported lower profits, and more than 80% of firms expect they will have to raise prices.
The concentration risk in US markets has not gone away, and the recent rally in tech stocks has added to the valuation of already giant companies. The 10 largest companies in the S&P 500 now account for 37% of the index. In May last year, this was 32.5%.
A strong argument in favour of US equities is the country’s robust economic growth and this remains far higher than other developed economies. The US economy expanded at an annualised rate of 3% in the second quarter, compared to just 0.4% annualised growth for the Eurozone.
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These figures need to be treated with caution, however, as US tariffs have distorted recent GDP figures as companies front-loaded their imports to avoid paying higher levies. This data is also running with a time lag of several months.
Employment data is also backwards-looking, but usually comes with a shorter delay than economic data.
The US jobs market remains very strong. Unemployment is 4.2%, significantly below the pre-Covid rate. Average hourly earnings are rising at 3.8% annually (above CPI inflation of 2.7%), and this is also higher than the long-term pre-COVID trend.
However, there are unmistakable signs that the US jobs market is cooling, and last month’s non-farm payrolls data showed far fewer new jobs than expected and came with a significant downwards revision of recent data.
High inflation is also a factor in our view of US equities. Consumer price inflation remains above target, and the imposition of tariffs on most US imports will add additional upward pressure. This leaves the Federal Reserve with less room to cut rates, so it is likely to remain restrictive for growth.
The potential for a change in sentiment towards US growth stocks are reflected in our view of US and global markets
What should be done about US equity exposure? The US has been the mainstay of most investors wishing to take on equity risk, and it will remain central to the asset allocation for growth investors. The OECD expects the US economy to slow from 2.8% growth in 2024 to 1.6% this year, but this will still be ahead of the OECD forecast average of 1.4% and well ahead of expected growth in France, Italy and Germany.
The issue of changeable US policy making, including but not limited to tariffs, adds uncertainty. Data from Calastone shows large outflows from UK funds in July, with US and global funds seeing the biggest withdrawals as some investors grow wary of the US markets. This uncertainty and the potential for a change in sentiment towards US growth stocks are reflected in our view of US and global markets.
We are less positive towards highly valued growth stocks than some investors and have been keen to balance exposure to areas of the market with the highest valuation with more defensive, dividend generating stocks, as well as maintaining exposure to value stocks.
Charles Younes is deputy chief investment officer at FE Investments
