The exceptional performance of US equities continues, with the resumption of strong AI-related earnings growth boding well for the near term on Wall Street. However, eye-watering valuations raise a cautious note for the longer term.
The latest reporting season delivered a standout performance for the S&P 500 with 82% of companies beating expectations. Aggregate earnings growth is tracking at 10% year-on-year, double the long-term average.
Sales growth is robust, and margins are near record highs.
The wave of positive surprises has fuelled a rally in equities but strength is far from broad-based: nearly 90% of the earnings growth came from mega-cap tech and financials, while consensus estimates for the second half of the year point to a slowdown, raising concerns that the future may not be as rosy.
This year began in a much more negative way for Wall Street. Tariffs, trade tensions, recession worries and concerns over big tech competition saw the S&P 500 endure a historically poor start to 2025.
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Just before Trump’s bombshell tariff announcement, both the S&P500 and Nasdaq index were down in local terms, by around 5% and 10% respectively.
Other global markets, including the FTSE100, the German DAX and especially the Hang Seng were up. The slump was broad based, sinking every region, but the bounce back has seen leadership return to the US with particularly strong returns from the tech sector and ‘Magnificent Seven’.
Sustained dollar weakness has helped to boost export earnings. The markets also seem to be taking a more optimistic stance about global trade, despite the fact the average tariff rate for US imports looks to be only slightly below the levels first threatened in April.
Add to this resilient economic data and the expectation of two Fed rate cuts by year end and it sort of makes sense. Earnings forecasts have been upgraded everywhere, but nowhere faster than in America.
We are yet to see the full inflationary impact of tariffs within America and a more stagflationary feel to macro data could see stock markets dip
Equities perform an important growth function in any multi-asset portfolio, particularly for those with a high-risk appetite and/or long-time horizon.
Two factors make us wary of extrapolating the recent trend. We are yet to see the full inflationary impact of tariffs within America and a more stagflationary feel to macro data could see stock markets dip.
More fundamentally, and irrespective of the trade war, US equity valuations are back to eye-watering levels. A long period of market weakness could follow, as is often the case when you buy something that is already widely admired and expensive.
At 36x cycle adjusted earnings, US equities are roughly twice as expensive as their UK counterparts and the dominance of a handful of mega-cap stocks has reached levels not seen since the dot-com era.
Trump policies could push up Treasury yields, creating the sort of tech stock valuation headwind we saw in 2022
The earnings story backing the AI theme is compelling, but any number of things could go wrong.
Trump policies could push up Treasury yields, creating the sort of tech stock valuation headwind we saw in 2022. Cheap overseas competition could undermine the US business model. Or markets could simply fall under their own weight.
To this day, people debate what exactly it was that burst the dot com bubble in March 2000. These things are notoriously hard to time.
As asset allocators, there are three things we can do to manage through this level of uncertainty.
First, stay disciplined, rebalancing exposures periodically so stocks don’t become an ever-larger part of your portfolio.
Secondly, set a strategic weight for regional exposure that takes valuations into account. This means being easing off US equity exposure versus its 70%+ weight in global indices, with the added benefit of diversification away from the US dollar.
Mega-caps may be leading the charge today, but whether the US can sustain its dominance in the future, remains an open question
Lastly, operate a research-led tactical process than can reduce risk when the music stops.
Tactically, we are more positive on US equities than we were at the start of the year for the reasons set out above. Strategically, we are more cautious.
Expensive valuations, political risk, and the potential for a regime shift in global trade all argue for caution. Mega-caps may be leading the charge today, but whether the US can sustain its dominance in the future, remains an open question.
Trevor Greetham, head of multi asset at Royal London Asset Management
