As we like to say, valuation represents the scope of an opportunity, not the timing
Valuations are stretched but the rally could keep running. History tells us that mispricing can persist for years, until sentiment or the data turns. Investors rightly turn to valuations to identify mispriced assets, but valuations are a poor tool for market timing – we’ve run through the data and found a weak relationship between price ratios and future returns. Today’s high price-to-earnings ratios suggest investors are willing to pay a premium for earnings: one that is affordable if they are expecting growth to accelerate, and many investors are pricing in strong earnings growth. Given our team’s constructive view on the economic outlook (a gradual descent from above-trend growth toward just below trend growth), we think valuations could maintain these levels until macro or policy headwinds pick up.
Can U.S. outperformance continue?
In the near term, we think so. The geopolitical outlook points to further U.S. market outperformance. In developed markets, Germany is facing a lame duck Chancellor, and the French government has collapsed after a no-confidence vote. In emerging markets, the impeachment of South Korea’s president after he arbitrarily declared martial law contributes to turbulence in a delicate geopolitical balance; Brazil’s real has sold off after a too-large budget proposal. And this list excludes the multiple armed conflicts ongoing around the world. That’s driven enough demand for U.S. equities that the U.S. stock market now makes up 67% of the global market cap. The next biggest market is Japan’s, which only makes up about 6%.
The question for investors is: do you believe momentum can take the U.S. market higher, or are you a mean reversion believer who thinks the spread will revert? We think the momentum trade – supported by strong earnings quality and economic outperformance – could win out until U.S. growth slows.
Portfolio strategy
High valuations might not stop equities from performing, but higher yields are a different story. The first chart below shows that equities have struggled when the U.S. 10-year yield climbs above 4.5%. If rates push back up to this level, it could be a good time for investors to consider taking profits in equity gains and reallocate away from rates-sensitive asset classes. We think investors can also consider adding equity-like risk in fixed income assets, specifically short-duration credit. The second chart below shows yield per duration, or a return per unit of risk measure, of fixed income asset classes; short-duration high yield credit is leading the pack.
Sources: New York Life Investments Global Market Strategy, Bloomberg, Macrobond, December 2024. Convertibles represents the Bloomberg U.S. Convertibles Liquid Bond Index. EM Agg represents the Bloomberg Emerging Markets (EM) Hard Currency Aggregate Index- a flagship hard currency EM debt benchmark. EM govt represents the Bloomberg Emerging Markets Local Currency Government Index-a flagship index that measures the performance of local currency Emerging Markets (EM) debt. Global agg represents the Bloomberg Global Aggregate Index- a flagship measure of global investment grade debt. Global high yield represents the Bloomberg Global High Yield Index-a measure of the global high yield debt market. Loans represents the Bloomberg US Leveraged Loan Index-measures the institutional leveraged loan market. Muni represents the Bloomberg U.S. Municipal Index-covers the long-term tax-exempt bond market. U.S. agg represents the Bloomberg US Aggregate Index-a broad-based benchmark that measures the investment grade bond market. U.S. high yield represents the iBoxx USD Liquid High Yield Total Return Index-measures the sub-investment grade, corporate bond market. U.S. MBS represents the Bloomberg US Mortgage-Backed Securities (MBS) Index-tracks agency mortgage-backed pass-through securities. U.S. HY muni represents the Bloomberg Muni High Yield Total Return Index. Short duration (SD) high yield represents the Bloomberg US High Yield Ba/B 1% Cap 1-5 Year TR Index. It is not possible to invest in an index. Past performance is not a guarantee of future results.
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