One week / one topic: Back to the US R-star

What happened?

The start of the year has not been in line with consensus expectations.

I would venture that most investors, taken individually, would acknowledge that forecasts are largely a waste of time – and yet, as humans, we just can’t help ourselves.

(Warren Buffett: “We've long felt that the value of stock forecasters is to make fortune-tellers look good”)

Not only S&P 500 forecasts are usually wide of the mark…

…but rate forecasts – despite fixed income markets being allegedly ‘smarter’ – are no better.

So: goodbye US exceptionalism, hello sticky inflation and ‘higher forever’ rates?

Maybe, maybe not… but very high US equity valuations (blue) leave little margin for error in the context of higher rates (red, US 10yr bond futures).

All of a sudden, markets are once again focusing on inflation and what central banks would consider as the natural rate of interest (or R-star, in the US).

Following much stronger than expected economic data, recent inflation expectations and policymaker comments do not bode well for further rate cuts, which – going into the new year – were largely considered as a necessary condition for continued equities appreciation.

So, is this the beginning of the end for the AI-fueled raging bull market that defied expectations for the past two years – or just a bump in the road towards inevitably higher equity prices?

Our observations

• Fundamentals: When the SPX has traded at ~24 fwd P/E like today, subsequent 10-year forward returns were close to zero. This is not enough to sell it all and go to cash of course, and maybe this time is really different… but it does remain a historical fact.

• Price action: Tuesday saw the largest volume ever for the Nasdaq (-1.8% on the day) and also a record for US-listed penny stocks, i.e. highly speculative bets. In aggregate, not exactly a vote of confidence for ‘everything will be fine, just buy and hold’…

• Investor beliefs: So far, bonds are not responding to rate cuts as they usually do. Equities have taken notice, but is it enough to convince the true believers to reconsider their sky-high US equity allocations?

So what?

While we have been running healthy equity allocation levels as of late, higher yields increase the chances of a more serious equity setback. (After all, we are still only 4.5% lower than the all-time highs reached last month)

The US economy looks to be reaccelerating given the shock payrolls beat on Friday, and in the space of one month we went from more than three Fed rate cuts priced in for 2025 to (maybe) one.

The Mag Seven are indeed wonderful businesses, but – especially in light of current index concentration levels – at some point continued earnings growth might just not be enough to offset US 10yr rates approaching 5%...

For context, in 2024 just five companies (Nvidia, Apple, Amazon, Alphabet, Broadcom) added $6trn in market value – equivalent to the total size of the UK and German stock markets – and generated 46% of S&P 500 returns.

How likely is this to repeat in 2025?

Putting it all together, we are therefore inclined to reduce our US equities position at current levels.

Mood music: The Beatles – Back in the U.S.S.R.