The US equity market is once again touching all-time highs. Valuations are firmly back among the highest on record, fuelled by expectations that the pace of company earnings growth will be roughly one-and-a-half times the historic average.
The market environment is redolent of clear blue skies ahead: a growing economy, exceptional corporate earnings, inflation back under control without troubling a resilient labour market. It is an appealing vista – but, in our view, a dangerously complacent one. It is not difficult to identify a number of risks, any one of which could derail the equity market’s ascent. In this note we probe some of these risks before turning to valuation metrics, where we find a market continuing to price for perfection.
Risks A-Plenty
- Growth: US GDP contracted 0.5% in the first quarter, with corporate profits declining and consumption barely growing. True, trade distortions mean a rebound in the headline figure is likely in the second quarter, but this won’t address the weakness in consumption. We note that both the OECD and the Federal Reserve have recently revised down their economic growth projections for the calendar year.
- Employment: though the unemployment rate has held steady around 4.2% for the past year, there are ominous developments beneath the surface of the US labour market. Increasing numbers of workers are taking part- time work for want of full-time opportunities, the number of companies filing notice of impending job cuts has spiked higher, and those who lose their jobs are finding it increasingly difficult to re-enter the workforce. These are all trends that, historically, have preceded a meaningful rise in unemployment.
- Consumers: signs of strain are increasingly obvious among US consumers. With the covid-era moratorium on student loan repayments now ended, a record 31% of borrowers – 5.8m people – are classed as delinquent, a marked step up from the pre-pandemic delinquency rate of 12%. Meanwhile, the latest retail sales data showed a sharp slowdown in spending in May, including in restaurants and bars where it is difficult to lay the blame on tariff-related distortions.
- Trade Wars: tariffs have not gone away. The 90-day pause of Trump’s ‘liberation day’ tariffs expires in early July. A further postponement appears possible. Nonetheless, even the lower levies currently in place on US imports are the highest since the ill-fated Smoot-Hawley act that helped usher in the 1930s depression. Tariffs are expected to raise some $400bn a year for the US government, but this must either be paid for by consumers who are already struggling, or by companies who will see their profit margins decline.
- Inflation: to the extent that tariffs are passed onto consumers, they are inflationary. This is particularly uncomfortable given signs that, even before their imposition, inflationary pressures were beginning to rekindle. Rent on the median two-bed New York apartment has risen 17.5% year-on-year, Trump’s crackdown on immigration is pushing up prices in areas like agriculture and home care while services inflation remains uncomfortably high.
- Interest Rates: the Federal Reserve continues to walk a narrow path between fading growth on one side and stubborn inflation on the other. Though tariffs have not yet made their mark on inflation data, the US central bank recently revised up its projected year-end inflation rate to 3.1%, well beyond its 2.0% target. Against this backdrop, hopes for interest rate cuts can surely only be realised in the event of a material rise in unemployment.
- Government Deficits: the US Treasury is expected to issue a staggering $1,000,000,000,000 of new debt this year. This comes at a time when investors are already questioning the status of US government debt as ‘the world’s risk- free asset’. It is not only that the Trump administration’s unpredictability merits some sort of risk premium, nor that it appears hostile to overseas investors (who own c30% of the US Treasury market), it is also the risk that the yield on offer is eroded by sustained, high inflation. According to the Financial Times, net outflows from long-dated US bond funds have hit nearly $11bn so far in the second quarter, a meaningful change from average inflows of c$20bn over the past twelve quarters.
- Debt Sustainability: even the most optimistic forecasts suggest tariff revenues will merely offset those foregone by the tax cuts proposed in Donald Trump’s ‘Big Beautiful Bill’. Tax cuts are aimed squarely at the wealthy who are more likely to save the gains than to spend them. Consequently, the boost to US growth prospects is expected to be relatively muted. This means that concerns over the trajectory and sustainability of US government debt levels are likely to persist.
The economic and political background, then, is anything but benign. From an investor’s perspective, it is not necessary for all of these risks to unfold at once – any one of them is, in our view, sufficient to justify a degree of caution. Yet investors appear largely oblivious, content to keep investing in a market that requires an historically exceptional combination of events to justify further gains.
Where Is The Margin of Safety?
A simple exercise highlights the degree of optimism currently baked into the US equity market. If we assume a certain rate of profit growth over the next twelve months, and then assume investors are willing to pay a certain multiple of those earnings, we can calculate the market level that corresponds to these assumptions. This approach allows us to change our assumptions and explore the potential gains – or losses – at various combinations of earnings growth and valuations (Fig.1).
The green box highlights the current situation: current market pricing reflects expected earnings growth of c13% and a valuation multiple on those earnings of 21.5x.
To put the earnings growth expectations into perspective, over the past twenty years corporate earnings have expanded at an annual average of around 8%, so the consensus is expecting the next twelve months to be something like 50% better than average for corporate profitability. Given the risks identified above, this seems a tall order. At the same time, a valuation multiple of 21.5x on these earnings means the market has only ever been more expensive 7% of the time in the past twenty years. In other words, both earnings expectations and valuations are very ambitious.
If it transpires that company earnings growth is, instead, only average – a not unreasonable assumption given the clear slowing of the US economy thus far in 2025 – US equity investors should brace themselves for a loss of around 5%, assuming valuations are unchanged. Of course, investor sentiment might well be dented by disappointing earnings, resulting in lower valuations. If, alongside a return to average earnings growth, the market de-rates to its 10-year average valuation multiple of 18.5x, indices could quickly fall 17% to 20%. If we consider that earnings have fallen c15% on average during recessions we can see that market downside in a malign outcome could be very significant indeed.
But what if our caution over the US economic outlook is misplaced? What if earnings growth comes in closer to double the historic average at 15% and valuations surpass anything seen in the past 20 years, reaching 23.0x? In that case, according to the matrix above, the market ‘should’ be 8% higher. This might appear an attractive prospect but, to our minds, the potential upside is wholly insufficient compensation for the considerable risks involved – especially when compared to the 5% to 6% yields available on high quality short-dated bonds with little interest rate sensitivity and low risk of default.
And what would it take for the US equity market to deliver another year of returns in excess of 20%? Looking at the top right-hand corner of Fig.1 shows it would require earnings growth of 20%, a level only broached historically during post-recession economic recoveries, and a valuation of 24.5x – coincidentally matching the highest ever multiple, reached towards the end of the tech bubble, from which point the market halved.
This exercise reinforces our belief that the risks for US equity investors are tilted firmly to the downside, particularly relative to the attractive yields available on relatively low risk bonds. Why then do US equity market indices continue to march higher day-by-day, almost irrespective of economic and political developments? Our sense is that investors have developed an almost Pavlovian disposition to buy the stock market. A fifteen-year bull market, interrupted only briefly by sharp drawdowns from which losses have quickly been recovered, has conditioned investors to believe the US equity market only ever goes up, and riches are assured as long as one is always willing to ‘buy the dip’.
History tells us that this belief is likely to be misplaced. In our view, the level of the stock market must always and without exception be underpinned by company earnings valued at an appropriate multiple reflective of their growth prospects and attendant risks. As demonstrated above, extraordinary outcomes are required on both earnings growth and multiples if the US market is to continue ratcheting higher. Hence, we are counselling caution and client portfolios are positioned accordingly.
Equity markets will at some point present us with exceptional investment opportunities. However, these opportunities are likely to be found in the mirror image of the current market environment, when investors are more aware of the risks and less entranced by expectations of continued, outsized gains.
