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.

For investors – and many others – 2025 has got off to an interesting start. In a few short weeks, investors have had to contend with questions over the sustainability of government debt loads, the ending (or at least pausing) of the Federal Reserve’s short-lived interest rate cutting cycle, numerous threats to international trade flows, the apparent imperial ambitions of the ‘leader of the free world’, and the emergence of a purported technological breakthrough in China that threatens to pull the rug from beneath the feet of the US tech giants that dominate the global investment landscape.

While each of these developments merits careful consideration, it can at times seem impossible to see the wood
for the trees. At such times, we find it pays to focus on first principles, and to use the conclusions to anchor our
investment views amidst the sturm und drang. In this update, we go back to basics to take a considered look at the current market environment beyond the excitable headlines.

Paramount among our principles is the notion that valuation is, and must always be, the decisive factor in the success of any investment. No matter how secure the asset or how spectacular the growth prospects, the more an investor pays for it now, the less scope there is for the price to rise in the future.

We are therefore put on alert by the recognition that the US stock market – which currently accounts for an extraordinary 66% of global equity indices – has rarely been more expensive (Fig.1).

Fig.1: As measured by the Cyclically Adjusted Price-Earnings (CAPE) Ratio, the US equity market is in the top 10% of its historic range

The Cyclically Adjusted Price-Earnings Ratio compares the price of an investment to its inflation-adjusted earnings over the previous ten years. The aim is to produce a more stable measure of value compared to ratios that rely on only one year’s earnings, and which can be volatile and misleading, particularly at times when the economic cycle is turning

In a world in which business (and government) leaders actively seek to ‘move fast and break things’, some would argue that our insistence on the importance of valuation is outdated. Our response is two-fold. First, we note that there has, over the course of several economic cycles and throughout numerous bull markets, bear markets, manias and panics, been an enduring relationship between valuations at the point of investment and the long-term returns that investment subsequently yields (Fig.2). Second, though we recognise that capital light technology companies deserve to trade at a premium to the slow-moving industrial heavyweights of yore, we fail to see that this negates the conclusions drawn from basic investment theory and half a century of evidence: that buying at an extraordinarily high valuation demands that the investment surpasses the extraordinarily ambitious expectations embedded in those valuations. Empirically, neither the fastest growing nor the largest companies have tended to hold onto their crowns for long.

Fig.2: Historically, there has been a persistent relationship between valuations at the point of investment and the returns investors have earned over the subsequent ten years

The red dot marks the point on the historic regression that corresponds to the current valuation of the US equity market. It implies investors should expect very low returns from US equities over the next decade.

The Chancellor delivered her first Budget on 30 October 2024, the first under the new Labour government.

Here is our summary of some of the key points.

Download our summary here.

Our macroeconomic outlook is by now well-rehearsed: high interest rates tame inflation only by bearing down on economic activity. As the economy slows, corporate profitability declines, workers are laid off and unemployment rises. Given monetary policy operates with ‘long and variable lags’ in both directions, cuts to interest rates at this stage are invariably too little, too late, and the economy slides into recession. With unemployment already rising – both in the UK and the US – and GDP data pointing to a decline in US corporate profits in the first quarter of this year, we continue to see signs that the cycle is – albeit slowly – evolving as expected.

With yields on high quality short-dated bonds comfortably in excess of inflation, we see little to be gained in pinning our hopes on a positive economic surprise arriving just in time to validate very expensive equity markets. In this, however, we find ourselves in the minority. While many of the fund managers and investment strategists we speak with recognise the economy is slowing, belief in the Federal Reserve’s ability to manage an economic soft landing remains, for the most part, resolute. More worrying still, many market participants seem to think the stock market will prove immune to an economic slowdown. In our view, this belief is misguided, failing to recognise the range and interconnectedness of the risks stacked against it. We highlight four of the key risks below.

Economic cycles

The primary risk that investors are underestimating is a downturn in the economic cycle. Though high savings levels, fixed term mortgages and sound balance sheets have dampened the impact of rising interest rates, we have no doubt that, both in the UK and the US, an ever-increasing number of households and businesses are feeling the strain. The implications are becoming clear in the US labour market. The unemployment rate has risen from a low of 3.4% in April 2023 to 4.1% in June. If it rises only a little from here, the increase in joblessness will be sufficient to trigger the so-called ‘Sahm Rule’. Not a rule as such, this is rather an observation that, historically, whenever the unemployment rate has risen by half a percentage point within a year, it has marked the start of a recession, following which further job losses have been inevitable (Fig.1).

Of course, the Federal Reserve is well aware of this history, and stands ready to cut interest rates if necessary – and if permitted by further easing of inflationary pressures. Though the worst of the post-pandemic surge in prices is behind us, the Fed’s preferred inflation measure is making only slow progress towards its 2% target. Consequently, the Fed has signalled only one quarter-point cut in interest rates over the remainder of the year, despite the troubling signs in the labour market. In our view, a single rate cut will do next to nothing to support the real economy. Yet for the Fed to do more, the slowdown must be so pronounced that corporate profitability would surely be under marked pressure.

Irrational Exuberance and Stock Market Valuations

Counter to all economic rationale, it appears possible that rate cuts may, initially at least, stimulate further speculative gains in the stock market. We recently read a report from a US investment manager acknowledging the mounting risks to their base case of resilient economic growth. What struck us was the claim that the deteriorating growth outlook was encouraging them to increase their year-end targets for the US stock market.

From a purely mathematical perspective, falling interest rates can, in isolation, justify higher equity valuations. But rates will not fall in isolation: they will only head meaningfully lower in the context of a sharply slowing economy, and therefore sharply slowing corporate earnings growth. Interestingly, parts of the market appear to have taken this onboard: defensive sectors such as utilities and consumer staples have outperformed more economically sensitive sectors such as industrials and consumer discretionary. Yet, with the US stock market hitting a series of record highs in recent weeks, slower corporate profit growth is clearly not a widely held concern, giving rise to our second risk – that stock market valuations are unsupportable.

This brings us to artificial intelligence and the belief that some companies can grow their earnings irrespective of the economic cycle. With consistently strong profit growth in perpetuity, it is argued, there is almost no valuation too high for such companies. We are sceptical of such claims. Firstly, we stand firm in our belief that valuation is the difference between a good company and a good investment: even the very best company will prove a poor investment if it is bought at too high a price. Secondly, we have yet to find a company whose earnings are not, to some extent, influenced by the economic cycle – for example, Microsoft’s earnings per share dropped 13% in 2009 and Apple’s earnings fell 11% in 2016, even as the economy avoided recession.

At this point, we think it instructive to consider the history of Cisco, the US technology giant in the early part of this century. The company was identified as the leading provider of the ‘picks and shovels’ supporting the revolutionary potential of the internet. In five years, its share price rose 3,860% to a high of $80 in March 2000. In early July this year, Cisco’s share price was around $47, still 42% below its peak nearly a quarter of a century later. Importantly, this has occurred in spite of the company having grown its earnings by an average 14% a year over this period, meeting – or even exceeding – the expectations that were held to justify the eye-wateringly high share price all those years ago (Fig.2). Investors in Nvidia and the like would, we suggest, do well to reacquaint themselves with this history.

Financialisation

Such were the excesses of the tech bubble that its demise triggered a full-blown recession in the US. In response, the Federal Reserve slashed interest rates from 6½% to 1¾% in a little over a year. Regardless, unemployment rose from 3.9% at the end of 2000 to 5.9% by early 2002, and then – in spite of yet more rate cuts – to 6.3% by mid-2003. Cisco shares lost 90% of their value as, peak to trough, the US equity market halved.

Today, we hear all too often that a recession is impossible because household and corporate balance sheets are in good order, and there are ‘no clear imbalances’ in the economy.

This argument is used to justify relentless gains in the stock market, failing to recognise our third risk in the system: that the gains themselves are creating an economic Achilles’ heel. As a proportion of US GDP, wages have seldom been lower, while the size of the stock market has never been greater. Gallup calculates that 58% of American households have some exposure to equities, five percentage points higher than the previous peaks of ownership hit – ominously – in 2001 and 2007. The US economy has never been more exposed to the vagaries of the stock market. Mixed with stretched valuations and a deteriorating economic outlook, this strikes us as a heady and dangerous brew.

Politics: debt and elections

Our final risk in the system is easy to see but difficult to quantify. Here in the UK, with the scars from Liz Truss’ “mini budget” still raw, the challenges facing the new Labour government are self evident. Public services are in need of funding while growth could certainly benefit from a shot in the arm. Yet the tax burden is high and government debt as a proportion of GDP has never been higher in peace time. It seems likely that budgetary concerns must limit the Starmer government’s ambitions.
The US is flirting with a similar predicament. After huge unfunded expenditures through the pandemic, US government debt levels are also at record highs. The US government now pays more than $1trillion a year in interest, a fifth of its total revenues and a greater expense than its sizeable defence budget. Nonetheless, with November’s presidential election looming, neither candidate is keen to discuss the merits of – or need for – fiscal responsibility. The bond market, however, may not be so willing to ignore the issue. Though US sovereign debt remains the world’s ultimate safe haven asset, the government’s ability to issue ever greater quantities of it is not without bounds. Indeed, there are tentative signs that the infamous ‘bond vigilantes’ are beginning to probe the sustainability of the government deficit. At the very least, investors should question the extent to which fiscal policy can feasibly be relied upon to extend the current cycle, or to offset a future recession.

Risk Assessment

We have been surprised by the longevity of this economic cycle. The slow transmission of monetary policy, together with unparalleled fiscal expenditures, has allowed growth to endure far longer than we thought possible in a world of record debt and high interest rates. However, in doing so, we believe risk has been stacked upon risk. Investors’ refusal to countenance the likelihood of an economic slowdown and the consequences for corporate profitability – and to recognise that meaningful cuts to interest rates are only possible should growth weaken significantly – have propelled the stock market to precarious heights. Fearful of missing out, and emboldened by the mania surrounding artificial intelligence, more and more investors have eagerly climbed aboard, leaving the US economy more exposed to the risk of a correction than ever before. Meanwhile, there are signs that even the US government might be constrained in its ability to support future economic growth.

These risks are interlinked: we believe any one of them has the potential to topple the whole edifice. For these reasons, we remain cautious.

With the inflationary threat widely thought to have been defeated, stock markets have enjoyed a broad-based rally fuelled by hopes that central banks will soon cut interest rates. This reflects investors’ increasing optimism in the likelihood of a soft economic landing, in which economic output continues to grow apace while inflation subsides. This is an historically rare pairing; the two normally move in the same direction. Furthermore, periods of falling inflation have historically gone hand-in-hand with thinner corporate profit margins and slower earnings growth. This presents a challenge to market expectations which require earnings growth to accelerate from near zero to a healthy double-digit pace – even as inflation eases back to target.

These considerations, in our view, leave the US equity market in a vulnerable position. Earnings forecasts appear ambitious, and valuations are heady – even if the soft landing comes to pass. Though we continue to have concerns over the macroeconomic outlook, this set-up leads us to believe that a recession is not a prerequisite for equity market returns to disappoint, particularly relative to the 5% yields currently available from high quality bonds. We therefore continue to recommend caution, even – or perhaps especially – as equity markets continue to rise.

The Macroeconomic Outlook

We have for some time expected one of the most aggressive monetary hiking cycles on record to tip developed market economies into recession. While acknowledging ‘long and variable lags’, we have been surprised by the resilience of the global economy, and that of the US in particular. A strong labour market and excess savings have supported households through the cost of living crisis and, with wages now rising more quickly than prices, a resumption in normal service from the all-powerful US consumer is expected. Markets are presuming that this will be sufficient to stave off the threat of recession, but moderate enough not to stoke inflationary flames, leaving central banks free to cut interest rates.

We continue to doubt this narrative. As we have previously argued, soft landings are historically rare – and for good reason: without either fiscal or monetary policy constraining economic growth, there are few viable ways to force inflation to fall back to target. Economic growth implies rising demand – and when, as now, the economy is already operating at full capacity, additional demand is inflationary. Higher interest rates bear down on inflation only by bearing down on demand, and hence growth. This coarseness of monetary policy is ill-equipped to achieve the delicate balance between growth and inflation required of a soft landing.

Thus far, high interest rates appear to have made little impression on growth. That is because they are yet to fully work their way into the economy – but this is now changing. The first three weeks of 2024 saw a record $153bn of investment grade debt issuance as companies rushed to take advantage of the sharp decline in yields over the last two months of 2023. Reacting to the same stimulus, issuance has also been high in government, high yield and emerging bond markets – there have even been nascent signs of life in the frozen US housing market. Yet yields are only back to where they were a year ago, at which point the Federal Reserve had already implemented an eye-watering 4¼% of rate hikes (that is, four-fifths of the trough-to-peak total). The borrowers rushing to issue debt might have avoided the very worst of the interest rate pain, but they must now accommodate meaningfully higher interest costs nonetheless.

Meanwhile, outstanding credit card debt has surpassed $1tr – up more than 14% over the past year – while the use of ‘buy now pay later’ facilities expanded 40% year-on-year to late 2023. Worryingly, delinquency rates (which measure the proportion of consumers falling behind on their debt payments) are already back to pre-pandemic levels and continue to rise. In the corporate sector, some 40% of the Russell 2000 index of US smaller companies is unprofitable. These are sobering statistics in the context of an economy operating at full employment, enjoying above-trend growth and which is still only part-way through the process of absorbing higher interest rates. We believe they are a legacy of the cheap and plentiful credit of the post-financial crisis period, which encouraged the proliferation of consumer borrowing and business models that cannot stand up to the rigours of positive real interest rates. The longer real rates stay above zero, the more likely the moment of reckoning.

The path to a soft landing is extremely narrow. While it is possible – through skill or by luck – that the Federal Reserve could lead the US economy safely along it, we think it more likely that the delicate balance can only be maintained temporarily. Lean a little too far one way and interest rates bear down too heavily on growth, tip a fraction in the other direction and robust demand opens the door to a second round of inflation and rate hikes.

The Market Outlook

Following the ‘everything rally’ in the last two months of 2023, equities – especially in the US – are priced in expectation of a pain-free resolution to the soft landing paradox that demands strong growth alongside low inflation and falling interest rates. While a recession would certainly settle this dilemma decisively, we do not believe it is required for equity markets to disappoint this year.
While an economist’s definition of a soft landing has economic growth holding firm while inflation subsides, investors tend to focus on the growth of corporate earnings. Intuitively, economic growth and company earnings are closely linked, but there are some nuances to the relationship that are perhaps less obvious. The connection between inflation, profit margins and earnings is of particular interest at this juncture.

As the last couple of years have made clear, inflation can make life uncomfortable for consumers: when prices are rising, each pound of expenditure buys fewer goods. In this environment, we might expect companies to reduce profit margins in the hope that prices a little lower than they might otherwise have been will help support demand. In practice, however, companies typically use the cover of inflation to increase profit margins, using price rises to offset any shortfall in demand and thereby delivering positive earnings growth. Conversely, periods of disinflation (in which inflation falls without turning negative) have historically gone hand-in-hand with thinner profit margins and slower earnings growth.

This experience has once again played out over the post-pandemic cycle. As inflation rose, profit margins were expanded, and earnings growth was strong. Subsequently, as inflation has eased, margins have fallen and earnings growth has disappeared.

Remember, the soft landing consensus requires economic growth to continue, allowing companies to grow profits even while inflation fades. Indeed, consensus forecasts for the S&P 500 currently point to 12% earnings growth in 2024 and 13% growth in 2025 – ambitious targets at almost any point in the cycle. However, as the chart below shows, earnings growth seldom picks up when inflation is falling, never mind accelerates to 12% from a standing start.

In short, we struggle to envisage a scenario in which corporate earnings can grow by 25% in the next two years while inflationary pressures are sufficiently muted to allow the Fed to cut rates by 1½% in the space of nine months – all of which the consensus demands.

Arguably, a disappointment on earnings can be withstood if valuations are reasonable. However, a range of measures indicate that this is not the case. While valuations appear most extreme among the largest US companies, particularly the so-called “Magnificent Seven” of Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla, the issue is not confined to these names, nor to the technology sector as a whole: eight of the ten sectors in both the MSCI World and S&P 500 indices are trading above their long-term average valuations. Following the sharp rally over the past couple of months, the forward price earnings multiple for the US stock market (based on expected 2024 earnings) is 19.9x. This is expensive: indeed, it has only been higher 11% of the time since 1985. A halving of 2024 growth forecasts would drive the multiple up to 21.4x, a value only surpassed at the height of the tech bubble and, briefly, in the immediate post-pandemic euphoria.

Conclusion

Hopes of imminent rate cuts have largely banished fears of recession from the financial headlines and the mood music in markets has been decidedly upbeat. Unfortunately, we think the optimism is misplaced. The combination of wishful earnings forecasts and lofty valuations is similar – if perhaps less extreme – to the conditions that preceded the 2022 market weakness. This leads us to believe that, while we remain wary of the macroeconomic outlook, it need not take a full-blooded recession for equity returns to disappoint.

While the resilience of the US labour market or renewed fiscal stimulus could forestall the growth slowdown we have long expected, neither resolves the paradox at the heart of the soft landing consensus. Inflation and interest rates may fall, or corporate profits may surpass already ambitious expectation, but the combination of the two is, at best, improbable. We therefore continue to recommend caution, even as the siren song of rising equity markets plays on.