Market Update: A rally that requires belief

The speed at which American markets’ Trump-phobia has gone back to Trump-phoria is something to behold.

When we try to make sense of this rally, we see many factors which suggest it could continue. But, that assessment does not change the fact that US stocks have become fundamentally more risky. Our investment philosophy suggests caution in this environment.

The rally-goers and the abstainers.

After the impressive recovery rally in US stocks, there are two camps of investors: the ‘buy the dip’ bulls and the still-sceptical bears. Many in the latter camp were forced to cover their shorts or sell their rapidly declining ‘put’ options this week, causing a short squeeze.

The bulls see the speed at which the US is making trade deals – few saw China coming – and think that the “art of the deal” interpretation of Trump was right all along. With tariffs set to fall back to (arguably) manageable levels and fresh US tax “cuts” (covered in a separate article), they think exceptional US company earnings growth should resume. They even suspect that Trump might succeed in bringing Russia and Ukraine to the table together – possibly this weekend.

These buyers are supported by the fact that measured volatility has dropped consistently below implied volatility (the cost of insuring against stock price drops) which essentially means you can make a lot of money by taking the risks nervous investors are not willing to.

The bears see this rally as a false dawn. On tariffs, there is still a bumpy road ahead for US-China negotiations, and US-EU negotiations are reportedly only inching forward. They see US corporate earnings already plateauing and, consequently, stock valuations becoming unreasonably expensive in price-to-earnings terms. Stretched valuations are made worse by the fact that ‘risk free’ bond yields have moved significantly higher too.

Investment professionals have a tendency to equate the first group with Trump-loving US retail investors, and the latter with more cautious professional investors. There is some truth to that caricature, but it is often laced with unearned self-superiority on the part of institutional investors. After all, retail investors that bought US stocks, when Trump declared it was a good opportunity, have made a lot of money in the last few weeks.

The nerves are showing up in bond markets.

Nevertheless, the move up in real (inflation-adjusted) bond yields has undeniably stretched relative equity valuations. On our model, they are back to January’s extreme levels. Only significantly stronger growth could justify that discrepancy. But as we discuss in our US budget article, we suspect higher US yields have more to do with deficit fears, due to tax cuts, than stronger growth.

Higher government bond yields have a knock-on effect on corporate bonds and private lending. Unfortunately, the Senior Loan Officers Opinion Survey (SLOOS), released this week, shows that US credit conditions are already worsening. As we suggested last week, banks are tightening their lending standards in expectation of a slower economy. Admittedly, the SLOOS was not as bad as we had feared, but it showed that Trump’s policies have not encouraged economic activity.

Higher US yields were, once again, correlated with a move up in UK government bond yields. This does not match the government’s tight fiscal policy and the Bank of England’s mildly dovish outlook. Some of the yield spike could be explained by the UK’s stronger-than-expected GDP growth for the first quarter of 2025.

However, much of the strength in Britain’s Q1 figures came from retail sales. The forward-looking estimates of those sales have already fallen from strong levels at the start of this year. Stock markets are pricing a relatively weak second half of the year for the UK, and they are probably right. But if we get further positive surprises in the next few months, that should mean a leg up for UK stocks.

We favour caution – even if the rally continues.

We are in the more cautious camp regarding recent market gains. As long-term investors, we focus on sources of long-term risk and return. Stretched earnings valuations might not lead to a short-term correction, but they do signify heightened risk. On that front, we note that investors still have not seen the economic impacts of Trump’s 10% ‘baseline’ tariff and the reduced(!) 40% tariff on Chinese goods. These might be better than we feared a month ago, but they would have been unthinkable a year ago. The inevitable price rises are yet to be felt.  April’s US inflation data seemed benign, at just 2.3% year-on-year. however, Barclays Research points out that tariff effects will peak in the second half of 2025, with core CPI heading above 4%.