U.S. equities have roared back to all-time highs, rising 13.6% from their late-March lows. April alone accounted for 10.4% of the rally, marking the best month for the market since 2020 and the 12th best monthly gain in over 75 years. Although we saw a geopolitical dip emerge in March, it once again proved to be a good opportunity for investors to deploy capital. Looking forward, several indicators (including stabilizing housing permits) lead us to believe markets can continue climbing the wall of worry.
For one, the labor market has alternated between positive and negative prints for the past 11 months, with net job creation modestly positive on balance. More broadly, the labor market has cooled over the past few years primarily due to drags from changes in immigration policy and the aging population. Although there are pockets of softer hiring, artificial intelligence (AI) does not appear to be driving widespread layoffs.
Against this backdrop, we are encouraged by initial jobless claims notching its lowest total since 1969 in late April alongside other recent signs of labor market stabilization. Looking ahead, we remain on watch for AI-driven job losses, but we are also eyeing AI job creation as previously unimaginable jobs emerge on the back of this technological advancement.
As we prepare for a Federal Reserve led by Kevin Warsh, it is important to remember that monetary policy decisions are made by a majority count of the 12 voting members of the Federal Open Market Committee (FOMC) rather than just the Fed Chair. While Warsh is on the record as favoring lower interest rates, his views appear out of sync with the rest of the FOMC at the moment. The FOMC’s meeting in late April produced no change in interest rates, but four dissents — the most since 1992 — with three of them opposing the “inclusion of an easing bias in the statement at this time.” Upside risks to inflation emanating from higher energy prices are likely to keep FOMC members wary of lowering rates until greater clarity emerges regarding the conflict in the Middle East.
The equity rally does appear to be vulnerable to a re-escalation of the conflict in the Middle East, particularly if disruption to trade in the Strait of Hormuz lasts longer than is currently expected (reopening around mid-year). Given that the bulk of the April rally occurred in conjunction with the de-escalation of tensions in the Middle East, we believe the risk of a prolonged supply bottleneck is real.
We continue to believe, however, that the economic impacts should remain manageable and not result in a meaningful economic slowdown: further pullbacks would likely represent buying opportunities, in our view. At the same time, we do not believe investors should be scared off by the markets being back at all-time highs. Our work (counterintuitively) shows that investing at new highs has historically outperformed deploying capital when the benchmark is below peak.
Valuations are elevated, with the S&P 500 Index trading back above 20x on a forward (next-12-month) P/E basis. However, U.S. equities have been trading at rich multiples since the pandemic, with the benchmark remaining above 20x most of the time (63%) since first crossing that threshold in April 2020. Importantly, lofty valuations have not been a headwind to returns; the S&P 500 has risen 147.5% over the past six years, or 16.3% annualized, which is roughly double the long-term average.
Much of this strength has been underpinned by robust earnings, with next-12-month earnings expectations rising 137% cumulatively over the past six years. Sell-side consensus expectations for mid-teens earnings growth may seem lofty at first blush. However, these expectations have been moving steadily higher, bucking the historical pattern and providing a fundamental support to the market rally. Information technology, energy and materials sectors are showing notable strength. With the first-quarter earnings season now past the two-thirds mark (by market cap), results so far have been solid, with strong delivery and upside surprises across sectors. This is an encouraging start to the year.
We continue to believe non-U.S. equities present an attractive opportunity relative to domestic stocks. Emerging markets (EM) look particularly compelling despite their recent strength, with robust revisions to earnings expectations powering their returns and supporting a continued constructive fundamental outlook. Valuations also remain less challenging than in the U.S., and although some EM economies are significant oil importers, the adage that the stock market is not the economy rings even more true in the case of many EM countries. Developed non-U.S. equities should also benefit from positive earnings revisions and attractive valuations, although to a lesser degree.
In sum, markets have quickly reclaimed new highs, yet the underlying backdrop still appears supportive: the labor market continues to stabilize and we believe the economic fallout from Middle East tensions will remain manageable. Elevated valuations warrant selectivity, but history suggests investors needn’t shy away from new highs, particularly when earnings expectations are holding up. We would stay disciplined, using volatility as an opportunity to deploy capital, while modestly favoring the stronger earnings revisions and more reasonable valuations available in non-U.S. equities.
Jeffrey Schulze, CFA, is Director, Head of Economic and Market Strategy at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.
Performance source: Internal. Benchmark source: Standard & Poor’s.
Performance source: Internal. Benchmark source: Morgan Stanley Capital International. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance is preliminary and subject to change. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent. Further distribution is prohibited.
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