Equities priced for perfection
Over the past quarters, equity markets have risen sharply, supported by strong growth in the U.S. economy (approximately 3.9% on an annualized basis). At the same time, long-term interest rates have declined, and gold prices have increased substantially. This combination typically occurs only when liquidity conditions are exceptionally loose.
In such an environment, more money is available than the real economy can absorb, causing excess capital to flow into asset markets and drive prices ever higher. This can easily push equity valuations to levels that can only be justified if the future turns out to be nearly perfect—characterized by robust economic and profit growth, alongside persistently low inflation and interest rates.
In our view, equities—particularly in the United States—have reached this point. Markets continue to assume that AI will deliver a significant boost to productivity, enabling the economy to grow strongly without triggering substantial inflationary pressures. It is also assumed that the Federal Reserve will be able to cut interest rates meaningfully in the coming period.
Of course, we hope this optimistic scenario materializes, but we have strong reservations:
- AI will undoubtedly contribute to higher productivity growth. However, this is offset by stagnation—or even contraction—of the labor force. This implies that productivity would have to rise far more rapidly than most experts expect in order for U.S. economic growth to sustainably exceed an average of 2% in the years ahead.
- Enormous sums are currently being invested in anything related to AI—not only in the U.S., but also in China and other countries. This will likely result in fierce competition, and it remains to be seen how much return these investments will ultimately generate.
- Due to demographic aging, government expenditures are rising while tax revenues are not increasing substantially. With economic growth of roughly 2%, it becomes nearly impossible to significantly reduce fiscal deficits. Interest payments will rise to such an extent that they may crowd out spending needed to support future growth (education, R&D, infrastructure, etc.).
- The era of globalization is over. Economic tensions between the West and China are intensifying. Consequently, many products can no longer be manufactured where it is cheapest to do so. Securing supply chains is becoming a higher priority, which raises costs.
- Societal polarization continues to grow. As a result, both left-wing and right-wing populist parties are gaining support. The economic policies they advocate often dampen growth.
There is a significant chance that the Federal Reserve, and later also the ECB, will feel compelled to finance government deficits to a greater extent by creating additional money. This would amount to an inflationary policy. Our conclusion is therefore that the future is far from guaranteed to be as bright as current equity valuations seem to suggest.
Looking at the nearer term, markets are uncertain about how to position themselves regarding the U.S. economy in the coming quarters:
Will the still-strong economic growth soon generate many more jobs, triggering a positive feedback loop? Or will stagnating employment lead to declining consumer spending and set off a negative spiral—raising the risk of recession?
The Federal Reserve does not forecast such a downturn, but it is determined to avoid a recession at all costs. Given today’s high debt levels, a recession could easily escalate into a new credit crisis.
We expect that, due to the government shutdown and ongoing uncertainty surrounding import tariffs, economic growth will weaken significantly. Under such conditions, it is quite possible that the Fed will cut interest rates one or two additional times by 25 basis points.
From early next year, however, growth may begin to pick up again, supported by lower interest rates, increased fiscal stimulus, and—hopefully—reduced uncertainty and an end to the shutdown. U.S. growth could then stabilize around 2%.
At first glance, this does not appear to be a poor outlook. Yet, considering the points outlined above, it is also far from perfect. This is precisely why we believe that the room for further equity market gains may be very limited—and that a (significant) correction cannot be ruled out.
