Donald Trump’s decisive U.S. election victory has equity markets cheering, but rich valuations, lofty earnings targets and risks around policy timing should give investors pause.
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Key Takeaways
- Stock markets rallied following Republican wins for the White House and the Senate, although bond markets signalled caution.
- A number of risks could jeopardise this ebullience, including high equity valuations, ambitious earnings targets and inflationary policy moves such as tariffs.
- Prudent investors should consider profit-taking and tax-loss harvesting, while exploring opportunities in large-cap value, mid-cap growth and emerging markets.
The 2024 U.S. elections featured a decisive win by former president Donald Trump and clear control of the Senate by Republicans. Equity markets celebrated these results, based on the expectation for lower taxes and looser regulation: The S&P 500 Index rallied, yet again breaking records. Investors continued to press the so-called Trump trade, boosting small-capitalisation stocks, financials and cryptocurrencies.
Meanwhile, bond investors weighed in with apparent concern, sending 10-year Treasury yields higher by as many as 19 basis points on Wednesday alone, with bond prices dropping in tandem. This extended a meaningful rise in yields over the past month, driven by bond investors’ worries about unfunded tax cuts during Trump’s second term and the potential strain on the country’s debt load. The U.S. dollar has made gains on the back of surging rates, crushing other currencies globally, especially in emerging market countries.
Can equity markets ride the current momentum through year-end? It’s certainly possible. However, Morgan Stanley’s Global Investment Committee does not recommend chasing these trends aggressively into 2025. Rather, we continue to emphasise balance and diversification, based on three concerns about the equity market’s recent ebullience.
1. Equity valuations remain stretched.
Investors will need to reckon with rich equity valuations, especially as interest rates climb. Even as the Federal Reserve cuts its policy rate, U.S. government bond yields have risen in recent weeks as investors weighed risks around inflation and swelling U.S. debt and deficits. Higher rates often weigh on stock valuations by increasing companies’ borrowing costs and curbing consumer spending. This could drag on corporate profitability, while also making future earnings look less attractive.
In particular, strong foundational growth in the economy has prompted a move higher in the inflation-adjusted 10-year Treasury rate to about 2%, a level once associated with forward price-earnings multiples around 17x. Currently, that ratio is a rich 23x, which we think may leave stocks vulnerable. Equities also become less attractive as stretched multiples and higher rates have squeezed the so-called equity risk premium—or the extra return an investor can expect for owning stocks over risk-free Treasuries—to less than 30 basis points, versus a long-term average of about 275 basis points.
2. Corporate earnings targets are lofty.
Consider the ambitious corporate earnings estimates for 2025, which peg profit growth at 15%. Such an outlook seems increasingly at odds with the current single-digit pace of earnings growth and weaker-than-expected productivity growth. Granted, sectors including traditional energy and financials may see earnings estimates rise on increased regulatory clarity following Trump’s election. However, higher rates and the stronger U.S. dollar present substantial obstacles for U.S. multinationals, potentially raising borrowing costs and making their products and services more expensive abroad. The beleaguered U.S. manufacturing sector could also be vulnerable if new tariffs increase the cost of importing materials, raising production costs for some firms.
3. Risks loom around policy timing.
A final factor to consider is the order and timing of policy implementation by the incoming Trump administration. Policy sequencing in Washington will be critical to ensure that any growth-stimulating efforts, such as deregulation and lower taxes, are not completely offset by disruptive and inflationary actions, such as tariffs that raise prices in the U.S. or immigration curbs that slow labor-force growth and wage disinflation. The latter initiatives could affect key service industries, small businesses and companies linked to U.S. agribusiness.
What Should Investors Do Now?
Considering these risks, the stock market’s current high valuations, lofty earnings expectations, and ebullient sentiment may leave some investors in a precarious spot.
Prudent tactical investors should consider taking profits in the S&P 500 while looking for opportunities to help offset the tax liability from those gains by selling other securities at a loss. Investment opportunities exist especially in large-cap value and mid-cap growth. We also see opportunities in emerging markets as currency volatility has surged.
Long-term investors should consider rebalancing portfolios and pursuing maximum diversification across equities and bonds, as well as in real assets, hedge funds and private investments.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from November 11, 2024, “Navigating the Trump Trade.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
