Exercise caution as equities approach elevated valuations

Key messages:

• Equity markets have rallied back to stretched valuations. Earnings growth has not kept pace.
• Central banks are constrained in their ability to cut rates aggressively and support reacceleration in growth.
• Be cautious when equity valuations are stretched. Diversify and consider downside protection in multi-asset portfolios.

Equity markets have rallied back to stretched valuations.

The 90 days since liberation day 1.0 in April passed quickly. Few trade deals were agreed. More tariffs are threatened. Economic growth has slowed and inflation remains sticky. And yet, equity markets have recovered all of their price losses, and price-earnings ratios are back near their peaks. Historically, PE ratios at these levels have not preceded strong equity market returns.

Chart 1: PE ratios (solid lines) are well above their long-run averages (dashed lines).

There is a center of gravity that tends to pull the ratios back toward its average. The question is, will it happen quickly (through falling prices and negative returns) or gradually (through rising earnings).

Earnings growth needs to recover to justify further price gains.

Earnings growth had been improving in the US and Australia through 2024. However, Australia’s index has had close to three years of negative earnings growth while US earnings had climbed above 10%. But earnings growth has plateaued in early 2025. In the US, weaker sales growth has not been offset by stabilisation in margins. In Australia, somewhat better sales growth has been more than offset by a weaker margin trajectory.

Chart 2: Earnings growth appears to have plateaued in the US and Australia.

Higher or sticky inflation could protect margins

In the US, inflation has started to pick up from its downwards trajectory. Recently, the impact of President Trump’s tariffs have clearly started to show through. That could support margins, if corporate America can protect pricing power and lift prices. We remain skeptical that households will be able to absorb much more in the way of price increases, however.

Chart 3: Sticky or rising inflation could assist with margin expansion and support earnings.

In Australia, inflation looks to be slowing as growth remains weak. Downwards pressure on commodity prices also remain a challenge on margins for the resource heavy index. Further rate cuts from the RBA are a risk for the financial sector, especially if the Australian yield curve does not steepen materially.

Valuations could be supported by deep rate cuts from the Fed and RBA

Deep rate cuts from central banks are another avenue for supporting lofty valuations. The Fed and the RBA have both started their rate cut cycle. But a surprise pause from the RBA and tariff uncertainty in the US leaves the pathway uncertain. We continue to expect a couple of rate cuts from both the Fed and the RBA over the next six to nine months.

Chart 4: Rate cuts have started, and more are likely in the near-term.

The long-end of the curve muddies the outlook.

While further rate cuts are likely, the longer-end of the US and Australian yield curve have remained around 4.5% for some time now. The longer-dated yields have been propped up by a combination of inflation uncertainty, increased fiscal spending and expectations for growing debt and deficits, and US policy uncertainty adding to risk premium in US Treasuries. We expect the Australian 10-year bond yield could fall further and faster than the US Treasury yield, but Chart 4 shows these two yields are very closely correlated, potentially limiting any break lower in the Australian yield.

Chart 5: US and Australian 10-year yields are moving in lockstep.

Be cautious with valuations at stretched levels.

Historically, elevated equity market valuations have given way to weaker forward-looking returns. Right now, we think earnings growth could struggle amid slowing global growth and tariff uncertainty. Central banks could cut rates sufficiently to help justify the stretched valuations, but the scope for deep cuts is hampered by sticky inflation.

Diversify and downside resilience.

We think risks are skewed towards lower returns for equity investors, especially compared to the c.15% average annual returns equity investors have enjoyed over the past three to five years. And we see greater risk of market volatility. This does not mean that we expect deep drawdowns in equities. But it does suggest some caution in chasing rallies, especially when prices are at or near record highs.

For investors, we suggest building some downside resilience into multi-asset portfolios will be important. But most critically, we continue to suggest holding diversified exposures across geographies, sectors and asset classes as the best way to deal with this volatility.

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