Global markets Ask CIO – Stocks, cash, and SI

Is the equity rally sustainable?

The S&P 500 rebounded quickly following the March banking turmoil, and volatility has fallen. But we do not think the likelihood of tighter credit conditions and lower growth is adequately reflected in US equity market pricing today. The Federal Reserve’s Senior Loan Officer Opinion Survey in April confirmed tighter lending standards across business and household lending, as well as weaker credit demand.

The S&P 500 is currently trading at 18 times 12-month forward earnings. Historically, when the S&P 500 traded above 18x, consensus earnings growth expectations were robust (14% on average) or the 10-year US Treasury yield was less than 2%. We expect S&P 500 earnings to contract in 2023, and the 10-year Treasury yield is around 3.5%.

Given current valuations and the potential macro scenarios from here, we see better risk-reward in high-quality bonds than in broad US equity indexes. Within equities, we prefer more defensive sectors like consumer staples and utilities. We also recommend diversifying beyond the US market, including into emerging markets and select European themes (e.g., German equities and European consumer stocks).

What should I do with my cash holdings?

The Federal Reserve raised policy rates last week, taking the federal funds target range to 5–5.25%, but left the door open to pausing the hiking cycle at its June meeting. For many investors, rising interest rates and uncertainty over the economic outlook have increased the appeal of cash deposits. But we think this appeal is superficial. Inflation has reliably eroded the real value of cash deposits over time, with a decline in purchasing power of 21% for euros, 23% for US dollars, and 25% for sterling since 2007. Deposit rates also have the potential to fall fast as the rate-hiking cycle turns.

We believe the current market environment provides an opportunity for investors to reevaluate their liquidity holdings, and ensure they are sufficiently invested and diversified. We recommend locking in attractive yields in high-quality bonds—for example, high grade (government) or investment grade—which also offer the potential for capital gains in the event of an economic downturn. Investors holding too much cash overall may consider averaging into diversified portfolios.

Read more in “10 reasons to put cash to work” (published 5 May 2023).

What are the key opportunities in sustainable investing?

Green investment is stepping up around the world in response to the US Inflation Reduction Act. The European Commission has responded with the EU Green Deal Industrial Plan for the Net-Zero Age. These commitments should particularly benefit innovative companies focused on improving resource efficiency, including energy (e.g., renewables, or clean air and carbon reduction solutions) and water. Read more in our recent report, “European greentech leaders: The next step up” (20 March 2023) or in “Sustainable Investing Perspectives” (8 May 2023).

We also like sustainable bonds (including green and multilateral development bonds), and see a growing opportunity to implement hedge funds and private markets within sustainable investment strategies, for example in the areas of education and health. Investors considering alternative investments like hedge funds and private markets need to be aware of risks like reduced liquidity, higher costs, and complexities.

For more topics, see Top 10 questions answered.