9. Both bonds and equities now look expensive, after a sharp recovery in equities and little sell off in bonds following the coronavirus bear market. This points to a period of time where we’re likely to experience below-average returns and potentially above-average volatility.
10. U.S. equities have lagged the rest of the world since mid-May, and we believe there is greater opportunity in non-U.S. equities compared with the S&P 500. The U.S. has been overvalued relative to non-U.S. for some time, pushing bargain hunters to look outside the U.S. Coronavirus trends and short-term economic indicators suggest that Europe is handling the pandemic better than the U.S., which could have ramifications for regional equity markets down the road.
Elevated U.S. Equity Valuations Cannot Cushion Against Bad News
Further good news on vaccines and treatments for COVID-19 helped to offset ongoing bad news from rising infection rates in parts of the world, especially in the critically important U.S. economy. The European Union’s (EU) massive fiscal plan and the agreement to issue joint liability debt, combined with expectations of another large fiscal package in the U.S., have raised hopes that fiscal support will continue until the pandemic recedes as an economic hazard.
Despite messy politics and the general desire to constrain increasing budget deficits, most policymakers understand that a premature end to fiscal support would risk and economic, and therefore political, disaster. Central banks have been on board since March, and more politicians acknowledge the need to stay the course.
While favorable, these developments still leave us cautious on the equity market in the near term, given that stock prices have already discounted a lot of good news. At 22 times 12-month forward earnings, U.S. stock valuations appear elevated and do not provide a cushion against bad news.1 Setbacks in fighting the pandemic will not derail the general reopening trend, but they underscore that the economic recovery may be long and bumpy.
A temporary equity setback could occur if certain U.S. economic data points disappoint. Employment data will be critical to monitor, given the risk that some of the temporary layoffs will become permanent. We do not expect the economic recovery to come to a halt, but the path will be bumpy and varied. Last week’s EU deal is a major step forward in the path to fiscal unity and reduces the longer-term risk of a breakup in the euro. Meanwhile, the U.S. dollar’s luster is fading, and further dollar weakness would not be a surprise. We would only expect a gradual decline, which would make international equities more attractive.
Robert C. Doll is senior portfolio manager and chief equity strategist at Nuveen.
1 Source: Bloomberg, Morningstar and FactSet
2 Source: Department of Labor
3 Source: Credit Suisse