U.S. equities have soared higher, and are increasingly expensive: the underlying reward/risk tradeoff remains poor. That said, several of our indicators suggest that the high-risk rally is not over.
There are several reasons why the equity prices could continue to rally for a time:
For one, the Fed is sensitive to dollar strength. Officials have acknowledged that monetary ease in the rest of the world will impact U.S. interest rate decisions because a strong dollar would tighten U.S. monetary conditions. This increases the likelihood that European and Japanese monetary ease will benefit both U.S. equities and bonds.
Second, deflation tail risks in remission: Continued compression of emerging market sovereign and U.S. corporate bond spreads suggest easing abroad is keeping the tail risks that plagued equities in late 2015/early 2016 in remission.
Third, the Fed has room to “wait and see”: Subdued inflation pressures across the board are letting both Fed hawks and doves mark down their terminal rate, or resting spot for the Federal funds rate.
Finally, early-warning indicators not flashing warning signs: Investment bank share prices are rising, both in absolute terms and relative to the S&P 500. Market breadth is improving, judging from the ratio of the equal-weighted Value Line Index to the market cap-weighted S&P 500. Junk bond yields continue to decline in absolute terms and vis-à-vis Treasury yields. In previous cycles, junk bonds have tended to lead equity prices.
The next Insight looks at some potential catalysts for an equity selloff.