Equities

Rate Relief vs. Rich Valuations

In the U.S., the stock market will need optimistic themes to sustain its ruthless run off the April 8 “Tariff Tantrum” lows.

One possibility: a mortgage refinancing boomlet. With average mortgage rates falling to 6 3/8ths, the Mortgage Bankers Association Refinance Index has already started to pop. Also, last month’s Conference Board survey witnessed the “plan to buy a home” question leap to a four-month high. We imagine another large slug of Americans will join them if rates fall below 6%.

Rate-driven optimism should not be relegated to residential property; it has the potential to cross over into commercial, manifesting in REIT outperformance.

In the COVID-19 and post-COVID-19 era, the real estate sector has almost always outperformed the S&P 500 when bond yields have fallen. However, the 10-Year T-note yield has declined from 4.58% on May 21 to 4.09%, yet real estate has refused to get out of bed. We think there is room for a bout of REIT outperformance, aiding our dividend screens.

Many bears point out that the economy has not yet felt the full brunt of the tariff saga. But we think this risk is overblown, as we have said all year.

Consider the arithmetic: in the first three quarters of last year, “customs and certain excise tax collections” were $95.7 billion. This year’s first three quarters witnessed $214.9 billion collected, a jump of $119.2 billion. Context: U.S. GDP is $30 trillion, Medicare spending will be $1.8 trillion this year, and NVIDIA’s market cap is $4.6 trillion. Hundreds of billions matter, but the bears need to simmer down.

There is more to tariffs than just dollars and cents. The U.S. has strained trade relations, order books are mucked up, and so on. But the bears need to come up with a better list of scary things, because the market doesn’t care. When it comes to getting pulses racing, none of the 2025 news flow appears as severe as Grexit, COVID-19 layoffs, the collapse of SVB or several frights that have surfaced over the years.

Because we frankly think the outlook for the economy in the next 6–12 months will prove more pleasant than the consensus, our view is to stay long and strong global equities.

Respondents to the National Federation of Independent Business (NFIB) survey seem to be coming around. In August, the ranks of those who said the economy would be better six months from now exceeded those who said it would be worse by 34 percentage points, akin to economic recovery era responses collected from 1991-1992, 2002-2004 and 2016-2018.

The problem for many years has been the stock market’s rich valuations. The Street consensus for 2026 S&P 500 earnings is about $300. At 6,715, the market’s forward P/E multiple is 22.4. But the primary “risk” the Fed is running, if we can call it that, is sending this runaway stock market running even more.

Consider what banks told the New York Fed in its Senior Loan Officer Survey: as a collective, they are easing standards for the first time since spring 2022, with improvement in nine consecutive quarters.

Intriguingly, prior Fed rate-cutting cycles rarely commenced when banks were already lending freely and the unemployment rate’s first digit was a 4. In many episodes, the New York Fed’s survey was either at prohibitively tight readings or it was moving directionally toward one. We see it in U.S. loan growth, which has jumped 4.6% YoY; the trough was 20 months ago.

In the meantime, now that the Fed is easing into an economy that is doing anything but rolling over, we looked back to see which sectors tended to work out in the year after the Fed’s first easing actions.

Using Datastream aggregates to 1974, the Consumer Discretionary sector went on to beat the market in 9 of the 12 one-year periods afterward. Poor performers included Energy and Utilities, which beat the market in only 17% and 25% of the 12-month windows, respectively.

Small caps are a real quandary. With balance sheets loaded with floating rate debt, the group stands to benefit more than large-cap peers if the Fed comes through on 2026 rate reductions. Also, Value players will find solace in seeing small caps trading at a 35% forward P/E discount to large caps; the median since 2002 has been a 16.6% discount.

However, take heed: junky small caps just posted one of their boldest six-month runs of our careers. The Russell 2000 is generally considered to be a lower-quality small-cap Index than the S&P 600, owing to the abundance of money-losing companies in the former. Over the last half year, the Russell 2000 has outperformed the S&P 600 by 6.4%, akin to the performance differential registered in spring 1999.

Yes, we like small caps, and yes, we think they should be overweighted. But no, the Russell 2000 does not look like a ripe idea. Aggressive quality screens are in order in small caps.

Our favorite stock market remains Japan. Despite prognostications of trade war doom, the country’s economy remains in rude health; the primary manufacturing gauge, the quarterly Tankan survey, has been in a gentle uptrend since Q1 2023. It ticked up ever so slightly once again in Q3.

The Nikkei 225 Index is challenging 49,000, up from sub-40,000 levels at 2024’s close. Fortunately, the stock market’s sharp ascent in recent years has been matched by earnings and dividend growth. Those metrics are +250% and +209%, respectively, from the start of “Abenomics” in 2012. These figures easily exceeded the 143% and 138% growth in the MSCI USA’s earnings and dividends, respectively.

The country’s shareholder yield, which is the sum of the dividend and buyback yields, is 3.9%, the same level as was on offer in late 2008. There are cheap stocks and cheap stock markets, if you are willing to look overseas.

In Japan strategies, yen-hedged equity mandates look like they can be helped if the dollar’s lopsided bearish sentiment gives way to a USD relief rally. In BofA’s September Fund Managers Survey, the dollar ranked 21st out of 22 line items in the list of asset allocation choices. The other two groups that were similarly unloved (#20 and #22, respectively) were REITs and Energy.