Is the US equity market peaking?

BULL markets don’t typically die of old age. So says Principal Asset Management (Principal AM) in its latest report on the US equity market outlook, noting that while the current bull market has enjoyed a strong run, history suggests that age alone is not a death sentence for rallies.

With US equities delivering double-digit returns over the past two years and valuations looking increasingly expensive, investors are beginning to question whether the rally has more room to run or if markets have finally peaked.

However, Principal AM cautions against reading too much into market age alone.

“Bull markets don’t just die of old age, and history may prove to be a useful guide to identify any catalysts that may signal a potential turn in markets,” it says.

The fund management company notes that an analysis of the S&P 500 since 1965 suggests that the US Federal Reserve (Fed) is the most common factor that has triggered the end of sustained equity market rallies.

Usual suspect

Market returns are heavily influenced by the economic backdrop, and the Fed’s monetary policy decisions often set the tone. Its ability to shift policy quickly can dramatically sway markets, ushering in different market regimes depending on its stance.

Looking back at previous rate-hiking cycles – in 1968, 1972, 1980, 1983, 2018 and 2021 – Principal AM notes that markets generally peaked at the start or midway through the Fed’s tightening phase.

“A hawkish pivot from the Fed in response to either economic overheating or spiralling inflation concerns hurt both market sentiment and economic conditions very quickly,” it states.

The impact varied based on the broader economic context.

When economic growth slowed without triggering a recession, market drawdowns were typically milder.

“In instances where the Fed, after embarking on a hiking cycle, kept interest rates elevated for a prolonged period, markets often could sustain their rally - particularly as these periods were associated with strong earnings momentum,” Principal AM explains.

However, even in such scenarios, markets eventually reached a peak. The Fed’s reluctance to adjust policy in a timely manner often led to an overly restrictive environment.

“In other words, the Fed likely acted too late in recalibrating its policy stance – as inflation gradually normalised, real rates rose, passively increasing policy restriction and putting downward pressure on growth and earnings,” Principal AM notes.

Black swan events

While the Fed is often a central player, Principal AM reminds investors that other unforeseen events can also disrupt markets.

“While it’s easy to put all of the blame on the Fed, other exogenous shocks do occur, which can have a significant impact on markets and are especially difficult to predict,” it states.

Key historical examples include the 1987 market crash, largely driven by programme trading, the 1990 oil price spike during the Gulf War, and the 2019 Covid-19 pandemic, which abruptly ended a recovery and led to a sharp but short-lived recession.

Principal AM believes that today’s macroeconomic conditions do not mirror those preceding past market peaks.

With inflation easing from 2022 highs and a balanced US labour market, the Fed has adopted a “wait-and-see” approach, holding off on further rate cuts.

“While labour market strength is moderating, overall conditions remain resilient. The services sector continues to hold up well, and industrial activity is finally rebounding,” Principal AM observes.

It expects above-trend growth through mid-2025, followed by a gradual return to trend.

However, the outlook is not without risks. January’s consumer price index (CPI) showed the strongest monthly rise since August 2023, rekindling inflation concerns.

Additionally, US President Donald Trump’s administration’s swift policy changes – ranging from immigration reforms to an escalating trade war – add layers of uncertainty.

“While the Fed may initially look past tariff-driven inflation, persistent price pressures and the risk of unanchored inflation expectations could prompt a more cautious stance,” Principal AM cautions.

“Although the bar for a rate hike remains high, a hawkish pivot – driven by rising inflation expectations, stronger economic momentum, continued declines in unemployment, or a reacceleration of inflation – could bring an abrupt end to the current bull market,” it adds.

What should investors do?

While the path forward may not be straightforward, Principal AM advises a balanced approach.

“A narrow but viable path remains for valuations to expand further, especially if earnings growth continues to deliver as expected,” it argues.

However, investors should proceed with caution.

“While conditions still support additional upside, navigating the period ahead for risk assets requires caution. Policy uncertainty looms larger than ever and poses a significant challenge to sustain bullish sentiment,” Principal AM points out.

“Prudent investors should remain vigilant, balancing optimism with a strategic approach to risk in today’s evolving market environment,” it adds.