The rally in US equity prices in recent weeks has not been backed by any improvement in the earnings outlook, leading to overvaluations for many companies given a likely slowdown in economic growth in the US, according to Talaria Asset Management co-chief investment officer Hugh Selby-Smith.

A resumption in risk appetite in recent weeks has seen investors paying more for US companies, with the expectation that given moderating inflation, interest rates may have peaked.

“There is certainly nothing in earnings outcomes that justify an increase in US equity prices. The entire rally of November was a price-earnings (P/E) expansion, so investors are paying more for the same level of earnings. Yet since the beginning of the year, earnings expectations have continued to decline,” Mr Selby-Smith said.

“That decline is likely to continue into 2024 as corporate earnings fall and unemployment increases. As a result, we see the rally in US share prices as a potential risk for investors given that the US economy has yet to feel the full impact of higher interest rates,” he said.

According to Mr Selby-Smith, trailing and forward P/Es, price-to-book and price-to-sales numbers are all well ahead of their 40-year averages for the S&P 500.  This comes despite lower estimates for company earnings, weaker industrial production and high levels of government debt.

“Looking at previous US rate hiking cycles since World War II, in all occasions the US manufacturing index declined, while 12 out of 13 times there was a subsequent earnings recession. When earnings drop, generally equity prices also drop. So, if history is any guide, the outlook for US equities in 2024 is not good.”

Against such a backdrop, income as a source of return will likely be more important than ever for investors given capital gains will be more difficult to achieve.

In addition, investors should look for companies that are resilient to an economic slowdown. That includes the global healthcare sector, with companies such as Johnson & Johnson, Roche and Sanofi, Mr Selby-Smith said.

“These companies have very little debt, high levels of free cash flow, they don’t have much sensitivity to the economic cycle, and they aren’t really impacted by higher inflation or interest rates.

“Certain utilities might also do well now that interest rates have probably peaked and their share prices have come down. Many utilities also offer good earnings and dividends growth.

“In contrast, financial companies that have leverage, energy companies and high growth companies like technology companies will likely be more challenged in the period ahead.”

What about bonds?

In terms of bonds, Mr Selby-Smith said despite improved bond yields compared to the previous decade, the real return on bonds – or after accounting for inflation – remains low.

“If bonds are paying a yield of 4 per cent and market inflation expectations are correct, then investors are making only a modest a real return on bonds - assuming those expectations are correct. Investors would need inflation to come down further to improve that return, while being locked into it.

“However, if they are able to earn a higher return from the combination of income and capital gains on equities, that could deliver an attractive investment outcome to investors,” he said.