US Stocks Surge Amid Record Highs, Inflation, and Rebalancing Risks

US Stocks Surge Amid Record Highs, Inflation, and Rebalancing Risks 

As stock markets continue to reach unprecedented highs, equities maintain their upward trajectory relative to bonds, growing increasingly expensive in comparison. This relentless climb in stock prices underscores a deepening divergence between the two asset classes. The near-record exposure of portfolios to equities heightens the risk of rebalancing, as investors may eventually pivot by selling stocks to acquire bonds, thereby reconfiguring their asset allocations.

The dominance of US equities in the global investment landscape has solidified. With limited alternatives among high-quality international companies, global capital continues to funnel disproportionately into the US stock market. This surge has elevated the US to a staggering three-quarters share of the MSCI World Index, up significantly from just over 50% in 2012. The mantra "There Is No Alternative" (TINA) now applies almost exclusively to American equities.

Valuations in the US large-cap market have reached extraordinary levels, a phenomenon that could undermine long-term performance. Expecting returns to sustain the pace of approximately 25% annually, as seen over the past two years, is increasingly unrealistic. Even as equities outpace bonds, the latter are beginning to grapple with the implications of persistent fiscal deficits and the abandonment of austerity as a widely accepted economic policy. This shift has left bond markets recalibrating to a new era of fiscal dynamics, indirectly influencing the relationship between stocks and bonds.

The swift rise in the stock-to-bond valuation ratio has propelled the cross-sectoral valuation of equities—spanning households, financial institutions, corporations, and foreign investors—relative to fixed-income holdings to near-record peaks. This phenomenon heightens the risk of downward pressure on stock prices, not necessarily due to deteriorating earnings or economic missteps, but as a consequence of mechanical portfolio adjustments favoring bonds over equities.

Looming in the background is the persistent yet increasingly visible issue of inflation. Though inflationary pressures have always been present, they are gaining prominence, particularly with economic policies linked to significant fiscal expansion. The policies championed by Donald Trump, including proposed tariffs and deregulation, have inflationary potential, at least initially. While tariffs may eventually exert a disinflationary effect, the immediate impact is expected to stoke rising prices.

This potential inflationary shock might lead investors to mistakenly view equities as a reliable hedge against inflation, despite historical evidence suggesting otherwise. A significant inflation-induced price shock would remain a tail-risk scenario, albeit one with far-reaching implications for asset allocations and market dynamics.

Ultimately, US equities could find themselves a casualty of their own remarkable success. The unparalleled rise of the US stock market may prompt a natural rebalancing toward bonds, which stand to benefit as investors seek diversification and stability. The dynamics of capital flows, valuation extremes, and shifting fiscal and monetary policies will likely shape the trajectory of both asset classes in the years to come, with stocks facing the dual challenge of their elevated status and the rebalancing pressures it invites.