US, European stocks rise despite looming risks

US stocks continued to rally last week, including a strong showing from small caps,¹ despite growing worries from individual investors. So what’s prompting stocks to climb the proverbial “wall of worry?” Many investors in US stocks are clearly focusing on positive catalysts such as the potential for significant deregulation and tax cuts under the incoming Trump administration, while ignoring risks such as the potential economic impact of tariffs and very restrictive immigration policies. In this article, I’ll explain the risks, explore why I believe optimism is justified, and highlight some positive trends to watch around the world.

Bullish sentiment falls while bearish sentiment rises

First, let’s get a sense of how high the wall of worry is. Here are the findings from the most recent weekly American Association of Individual Investors (AAII) Sentiment Survey published on Nov. 21:

• Bullish sentiment, defined as expectations that stock prices will rise over the next six months, fell 8.6 percentage points to 41.3%.² (That said, it remains higher than its historical average of 37.5%, marking the 54th time it has been above its historical average in the last 55 weeks).
• Bearish sentiment, defined as expectations that stock prices will fall over the next six months, increased 4.9 percentage points to 33.2%. It’s worth noting that bearish sentiment is now above its historical average for the first time in 10 weeks.

High valuations

I have also heard from many clients over the last year who are worried about high valuations. It’s true that some stocks, especially US large-cap stocks, have very high price-to-earnings ratios and are arguably priced for perfection or near perfection. However, it’s clear from the ongoing stock market rally that most investors are overlooking valuations and are continuing to invest.

A resurgence of inflation may be the biggest risk facing the market

As I’ve said before, when it comes to the two main policy risks of tariffs and immigration, immigration is the far greater economic concern for me because of already tight labour markets – especially in certain industries – that can drive up labour costs. And deportations would not be reversible like tariffs, which is a recipe for higher and sticky inflation. And so, unsurprisingly, I think the biggest risk going forward is the potential for a resurgence in inflation. That could further slow Federal Reserve (Fed) easing – or even stop it.

As for me, I think the path of easing will be more gradual, but still significant. The Federal Open Market Committee meeting minutes released last week didn’t alter my expectations for the Fed; they confirmed that the path of easing will be somewhat slower than expected a few months ago, but that the Fed remains data dependent. As I’ve said before, I don’t expect the Fed to cut in December. That is a view I’ve held for a while, but it was confirmed by the minutes: “upside risks to the inflation outlook were seen as little changed, while downside risks to employment and growth were seen as having decreased somewhat.”³ It was also confirmed by the most recent Personal Consumption Expenditures print. While it was in line with expectations, it remains elevated; not much disinflationary progress has been made recently. That suggests more caution for the Fed in the near term

Bond vigilantes could pose risks as well

Another risk is the potential for bond vigilantism among investors who might sell their Treasury bonds in protest of government policies that grow the deficit. Such a sell-off would likely result in rising yields that could exert downward pressure on stocks.

However, we actually saw a reversal of higher yields last week, driven largely by the nomination of Scott Bessent to be US Treasury Secretary. Bessent is perceived to be rational and moderate when it comes to tariffs. More importantly, Bessent is considered to be a fiscal conservative, which seems to be just what the US needs right now. Bessent has proposed a plan to reduce the federal budget deficit to 3% of gross domestic product (GDP) – a benchmark that the European Union is also using for its member nations. His nomination and the potential for more fiscal discipline was enough to reverse much of the “yield climb” that has been seen in the 10-year US Treasury yield since President-elect Trump began leading in betting odds well before the presidential election. The 10-year US Treasury yield fell from well above 4.4% to 4.175% last week⁴, which helps explain the recent wind beneath the wings of stocks – despite investor worries.

European stocks have also been climbing a wall of worry

We also saw stocks perform well in other parts of the world, again ignoring fears. European equities, as represented by the MSCI Europe Index, returned 1.8% last week despite some challenging developments.⁵ Following is a recap of just a few of those recent developments:

• The flash services and manufacturing Purchasing Managers’ Index (PMI) readings for the euro area were disappointing, with both in contraction territory. Eurozone services PMI negatively surprised and fell into contraction territory at 49.2, a 10-month low, while eurozone manufacturing PMI fell to 45.2.⁶ Having said that, it’s important to note that there were significant differences within the eurozone. Germany and France each saw output decrease, which is not surprising given the headwinds they face. However, the rest of the eurozone continued to see business activity increase.
• Eurozone Consumer Confidence (preliminary reading) decreased to -13.7 in November 2024, below its long-term average and worse than market expectations.⁷ This was the lowest reading since June. There was a material decline in consumers’ assessment of the overall economy as well as their household financial outlook.
• The flash estimate on November euro area inflation was 2.3% year-over-year, up from 2.0% year-over-year in October, which exceeded the ECB’s target inflation rate. However, core inflation was stable so it shouldn’t slow down monetary policy easing.⁸
• Germany retail sales fell 1.5% month-over-month for October, which was worse than expected.⁹
• The unemployment rate for Germany for November was 6.1%, the same as October; this is the highest level since February 2021.⁹
• The French 10-year government bond yield eclipsed that of the Greek 10-year bond yield for the first time last week, due to the perilous budget situation in France. France is under pressure by the EU to get its deficit down to 3% of GDP; the goal was to do that by 2027, although Prime Minister Michel Barnier had decided to delay reaching that goal to 2029 in order to more gradually ease into fiscal austerity. France is expected to have a budget deficit this year of 6.1% of GDP; Barnier’s plan would lower the deficit to 5.1% of GDP in 2025 through a mix of spending cuts and tax increases, although he has received significant opposition. Far-right National Rally leader Marine le Pen announced last week she would vote “no confidence” and topple France’s minority government unless changes are made to the country’s budget bill – specifically around not increasing the electricity tax and increasing pension levels. This of course will make it much harder for France to meet EU fiscal targets after its budget had just been given the green light by the European Commission – and it could mean the prime minister’s job will once again be vacant. The next several weeks will be a nail-biter, as the budget bill for next year must be passed by Dec. 21.

Supportive monetary policy can justify stocks’ climb

In short, I’m happy to see markets climbing a wall of worry – I think optimism in the face of challenges is often justified, especially when monetary policy is becoming supportive. And I’m happy to see the broadening in markets with the recent strong showing from small-caps. In my view, this is also justified given that we anticipate an economic re-acceleration in 2025.

Looking beyond the wall of worry

I should add that not all developments are worrisome. There are good things happening as well:

• In a perfect illustration of the “bad news is good news” paradigm, expectations rose last week that the European Central Bank would ease more quickly than previously expected given weak economic data.
• Last week, Japan’s government announced a $250 billion fiscal stimulus program (about 4% of GDP), which pushed up bond yields and expectations around the Bank of Japan’s anticipated tightening path. That in turned strengthened the yen. This stimulus plan is a form of industrial policy not dissimilar to what we have seen from other developed countries, including the US, such as the CHIPS Act. It would support the artificial intelligence and semiconductor industries and would also provide cash subsidies for energy for lower-income households. While there is no guarantee this will pass the Diet, it is good news for the Japanese stock market and economy.
• The Japanese government also proposed a higher investment return target for the nation’s largest pension fund, a move that is likely to result in increased purchases of stocks.
• China’s manufacturing activity is on an upswing, with the Caixin Manufacturing PMI rising to 51.5 for November, well above expectations.¹⁰ This is a five-month high. Even more encouraging is that the new orders sub-index hit a 3.5 year high. This echoes improvement seen in China’s official manufacturing PMI.
• The Canadian Federation of Independent Business (CFIB) released its November Business Barometer, a long-term index reflecting 12-month forward expectations for business performance in Canada. The Business Barometer rose to 59.7 in November 2024 from 55.8 in October, reaching its highest level since May 2022.¹¹ This uptick is broad-based and reflects a general increase in optimism across most sectors.

What might this mean for investors?

All this suggests to me that stocks are justified in climbing the wall of worry. However, I believe it could make sense to take profits and “right size” exposure to more expensive areas of the US stock market (large-cap growth, especially tech) while adding to exposure to US mid-caps and small caps, which sport lower valuations and have the potential to handily benefit from an economic re-acceleration next year.

I believe it could also be time to ensure adequate exposure to non-US stocks and fixed income. Volatility is low right now and we might be lulled into a false sense of security, but there will likely be hiccups and sell-offs in coming months, which makes a good argument for the importance of exposure to alternatives that have historically had lower correlations to equities; now might be a particularly attractive time to add exposure to real estate.

Giving thanks

Last Thursday was Thanksgiving in the US. While the Thanksgiving holiday might be American (and Canadian), gratitude is universal. And so it was a wonderful opportunity to spend time with my loved ones and reflect on what I’m thankful for. Beyond my family (furry and non-furry), I’m very grateful to do what I love every single day, and I try to never take that for granted. Part of why I love my job is that I have the privilege of working with so many brilliant and insightful colleagues who also happen to be kind and good people. I’m especially grateful for the members of the Global Market Strategy Office, who make me smarter every day. And I’m grateful for my long-serving (and long-suffering) editor who turns lemons into lemonade each week (Editor’s Note: No suffering at all!) And I’m incredibly grateful for you readers. I am humbled that you take time out of your busy week to read what I have to say.

Looking ahead

This week will be an important one. I will be focused on the Job Openings and Labor Turnover Survey report and the November employment situation report in the US since the Fed has said it doesn’t want to see a further deterioration in employment. I will also be following eurozone retail sales as well as the preliminary University of Michigan Survey of Consumers and the Fed’s Beige Book, which is usually chock full of good anecdotal information.