Market optimism masks underlying fragility

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Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Leslie Alba, head of portfolio solutions, total investment solutions, CIBC Asset Management 

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As we head into the fourth quarter of 2025, when we look at the market environment, three themes really stand out: tight credit spreads, stretched valuations and a growing sense of euphoria among investors. 

Tight credit spreads generally mean that investors are demanding very little extra yield for taking on riskier corporate bonds versus government bonds, which is a strong sign of risk appetite. And then at the same time, equities are trading at historically high levels relative to their underlying fundamentals, which points to stretched valuations. 

In our view, there are a few important factors that are driving this risk-on sentiment. First, the uncertainty around trade tariffs has diminished compared to earlier this year. Several markets are trading at all-time highs, with most markets now trading above levels seen before the last U.S. election, which does show that investors have largely put tariff concerns behind them. 

Second, corporate earnings have been robust. They’ve been pretty strong, especially in innovation-driven sectors like artificial intelligence. Now at CIBC Asset Management, we are optimistic about the innovation theme, but maybe a bit more cautious than consensus, and that’s because it’s important to recognize that heavy capital investments in artificial intelligence will eventually lead to higher depreciation expenses, and if revenues don’t keep up, profit margins will be under pressure. 

And then the third thing, in our view, that drives risk-on sentiment is anticipated policy actions such as interest rate cuts in Canada and the U.S. These expectations have contributed to a broad view that North America and the wider global economy are likely to avoid recession. But through all this positivity, we’re observing a growing sense of euphoria. 

Historically, the VIX Index, which gauges expected equity market volatility, has moved alongside the Economic Policy Uncertainty Index. But over the last year, apart from a spike in the VIX around Liberation Day at the beginning of April, equity market volatility has remained unusually subdued, even as economic uncertainty persists. 

And so overall, while we’re seeing renewed optimism and strong market health since the beginning of April, it’s important to note that surface level strength in equities does contrast with underlying fragility. 

Several investors may remember past cycles where market highs masked growing risks beneath the surface. So when spreads are tight and valuations are stretched, even a small shock can trigger outsized reactions, and that’s why risk management and a disciplined approach are more important now than ever. Today’s valuation environment suggests the risk-versus-reward balance is less attractive than earlier in the cycle, leaving very little room for error in monetary policy or corporate earnings. 

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Throughout the year so far, we’re seeing a shift away from U.S. market dominance. 

If we examine year-to-date performance through to the end of September, in Canadian dollar terms, the MSCI EAFE Index is up 26%, while the S&P 500 Index is up 11.1. And although U.S. dollar depreciation versus the Canadian dollar has impacted Canadian investors, and therefore Canadian dollar returns, international equities have outperformed U.S. equities, even in local currency terms. 

While over the past six months, U.S. equities have recovered and narrowed that gap, overall, global returns are showing greater breadth. Canadian equities are up 24% to the end of September, and emerging markets have matched that performance. 

And then within the U.S., small-cap stocks have also shown notable strength, which does contrast to the strength of the Mag Seven driving the majority of 2024 returns. And so given this backdrop, while the U.S. has long been the market leader, we are seeing a rising probability that its dominance will moderate. 

Canadian equities, for instance, offer attractive features. For one, earnings growth forecasts are on par with the S&P 500 companies. And Canadian equity valuations are much more reasonable. Also, looking ahead, the potential for a strong economic recovery in Canada could provide a tailwind for corporate earnings. 

Europe, meanwhile, is benefiting from strong fiscal support and a revitalized banking sector as interest rates return to positive territory. And this shift is improving risk appetite and could create sustained momentum for the region’s economy and markets. 

However, both Canada and Europe currently lack the innovation culture, especially in digital and artificial intelligence that has really fueled U.S. market leadership over the last decade. As long as innovation remains a key driver, Canada and Europe may struggle to fully catch up to the U.S. in the near term, but that’s not to say that they can’t lead in other sectors, or that future policy or corporate strategies won’t be aimed at closing that gap. 

Where we are seeing the most significant change in the technology landscape is between the U.S. and Asia, with China really at the forefront. China’s rapid progress in technology and production, particularly in electric vehicles, artificial intelligence, and renewables is arguably reshaping global investment trends. And despite ongoing geopolitical tensions and policy risks, China’s influence is growing, and contributing to a more multipolar investment environment. 

All that to say that to us the implication for investors is clear: relying on a single region or sector for outsized returns is becoming less viable. So diversification is a key strategy for managing risk and for capturing opportunity in a complex and changing global landscape. 

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Considering the benefits of private assets in retail portfolios, there’s a growing trend towards democratizing access to these investments. Private assets offer unique return opportunities that aren’t available in public markets. And because private assets are valued less frequently than public assets, their reported returns show lower correlation with traditional stocks and bonds, which does help to reduce experience volatility in a broader portfolio. 

What I find most compelling about private equity in particular, is that many of today’s most innovative companies remain private for a longer period. So excluding private assets from a portfolio means potentially missing out on dynamic growth opportunities. 

However, it’s essential for investors to be aware of the risks, particularly illiquidity. The best way to balance these risks is to ensure allocations are modest and aligned with long-term investment objectives and risk tolerance. Private assets can enhance diversification, but they shouldn’t compromise an investor’s need for liquidity. For retail investors in particular, it’s crucial to ask questions about transparency, exit options and how private assets really fit into their broader financial plan. These investments can add value, but only if approached thoughtfully. 

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Our long-term strategic asset allocation remains neutral between equity and fixed income. And that’s because our long-term strategic asset allocation is rooted in the productivity of the assets we invest in. 

For equities, we focus on the trajectory of corporate earnings, and for bonds, we’re looking at yields and inflation. 

So our long-term perspective remains unchanged, even if near-term uncertainty and market fragility persist. We continue to believe equities will remain the cornerstone for wealth accumulation, and our central expectation is for policy rates and inflation to normalize over time. 

So by keeping a steady focus on long-term fundamentals, we avoid overreacting to short-term market noise and prevent over trading. Staying diversified and attentive to signals of fundamental change, rather than short-term volatility is key for prudent asset allocation. 

But the takeaway really is that patience and discipline are critical. We take a dynamic, diversified approach — one that’s responsive to real shifts, but not driven by headlines, to help investors weather uncertainty and capture long-term growth. 

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So our long-term outlook on capital markets remains positive. Despite economic fragility, we are seeing solid response from central banks in terms of monetary impulse. And so if those policies are effective, then we should be able to sidestep recessions in Canada and the U.S., and across the globe. 

But we do believe that the risks are more balanced to the downside because of where valuations are today, where any shock could result in an outsized impact on markets. 

There are some key factors that deserve attention and one of the biggest ones — top of mind for us right now — is institutional stability. So any erosion of Fed independence could have major consequences, including higher inflation expectations, a weaker U.S. dollar and rising long-term bond yields. So our central expectation is that a sudden shift in institutional stability is unlikely, but a gradual weakening is a possibility that our team continues to monitor.

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