MARKET UPDATE [MAY 2026]

BAORO

RESEARCH

MARKET OVERVIEW

Throughout May, financial markets increasingly shifted their focus from the prospect of interest-rate cuts to the possibility that central banks may need to tighten policy further if inflation pressures persist. At the U.S. Federal Reserve, internal discussions moved away from when rate reductions might begin toward what conditions could justify additional increases. Three Federal Reserve presidents dissented from language implying future rate cuts, while Minneapolis Fed President Neel Kashkari outlined scenarios in which an extended closure of the Strait of Hormuz could necessitate a series of rate hikes. Similar concerns emerged globally. Bank of Canada Governor Tiff Macklem pledged to act if higher energy prices begin spreading throughout the broader economy, while officials at both the European Central Bank and the Bank of Japan signaled that further rate increases remain possible if inflation does not improve.

Despite inflation concerns stemming from the conflict involving Iran and disruptions to energy markets, equity markets remained resilient. The S&P 500 and Nasdaq repeatedly reached record highs during the month as investors responded positively to signs of economic strength and reports that Iran had presented Washington with a new proposal aimed at ending the conflict. Although the two sides remained far apart, investors viewed the proposal as a constructive step. Later in the month, an agreement to reopen the Strait of Hormuz further improved sentiment, with expectations that lower oil prices would eventually reduce transportation, manufacturing, food, and fuel costs worldwide, though the benefits are expected to take time to fully materialize.

Economic data generally pointed toward continued resilience in both the United States and Canada. U.S. factory activity expanded in April, while the services sector also continued to grow. New home sales and pending home sales increased despite elevated mortgage rates and economic uncertainty. The labor market showed signs of stabilization, with private-sector employers adding 109,000 jobs in April, making the strongest gain in 15 months and revised data showing stronger March hiring. Initial jobless claims remained historically low, while continuing claims declined modestly. Federal Reserve Chair Jerome Powell noted that improving labor market conditions allow policymakers to focus more directly on inflation risks. However, beneath the headline strength, challenges remained. Job growth continued to concentrate on healthcare, job openings trended lower, and employers cited trade policy uncertainty and energy shocks as reasons for delaying hiring decisions. A sharp slowdown in labor force growth caused by stricter immigration policies also suggests the economy may be unable to replicate the rapid job creation experienced during the post-pandemic expansion.

Inflation pressures remained a central concern throughout the month. U.S. consumer prices rose 3.8% year-over-year in April, reflecting higher energy costs associated with the Middle East conflict, while core inflation accelerated to 2.8%. Consumer inflation expectations also increased, with the University of Michigan’s survey showing long-term inflation expectations rising to 3.9% in May. In Canada, annual inflation accelerated to 2.8%, driven primarily by energy prices, though core inflation measures slowed to their weakest pace since early 2021. Manufacturing surveys in both countries indicated rising input costs, with Canadian producers experiencing the strongest cost pressures in more than three-and-a-half years and the fastest output-price inflation since late 2022. China’s central bank also warned about imported inflation risks as export growth accelerated.

Corporate earnings and investment activity provided additional support for markets. Analysts increasingly pointed to signs of economic reacceleration in first-quarter results, which were broadly stronger than expected. Major technology and artificial intelligence-related developments attracted investor attention, including surging shares of Cerebras ahead of its anticipated public debut and significant gains in Intel and Akamai Technologies tied to major technology and AI agreements. SpaceX’s anticipated public offering generated considerable interest, with proceeds expected to help finance ambitious projects requiring hundreds of billions of dollars in capital investment, including a proposed semiconductor manufacturing complex in partnership with Tesla.

At the same time, corporate restructuring remained widespread. Nissan announced job cuts in Europe, while PayPal, Coinbase, Intuit, Meta, and several other firms unveiled significant workforce reductions as they sought to improve efficiency and reposition for an increasingly AI-driven economy. Despite these announcements, broader layoff activity remained relatively subdued. According to Challenger, Gray & Christmas, total layoffs during the first four months of the year were approximately 50% lower than the same period a year earlier, while private-sector layoffs were down 10%.

Canada’s economy presented a mixed picture. Manufacturing activity strengthened considerably, with factory sales reaching their highest levels in more than a year and posting additional gains in April. However, the broader economy unexpectedly contracted for a second consecutive quarter, with GDP declining at a 0.1% annualized rate as exports weakened, imports increased, and both business and government investment softened. Nevertheless, preliminary estimates suggested economic activity rebounded in April. Prime Minister Mark Carney emphasized the need to double Canada’s electricity grid capacity by 2050, a project estimated to cost more than C$1 trillion, while signaling greater openness to natural-gas generation as part of the country’s future energy strategy.

Internationally, inflation and growth developments remained mixed. South Korea’s inflation rate climbed to a 21-month high, Australia’s central bank raised interest rates for a third consecutive meeting, and Japan’s economy accelerated during the first quarter, reinforcing the case for future rate increases. However, economic activity weakened across parts of Europe and Asia, creating difficult trade-offs for central banks facing slowing growth alongside persistent inflation pressures.

Consumer finances showed growing signs of strain despite generally favorable labor market conditions. Credit-card balances reached a record $1.25 trillion in the first quarter, while the share of balances at least 90 days delinquent rose to the highest level in 15 years. Average credit-card interest rates climbed to approximately 21%, significantly increasing borrowing costs for households. Consumer confidence deteriorated sharply, with the University of Michigan’s sentiment index falling to a record low of 44.8 as concerns about gasoline prices, Middle East tensions, and future inflation intensified.

Fiscal policy also played an important role in supporting consumer spending. Analysis of tax filing data suggested that provisions within the One Big Beautiful Bill Act (OBBBA) delivered significantly larger tax relief than initially expected. Total tax savings may have reached approximately $148 billion through refunds and reduced tax liabilities, with an additional $30 billion resulting from lower withholding throughout the year. Combined, these measures could help middle- and upper-middle-income households absorb the impact of higher energy prices resulting from the Iran conflict.

By month-end, investors remained focused on the delicate balance between resilient economic growth and persistent inflation risks. While stronger employment, corporate earnings, and manufacturing activity supported optimism, elevated energy costs, rising consumer inflation expectations, growing household debt burdens, and increasingly hawkish central bank rhetoric suggested that the path toward lower interest rates may be considerably longer than markets had anticipated earlier in the year.  

MARKET OUTLOOK

Inflation has re-emerged largely as we expected. Our main focus remains how the Federal Reserve will respond to this renewed inflationary backdrop. Fed funds futures still suggest that a rate hike is not yet the market’s base case, but several Fed officials have indicated they could shift quickly if Middle East tensions and the resulting oil-price pressures remain persistent. On the labor front, layoffs continue to weigh on growth, although recent data shows some improvement led by the healthcare sector. At the same time, tighter immigration policy continues to constrain labor supply. Taken together, the risk of stagflation still lingers, with inflation once again standing out as the key variable to monitor and manage.

As we noted in earlier Letters to Investors, our base-case scenario has been the “bubble” setup, which resembles conditions seen in the late 1980s and during the 2000–2001 technology bubble. In both cases, a reasonable base case would have been for inflation to reaccelerate, forcing the Federal Reserve to abandon its path toward easing and return to fighting inflation. We view a policy rate around 4.33% as an important signal to reduce equity exposure and position the portfolio more defensively. Recent developments suggest this scenario is not only still in place but may be strengthening.

If this base case continues to unfold, we believe it is important to prepare accordingly. Gold has historically served as a safe-haven asset, but its lack of cash flow generation, combined with its recent strong run, makes it less compelling to us as a defensive allocation today. U.S. Treasuries still appear to offer meaningful portfolio protection because they typically benefit from rising demand for safety. However, concerns around U.S. fiscal conditions and debt levels make them a less straightforward hedge than history might suggest.

Given these constraints, we continue to rely on both current and historical market narratives to guide portfolio positioning. For now, we still see attractive value in software, medical technology, and staffing, and we intend to continue allocating capital selectively to those areas.

MANAGEMENT DISCUSSION & ANANALYSIS

Key Changes to Fundamental Determinants of Market Growth and Risk.

S&P500 Market Cap (February → March): 65.154 trillion → 68.825 trillion

Analyst Consensus Earnings Forecasts (2026): 310.0 → 339.2

Model Earnings CAGR:  9.75% → 13.94%

S&P500 Aggregate Earnings (TTM) latest quarter estimates (in $ Billions):  617.34 → unchanged

S&P500 Aggregate Dividends (TTM) latest quarter estimates (in $ Billions): 165.16→ unchanged.

S&P500 Aggregate Buybacks (TTM) latest quarter estimates (in $ Billions): 249.00. → unchanged.

Model Payout Ratio: 77.85% → unchanged.

Implied Equity Risk Premium

The implied equity risk premium (IERP) represents the excess return investors demand for holding equities instead of risk-free government bond. As it is not directly observable, the IERP is estimated by discounting expected future cashflows, primarily aggregating dividends and share repurchases. At Baoro Research, we calculate the IERP each month at the market index level, utilizing it as an indicator of valuation conditions, investor sentiment, and consequently, potential market direction. As of April 2026, our estimate for the IERP stands at 4.44%, which remains notably below both the historical average of approximately 5.36% and the recessionary threshold of 6.16%.

Market Valuations

With an average equity risk premium of 5.36%, the adjusted implied fair value for the S&P 500 stands at 6247.26. Consequently, based on long-term averages, the market appears to be overvalued by 17.58%

S&P500 Value (IERP 6.16%)

An IERP of 6.16% is commonly observed during periods of economic downturns, which for value investors can indicate a suitable moment to reintroduce equity risk into portfolios. Should the current market narrative lead to challenging economic conditions, S&P500 valuations suggest prices could decrease to 5412.75    , a 28.59% decline from current levels. Despite the extent of this potential overvaluation, this remains the base case model, with the intention to reintroduce equity exposure if such a scenario unfolds.

S&P500 Value (IERP 6.91%)

An IERP of 6.91% is typically observed during periods of substantial market decline, such as at the height of the global financial crisis. Should a similar scenario arise, the index could experience further depreciation, with the S&P 500 potentially reaching 4806.43, which would be a decline of approximately 36.59%. While this extent of price decrease may appear improbable, it remains within the realm of possibility based on historical precedents. For instance, equity markets dropped 89% from peak to trough during the Great Depression (1929 to 1932), while during the dotcom bust and subsequent financial crisis, the Nasdaq Composite fell roughly 78% from its March 2000 high to its October 2002 low. Similarly, the S&P 500 and Dow Jones Industrial Average both declined by approximately 50 to 57% during the 2007 to 2009 financial crisis.

Multiples Lens

Due to variability in the inputs and outputs associated with the IERP model, a multiple-based valuation is also conducted. In this approach, cash flows are represented by the sum of aggregate S&P500 firms’ dividends and buybacks on a trailing twelve-month basis.

Data from our model indicates that the S&P 500 historically has an average price to cash flow ratio of 23.4. The multiples at plus or minus one standard deviation are 28.8 and 18.0, while the values at plus or minus two standard deviations are 34.2 and 12.6. Using the most recent trailing twelve months aggregation of firm dividends and buybacks, the following valuations are derived across these key multiples.

P/CF	Implied Index Lvl.
34.2 x	6346.64
28.8 x	5342.71
23.4 x	4338.78
18.0 x	3334.85
12.6 x	2330.92

Valuation Summary