U.S. equities have staged an impressive rally, overcoming challenges such as tariff-related volatility and Moody’s downgrade of the U.S. credit rating. From the April lows, the market has rebounded nearly 20%, with some analysts even predicting a challenge to record highs.

However, is the market truly risk-free? Lisa Shalett, Chief Investment Officer at morgan stanley Wealth Management, warns that investors may be overlooking three critical risks in the market—factors that could ultimately come back to bite.

Divergence Between Valuations and Fundamentals

Shalett highlights that investors are displaying “unwavering confidence” in the recent U.S.-China tariff pause, assuming it has permanently removed the uncertainty around trade wars. As a result, equity markets have returned to their early-year levels.

But she cautions that this rebound has occurred even as corporate earnings forecasts continue to be revised downward. This implies that investors are now paying more for each dollar of expected earnings than they were at the beginning of the year—meaning equity valuations have grown more expensive.

Bond Market Sends Warning Amid Equity Optimism

While a rise in short-term Treasury yields may suggest optimism about economic growth, Shalett points out that the 10-year Treasury yield hovering near 4.5% deserves attention.

This is because the U.S. government faces three looming fiscal challenges: tax policy, the debt ceiling, and the federal budget. Related legislative proposals could add another $2 trillion in federal debt and increase interest expenses by 50% over the next decade.

What does this imply? “Longer-term higher interest rates and pressure on equity valuations,” she said.

Unusual Dollar Trends Raise Market Questions

Since peaking on January 8, the U.S. dollar has declined 8% against major currencies. Shalett believes this reflects “a reallocation of global capital flows and reserve assets.”

She also notes that the dollar and oil prices are now rising in tandem—an unusual departure from their typical inverse relationship. If the dollar enters a prolonged depreciation cycle, it may lower U.S. equity valuations via capital outflows. In other words, a weaker dollar could scare off foreign investors.

Additional Signals from Gold

Traditionally, during a bull market, the S&P 500 is expected to outperform gold. Yet since 2022, gold has actually outpaced U.S. equities. Shalett interprets this as a sign that global central banks are adjusting their foreign reserve allocations to increase gold holdings—an indirect signal of increased caution toward risk assets like stocks.

Shalett’s Outlook and Strategy

Shalett advises investors to abandon hopes for continued valuation expansion and instead prepare for asset repricing. She expects U.S. equity markets to deliver average annual returns of 5% to 10%, accompanied by higher volatility, elevated real interest rates, and a weaker dollar.

Her asset allocation recommendations include increasing exposure to international equities, commodities, energy infrastructure, and hedge funds. She also suggests overweighting investment-grade and municipal bonds with short-to-intermediate durations.