Barometer: US stocks have more to give

Asset allocation: equities remain in the ascendancy

Many investors consider the outcome of the US election to be consequential for equity markets.

We’re not convinced. True, there are clear differences in policy between Donald Trump and Kamala Harris but even the most extreme change to the status quo – a Republican clean sweep of the White House and Congress – shouldn’t contain huge surprises. We have been here before, after all. A Trump-led administration is a known quantity, which wasn’t the case when the property tycoon secured the White House in 2016.  Tax cuts, immigration control, fossil fuels, tariff increases and deregulation will be the priorities, much as they were eight years ago.

All of which suggests investors should look more closely at fundamental developments when considering their asset allocations. And, in our view, they all point to being overweight equities. For one thing, our analysis shows that both corporate and household balance sheets are generally in good shape – suggesting the US economy will experience a soft landing, which is a positive for company earnings. What is more, leading economic indicators have been improving worldwide while interest rates have been falling – a rare occurrence that bodes well for stock markets. Then there’s liquidity. With China having recently added to the world’s supply of monetary stimulus, liquidity provision is growing at a rate that is in excess of nominal economic growth, which tends to boost stocks’ earnings multiples (see Fig. 2).

Our overweight in equity is counterbalanced by an underweight in cash and a neutral position in bonds, which are by and large fairly valued even if we believe the market is pricing in more US interest rate cuts than the Federal Reserve will eventually deliver. We expect the central bank to cut rates to around 4 per cent while futures markets are pricing in a terminal rate closer to 3.5 per cent.

Our stance is influenced partly by our business cycle indicators, which paint an encouraging picture for the world’s two largest economies.

In the US, economic conditions remain healthy, as evidenced by recent data showing GDP grew at a robust 2.8 per cent annualised pace in the third quarter. The engine powering the US continues to be consumer spending, which is proving more sustainable than we had envisaged earlier in the year.

Although we expect US GDP growth to slow over the coming months, we see a gentle decline that will be accompanied by a steady fall in inflation. Put differently, the stars appear to be aligning for a ‘soft landing’: a scenario that sees the US avoiding a recession and inflation falling at a pace that allows the Fed to reduce borrowing costs further in the coming months.

China, meanwhile, looks to have moved onto a more stable economic footing. With the Fed having cut interest rates in September, Chinese authorities were able to set in motion a large monetary stimulus plan amounting to some RMB2 trillion, or 1.6 per cent of GDP, to shore up an economy flirting with debt deflation. But we believe this is just one part of the recovery plan China’s government has in mind. In the coming months we expect a fiscal stimulus package of a similar magnitude, or some 1.5 per cent of GDP, which could be transformative for China’s near term economic prospects, as well as those for emerging economies more broadly. The fiscal package would, to some extent, counter any increase in US tariffs on Chinese goods exports.

Conditions in Europe are less favourable, however. The outlook for both consumer spending and industrial activity remains weak, which suggests the European Central Bank (ECB) will need to cut interest rates aggressively, by more, potentially, than the market currently discounts. 

Our liquidity gauges indicate conditions are broadly positive for riskier asset classes. With some two thirds of the world’s major central banks now cutting interest rates, and China having recently added to the supply of monetary stimulus, it would appear that stocks’ price-earnings multiples can hold at current levels if not inch a bit higher.

That doesn’t necessarily apply to stocks in Europe, however. Here, the credit squeeze resulting from continued quantitative tightening from the ECB could soon worsen once France and Germany begin implementing the sharp public spending cuts they have recently committed to.

The valuation metrics we monitor show that equities have in aggregate become more expensive. The recent rallies enjoyed by Chinese and emerging market stocks mean both look less compelling on valuation grounds. Even so, they remain among the cheapest equity markets on our scorecard. In fixed income and currency markets, meanwhile, European bonds now look very expensive, as does the US dollar.

Recent technical developments support our overweight position in equities. Seasonal factors are positive as stocks tend to do well heading into the year end, while investment inflows into equities among private investors are healthy; share buybacks, meanwhile, can be expected to remain strong.

Equities regions and sectors: bullish on China and the US

With China’s monetary stimulus package looking like it’s having a positive effect on the economy – and more support expected in the form of fiscal measures – it’s a good time to upgrade Chinese equities to overweight from neutral. And because we believe the US election is likely to produce a positive result for the country's corporate sector under most scenarios, we also upgrade US stocks to overweight.

In late September, Chinese policymakers finally launched a serious effort to reverse what was looking increasingly like debt deflation. This mostly entailed monetary measures worth some 1.6 per cent of GDP, aimed to boost credit demand and underpin both the property market and the banking sector’s crumbling balance sheet. This is likely to be followed by an equivalent fiscal package by the end of the year, with an even bigger stimulus likely if Trump wins a second US presidential term and launches punitive tariffs against China. So while Chinese stocks have already shot higher (year to date they’ve jumped 24 per cent in local currency terms, making them the world’s best performing equity market), we think more gains can be expected over the coming months. Valuations are still attractive considering that China’s total market cap is at a 20-year low relative to money supply – a proxy for the dry powder available to local investors.

A Trump win would also be good for US equities, which already benefit from the most positive corporate earnings expectations of all major equity markets (see Fig. 3). He’s likely to push for further tax cuts, though they probably won’t be as sizeable as the previous time round. And with consumer balance sheets remaining healthy, companies are likely to sustain their profit margins, even if some of Trump’s anti-immigration and anti-trade measures push up costs. However, a win by the Democrats wouldn’t necessarily be bad for the equity market, either. 

On sectors, we maintain our barbell strategy with an overweight in both the more cylical financials sector and defensive utilities. Financial companies are benefiting from solid net income margins, low default rates and an expected improvement in loan demand. And adjusted for earnings growth, banks remain the cheapest among global industry sectors. Utilities companies, meanwhile, have the best momentum among defensive sectors and they have an attractive dividend yield of some 4 per cent. 

Elsewhere, we downgrade Japanese equities to neutral from overweight on an increase in political risk. The country’s recent snap election saw the powerful Liberal Democratic Party (LDP) lose control of the lower house of parliament and the dominance it’s held over national politics since the mid-1950s. Valuations for the market are neutral after its outperformance of the past few years while monetary policy is tightening and economic growth momentum remains weak. We also doubt that the yen can weaken much more from here – removing a vital support for local stocks.

Fixed income and currencies: sticking with gold, trimming euro shorts

Although some 20 of the major 30 central banks we monitor are cutting interest rates more or less in tandem, divergences in policy will soon emerge, opening up various tactical investment opportunities in fixed income and currency markets.

We have, for example, chosen to take profits on our short position in the euro and raise it from underweight to neutral. Although the ECB is likely to have to cut rates further than the Fed, that prospective rate differential has largely been priced into the market. Upcoming cuts to public spending in the region’s two major economies, France and Germany, and lacklustre growth in Europe more generally make it likely that the ECB will find itself having to reduce rates to below the 2 per cent neutral rate – a scenario that we believe is already baked into the value of the euro, reducing the scope for any further depreciation.

We retain our neutral position on other currencies. Although the dollar looks overvalued on a number of metrics, US economic growth continues to outpace that of the rest of the developed world while a Trump US election victory – with a possible Republican sweep of Congress – is likely to keep the greenback well supported. 

However, we continue to use gold as a hedge against inflation and any politically-driven instability a Trump victory might generate. That’s notwithstanding the precious metal’s storming performance this year, which might otherwise be a temptation to take profits.

While a growing number of commentators have expressed concern about corporate bond valuations, we are more sanguine and so remain neutral on European and US credit, both high yield and investment grade. Despite tight credit spreads, company balance sheets are healthy – as are those of consumers, particularly in the US – and default rates are low and falling. Research shows that expected returns on credit are highly correlated with yield, allowing investors to overlook default rates, even in the high yield market.

Meanwhile, we remain overweight emerging market debt, with a preference for local currency debt. China’s stimulus should be supportive of other emerging economies, particularly in the region, especially if China’s imports rise in line with GDP growth and external tourism picks up – it’s still only 60 per cent of pre-Covid levels. EM currencies look cheap and EM real rates, especially in Latin America, are very attractive.

In sovereign debt, we remain neutral most developed government bonds. The picture is slightly muddled for US Treasury bonds: solid growth and the rising probability of a Trump sweep are clear negatives, but the recent rise in term premia – the risk component of bond returns – and the significant reduction in implied Fed rate cuts till end of 2025 are important offests. Net-net that doesn’t give a strong signal in either direction, while valuation suggests the bonds are broadly fair value after yields moved sharply higher over recent weeks reflecting the strength of the economy and Trump’s strength in the polls (see Fig. 4).

Global markets overview: a volatile Autumn

October was a tough month for global equity and markets. An escalating conflict in the Middle East and growing uncertainty over the outcome of US presidential elections left investors concerned for the health of the global economy.

Both equities and bonds finished the month in the red, but with stocks outperforming thanks to relatively healthy corporate earnings.

Among major equity regions, Japan was the only one to post gains – up over 2 per cent in local currency terms. The country’s export-focused market welcomed a retreat in the yen after the ruling Liberal Democrats lost their parliamentary majority in a snap general election. 

Also in Asia, Chinese equities had a particularly volatile month – early gains gave way to a steep sell off after the stimulus announcement fell short of investors’ expectations (see Fig. 5).

US equity markets fell but overall fared better than Europe thanks to healthy earnings dynamics. Of the S&P 500 companies that have already reported third quarter results, 77 per cent have beaten analysts’ earnings forecasts, according to LSEG I/B/E/S data.

Positive earnings surprises came from financial and communications services, which were two best performing sectors in October. Financials also benefited from expectations of less stringent regulation in the event of a Trump election victory.

In bond markets, UK gilts lost some 3 per cent in October, in local currency terms, as investors braced for bumper government debt issuance to help finance increased public spending on health and education.

Yields on 10-year Treasuries hit their highest levels since mid-July, as a run of positive data from the US consumer sector prompted a scaling back in expectations of future rate cuts. This was also good news for the US dollar, which set three-month highs versus a basket of currencies.

Gold gained 4.1 per cent, cashing in on its status as a defensive, safe haven asset. Oil, meanwhile, added 1.7 per cent in the face of tensions in the Middle East.