Barometer: Staying overweight equities as world economy avoids slowdown

Asset allocation: from soft-landing to no-landing

Not so long ago, the markets were convinced that the US would head into recession some time this year, dragging the rest of the world down with it. Now the most likely outcome is neither recession, nor even a soft landing. Rather, the highest probability scenario is that the economy continues to sail along steadily with only a modest short-lived deceleration (see Fig. 2). 

Against this backdrop, we expect stocks to outperform fixed income, and hence remain overweight equities and neutral bonds. We remain underweight cash as the global monetary easing cycle gets under way, even if the US Federal Reserve looks likely to lag other developed market central banks. 

There are, naturally risks to this benign view. US elections later this year could cause considerable turbulence, in light of the fact that Donald Trump is running neck-and-neck in the polls with incumbent Joe Biden. What’s more, some economists are even starting to worry about the US needing further rate hikes to mitigate fiscal largesse, while others think that an accidental hard landing is still possible. That’s worth bearing in mind given 80 per cent of assets are now trading above historical trend – risk appetite has been robust. 

Our business cycle indicators are sending positive signals about emerging markets and Australia, which tips the balance in favour of an upgrade to our world score. Emerging markets, not least China, are at the vanguard of the easing cycle, having been quick to tighten policy in the face of the post-Covid inflationary surge. That is set to support growth. Developed economies are showing more muted economic performance, but the euro zone and the UK are showing an improvement to activity.

For now, our signals are neutral for the US economy. We think the economy will slow from around a 3 per cent rate of growth to closer to 1 per cent before recovering back towards potential by the end of the year. Much of this temporary weakness would be driven by services consumption returning to more normal levels – real disposable income is growing at half of its potential pace, while consumer loan growth is also slowing.. We expect inflation to ease to 3.5 per cent by the end of the year, forcing the Fed to keep rates high for longer – though this doesn’t eliminate the possibility of insurance interest rate cuts.

Our liquidity indicators show that central bank policy paths are diverging. The Fed has a bias to cutting rates, and looks set to taper quantitative tightening, but is still circumscribed by sticky inflation. The Fed’s dot plots - the central bank's interest rate projections - suggest one to two quarter point cuts this year. When it does cut, we anticipate private borrowing will pick up, which then risks reigniting inflation. 

European central banks are charting their own easing paths, with the Swiss and Swedes already moving and now the European Central Bank set to join them. We expect the ECB to cut twice as much as the Fed in this easing cycle. China has started to ease incrementally, while Latin American and Eastern European economies are beginning to gain traction from easier monetary policy. 

Our valuation metrics show that US equities are trading at an extended but not extreme 20.5 times earnings after the market’s continued strong performance. Our bubble indicators aren’t showing warning signs, either. Other equity markets are converging in valuation terms on the US, while earnings have been strong, leading analysts to revise up their forecasts. 

The US 10-year Treasury bond’s valuation is in line with our fair value estimate. Treasury inflation protected bonds remain a good store of value, while gilts also appear attractive given dovish noises coming from the Bank of England. Both gold and copper prices are stretched above their fundamentals.

Our technical indicators show risk sentiment is solidly bullish. There is strong momentum in equities across all core markets except Japan, US investor sentiment indicators are again elevated, but not particularly stretched. Positions in S&P 500 futures are at the top of their historical range. Japanese bonds are tactically oversold. Long positions in gold and copper are stretched.

Equities regions and sectors: not all about tech

Move over chip makers and social media platforms. There is another equity sector whose performance is improving rapidly and vying for a spot at the top of the stock market leaderboard. Utility stocks are finally enjoying strong momentum, and, because they have been so unloved until recently, valuations are still attractive. The sector trades on a price to 12 months forward earnings ratio of 14.5 times compared to MSCI All Country World Index on 17.5 times (see Fig. 3). 

An imminent surge in electricity demand should be positive for earnings prospects. The move towards net zero will see the world switch towards electric cars and heating systems. At the same time, the rise of artificial intelligence and connected devices is generating ever more data, fuelling the need for more power-hungry data centres to process and store it securely.

For these reasons, we upgrade utilities to overweight. The move also adds a degree of defensiveness to our positioning, which can be beneficial if economic activity tapers off. 

Even so, we also expect continued strong performance from tech – across both IT and communication services sectors. In our view, the secular growth trends justify current valuations despite the recent deterioration in Big Tech earnings dynamics (which are still being revised upwards, but not as rapidly as before). In communication services, higher than average share buybacks (amounting to a ‘net buyback yield’ of 3.5 per cent versus 2 per cent for the overall market) provide an additional tailwind.

Separately, we remain underweight real estate, which is grappling with still high real interest rates and continued downgrades of analysts’ earnings expectations.

Among regions, we see some of the best potential in developed markets beyond the US – namely in the euro zone, Switzerland and Japan. All three offer much more attractive valuations than the US, which is by far the most expensive region in our model.

Prospects for the euro zone are supported by a positive reading on our leading indicators, while Switzerland offers positive corporate earnings dynamics and quality stocks at a more than reasonable price. Japan should benefit from corporate governance improvements, and from the combination of still-easy monetary policy and a weak yen.

We remain neutral on emerging market stocks, although the economic backdrop is brightening as monetary easing pays off and global trade picks up. A weaker dollar – if it materialises – could turn out to be the catalyst for an upgrade.

Fixed income and currencies: opportunities in US and the UK; JGBs oversold

US Treasuries continue to look attractive as the US economy is slowing more than others in the developed world. As inflation is proving sticky, we prefer to be overweight US inflation-protected bonds, which are more attractively priced. Linkers are a good store of value especially as we expect inflation to take a little longer to hit the Fed's 2 per cent target than either the market or the central bank itself believes.  

We upgrade our stance on Japanese government bonds (JGBs) to neutral from underweight. JGBs have come under pressure in recent months as expectations intensified for aggressive tightening from the Bank of Japan. But with the central bank now looking to take a more gradual approach, we expect JGB yields to retrace, particularly when the Japanese economy is flirting with recession.

What is more, the current JGB yield looks especially attractive for overseas investors in hedged terms. The 10-year JGB is yielding some 6.5 per cent hedged in the dollar, compared with 4.5 per cent in US Treasuries (see Fig. 4). 

We are also overweight UK gilts. UK economic growth remains weak, which should allow for a fall in inflation and interest rate cuts from the Bank of England. We expect cuts to total some 75 basis points by the year end, a more dovish scenario than the market currently prices in.

In credit, we remain overweight US investment grade bonds. Despite moderating growth, US companies are reporting strong earnings, margins are resilient and leverage is low - which will result in default rates remaining below historical averages. For income investors, high-quality US credit offers a more attractive yield than high dividend stocks.

In foreign exchange markets, we remain overweight the Japanese yen, which offers the most attractive valuation in our currency scorecard.

The yen is likely to benefit the most from a weakness in the dollar once the Fed begins cutting interest rates later in the year. The yen also offers a hedge in case the global economy takes an unexpectedly negative turn.

We are underweight the Swiss franc. Its long-term fundamentals may be attractive, but the Swiss National Bank’s dovish stance points to a further weakness in the currency.

We’re neutral on gold as its valuation remains stretched despite its attractive long-term potential as a diversifier and a safe-haven asset.

Global markets overview: powered by profit prospects

Equities powered higher in May, taking their cue from improving corporate earnings expectations (see Fig. 5) and an improving growth outlook.

Global stocks finished the month almost 4 per cent higher in local currency terms, taking their percentage gains for 2024 so far into double digits. The strong performance was accompanied by healthy investment inflows, with equity funds attracting some USD47 billion over the past four weeks.

Among sectors, energy stocks bucked the overall positive trend, as companies reported falling earnings and revenue. The sector finished the month slightly lower, also reflecting a retreat in oil prices.

In contrast, utilities were among best performing sectors, up almost 7 per cent. There were also continued gains from IT and communication services, which added around 8 per cent and 6 per cent, respectively. Investors welcomed stronger-than-expected results and upbeat forward guidance from chipmaker Nvidia.

Tech outperformance was also good news for US stock indices as IT and communication services together account for around 40 per cent of the S&P 500. The benchmark US index gained just under 5 per cent in May, posting its best monthly showing since February. With the first quarter earnings season almost over, 78 per cent of US companies have reported earnings above expectations, according to LSEG I/B/E/S data.

The upbeat earnings picture proved a boon for corporate bonds, with solid gains in US investment grade and high yield credit, European high yield and emerging market credit.

Performance in sovereign debt was more mixed.

Japanese governments bonds lost ground, reflecting expectations of faster interest rate hikes from the Bank of Japan as a positive output gap brings about moderate inflation.

The dollar finished the month a touch weaker, having lost ground versus most developed market currencies including the euro.