Barometer: US a bright spot as risks to rally multiply

Asset allocation: a note of caution

From the launch of cut-price new artificial intelligence technology to Donald Trump's trade tariffs on China, Canada and Mexico, it has been a turbulent start to the year for financial markets.

In stocks' favour, fundamentals remain broadly supportive: corporate earnings continue to surprise to the upside, liquidity conditions are positive and global economic growth remains steady.

Yet even bullish investors would concede that tariffs will eventually  take their toll on economic growth, that equity valuations are very stretched (see Fig. 2), and that the recent market turbulence is a timely reminder that market rallies don’t last for ever.

With all these factors in mind, we are taking some risk off the table by downgrading global equities to neutral and upgrading cash. 

We are also neutral bonds: although we expect nominal economic growth to slow worldwide, there isn't a clear valuation case for being overweight.

Our business activity indicators point to moderate growth for the global economy –  for now. If the tariffs unveiled by the US become permanent, they will materially change the macroeconomic landscape for this year. They will affect 44% of total US imports and will take the average tariff rate on US imports from 2% to 10%, on a par with trade barriers in place in 1948.

We estimate the announced tariffs will push up US inflation by approximately 1 percentage point, and reduce US GDP by around 0.8 percentage points, without factoring in any possible retalisation from US trading partners. This, in turn, will translate to an around 5% hit to US corproate earnings and a 10% reduction in price/earnings ratios relative to our baseline.

However, we think there is still a very good chance that Trump will back down on tariffs after scoring a political win, or that US courts will delay their implementation. That could leave room for a last leg of gains for US equities. We are comfortable remaining overweight US equities as the US economy is in a much stronger position to digest the growth-negative impact of tariffs. What is more, current corporate earnings dynamics are favourable while, broadly speaking, the US is a relatively defensive high profitability market.

Elswhere, even if tariffs pose a challenge to emerging markets, we believe that some large domestic-focused, defensive markets such as India and Indonesia could reverse recent underperformance.

Separately, our liquidity indicators remain supportive of riskier asset classes.

Of the 30 major central banks which we monitor, 21 (70%) are easing monetary policy, six (20%) are on hold, and only three (10%) are tightening. We see terminal rates of 4.25% in the US – implying one more cut from the US Federal Reserve – and 1.75% in the euro zone.

Valuation metrics show that global equities are extremely expensive (see Fig. 2), while bonds are close to fair value and cash is cheap.

More specifically, emerging Asian stocks look particularly attractive while the US is by far the most expensive equity market, with US stocks trading at a 12 month forward earnings multiple of 22 times (well above the long-term average of 16 or our current secular fair-value estimate of 19 times). However, our analysis suggests that the market could gain a further 15% before it screens as a bubble.

Technical indicators show renewed enthusiasm for US equities from retail investors, although this is counterbalanced by a more cautious stance from institutional ones . Bullish positions on S&P 500 futures remain relatively high, albeit the levels are below last year’s historic peaks – supporting the view that we are not yet in bubble territory. The technical signals for equities on a global level are less positive than a month ago, with the positive seasonality fading.

Equities regions and sectors: US and emerging markets to prove resilient

Global stocks have extended a year-end rally as resilient US economic growth, strong corporate earnings and expectations
for more business-friendly policies from the new US government have spurred investors to buy risky assets.

But cracks are beginning to appear.

Certain markets are proving vulnerable to protectionsit measures from the US. With valuations stretched, a growth and/or fiscal scare could trigger a correction. Then there's the possibility that Trump will be more aggressive and protectionist than initially anticipated - his initial move on tariffs has already destabilised global markets.

In aggregate, we expect equities’ price-earnings multiples to decline by 6 per cent by the year end and believe growth in corporate earnings will undershoot the consensus forecast by more than 4 percentage points (as Fig. 3 suggests). 

Some equity markets will, however, prove resilient.

Take US stocks, in which we remain overweight. It is true that US shares have reached historically unattractive valuations, with the market trading at 22 times earnings; they are also at their most expensive level relative to bonds since the dotcom bubble in 1999.

That said, companies in the world’s biggest economy enjoy strong earnings dynamics and capital flows at a time when economic
growth is running above potential. 

Moreover, the US economy is growing much faster than that of any other major developed country. This, in turn, supports the earnings of its companies, which are likely to outpace those in other developed economies. Greater adoption of AI technologies also is positive for US companies, which are the global leaders in the field.

Then there is the possibility of tax cuts and deregulation measures from the Trump administration, which should boost corporate bottom lines, even though some may be offset by the negative impact of increased trade tariffs and tighter immigration rules.

We also remain overweight emerging market stocks outside China. While the effects of looming US import tariffs are concerning,
emerging economies remain resilient. Further interest rate cuts by the Fed and easier monetary policy across the emerging world are likely to support developing economies’ already healthy fundamentals. Attractive valuations – especially for stocks in Latin America, the cheapest region on our scorecard -- and a likely recovery in commodity prices from improving manufacturing activity should also support emerging market equities.

Because we expect better performance from defensive companies with high quality recurring revenues, we are drawn to Swiss equities, in which we remain overweight. Moreover, we expect pharmaceutical and consumer staples companies to turn the corner, with both sectors well represented in the Swiss market.

Elsewhere, we are neutral in the euro zone and UK; both economies are likely to grow below potential this year. We have the same stance on equity markets in China, where growth is improving but still vulnerable to a number of risks, including lacklustre demand in real estate and construction as well as US-China trade frictions.

When it comes to sectors, we continue to like communication services stocks which have been resilient in the face of a sell-off triggered by the advances made by AI start-up DeepSeek.

The Chinese lab released its latest large language AI model, which offers a comparable performance to western counterparts like ChatGPT at a fraction of costs. While DeepSeek raised some concerns about the sustainability of AI spending, the development is a testament to a continuous decline in the unit economics of AI, where inference costs are already decreasing by more than 10 times a year since 2022. What is more, DeepSeek’s breakthrough is likely to reinforce the long-term trend towards cheaper, smaller but more capable AI models, which should drive up overall demand. The communication services sector offers exposure to the AI theme at reasonable valuations. Also, earnings estimates remain some of the strongest among equity sectors.

We also like financials, which we expect to benefit from a steeper yield curve and possible banking sector deregulation from the Trump administration. The sector enjoys healthy earnings dynamics while its valuations are fair, making it not just a Trump trade but a relatively cheap play on the global economy’s resilience.

We also like utilities, which offer defensive characteristics and stable earnings at an attractive valuation.

Fixed income and currencies: a finely balanced dollar

Although we have a neutral stance on fixed income overall we continue to be positive on corners of the credit market.

Bond investors are watching closely for the impact of early executive orders launched at the start of Donald Trump’s second presidency as well as other promised, but not yet delivered, measures. One problem is while Trump’s aim to deregulate the economy is potentially disinflationary, other measures like tariffs, anti-immigration policies and anticipated tax cuts are likely to push up prices. The fiscal dimension is also complicated by policies to cut spending on both government programmes and the federal bureaucracy.

Meanwhile, the US economy’s robust health – it continues to grow above trend – is likely to tie the Fed’s hands when it comes to lowering rates. As a result, the Treasury yield curve is upward sloping, which is unusual given how relatively high yields are now. This implies that the market expects nominal GDP growth to remain high for a long time. If that’s not the case, longer-dated Treasury bonds could be expected to rally. But with the situation finely balanced, we remain neutral on US Treasuries.

Elsewhere, with spreads on investment grade bonds having fallen to historically low levels (especially US investment grade spreads close to a record low at 80 basis points), there seems to be limited upside here. However, there’s more room for gains in European high yield corporate bonds. With official euro zone interest rates expected to fall more than in the US, credit yields should follow suit. 

In the currency markets, we remain neutral on the dollar. It’s no longer quite as expensive as it was, though there is some upward pressure as a result of Trump’s tariff announcements. More generally, however, economic fundamentals affecting the currency are evenly balanced . We have the same stance on the Japanese yen. Investors continue to expect the Bank of Japan (BoJ) to tighten policy, but it’s not clear how much of Japan’s inflation is being generated by domestic price pressures – service price inflation is still well below the BoJ’s target. Instead, Japanese inflation seems to be a by-product of yen weakness. As long as the yen doesn’t plummet, it could be that the BoJ holds off raising rates further, which lowers the likelihood of a sharp yen rally; as a result we remain neutral on the currency.

Finally, we maintain our overweight position in gold. Although the precious metal performed very strongly last year and started to look overbought, it remains a good hedge against unpredictability, not least US policy driven market volatility.

Global markets review

Global equities finished January with respectable gains, up some 3.3% in local currency terms. But the headline number masks a sharp rotation between sectors and regions.

After gaining some 32% in 2024, the IT sector plunged into the red in the first month of the new year as investors were unsettled by the launch of DeepSeek in China – a low cost AI model that investors fretted could question the advantage that current US tech leaders held. Shares in chipmaker Nvidia dropped as much as 17%, wiping off some USD600 million of market value in the biggest one-day loss in the history of the US stock market (see Fig. 5). The IT sector as a whole finished January down 1.1% as the DeepSeek news shone the spotlight on stretched valuations and sparked a wave of profit taking.

This weighed on US markets, where tech stocks have particularly heavy weightings. Instead, investors turned to Europe, where the indices are more balanced.

IT represents just 8% of Stoxx Europe 600 index, compared to 30% of the US S&P 500. The European benchmark finished January with a record closing high, posting its best monthly performance in over a year. Britain’s FTSE 100 also notched up a record high.

Performance in developed market government bonds was more even. US Treasuries gained 0.6%, digesting the implications of some of Donald Trump presidency's early pronouncements for economic growth and inflation. The Fed held interest rates steady, as expected, but investors noted a hawkish shift in its language which might reduce the likelihood and scale of future cuts.

Emerging market assets held up well across equities, government debt and credit. However, there was some volatility as investors braced for the possibility of tariffs from Trump (which have since been announced).

Market volatility proved a boon for gold, which added 7%. The dollar, meanwhile, finished January broadly flat.