Barometer: Conditions favour Swiss and financial stocks

Asset allocation: caution following market whiplash

A whipsaw month in the global equity markets – down 9 per cent during the month at one point followed by a rebound that left stocks slightly higher than where they started – leaves us caught between caution and optimism. With little having changed fundamentally on the month, we stick to our neutral position on equities. 

Our caution reflects the market’s recent volatility and signs of economic slowdown – not to mention uncertainty about the coming US election and lagged effects of monetary tightening. On the other hand, the fact that gains are spreading across the market, the imminent start of a US rate cutting cycle and our expectation that the global economy will see a soft landing are all positive.  

At the same time, we remain neutral on bonds and cash. Bonds have rallied strongly over the summer in anticipation of significant central bank easing, and there doesn’t appear to be significant value in the asset class given where yields now are. 

Both monetary and fiscal policy developments are high on the agenda. Central banks are poised to ease significantly while the outcome of the finely poised US election will in part determine the outlook for the country’s massive deficit.

Our business cycle indicators reinforce our caution, with our forecast for global growth tweaked lower on a less positive outlook for China. This summer’s Chinese data have been disappointing, though the economy should continue to be supported by a recovery in consumption, particularly services. But the dire state of the country’s housing market continues to cast a cloud over the country's growth prospects.

In the US, the labour market is entering a less benign phase, with any further softness unlikely to be without costs to growth. We expect the US economy to grow below its potential over the next four quarters driven by a slowdown in consumption and continued weakness in residential investment. Even so,  while the odds of a recession are marginally higher, businesses and households aren't excessively indebted. This, and the benefits from future rate cuts, should keep the downturn shallow. 

At the same time, we expect inflation to return to the US Federal Reserve’s 2 per cent target by the end of next year, though this will be a bumpy ride. Both an expected pickup in private sector borrowing and underlying solidity of the economy suggest to us that market expectations for eight quarter point rate cuts between now and next summer are overly aggressive (see Fig. 2).

Elsewhere, the euro zone has recently been growing at near potential, though this is largely driven by net exports rather than any strength of domestic economies within the single currency region. Meanwhile, rising goods prices mean that inflation momentum is running at well above the European Central Bank’s target, though these should ease over the coming months.

Our liquidity indicators are marginally tilted towards looser monetary conditions globally. A net 33 per cent of major developed and emerging market central banks are easing policy compared to 26 per cent last month. 

Liquidity should be given a boost as central banks, not least the Fed, end their quantitative tightening programmes – a natural complement to rate cuts. With no major additional fiscal impulse on the cards, central banks will look to stimulate private credit growth to sustain economic expansions – and we expect credit creation to amplify the effects of policy easing.

Our valuation indicators show that equities remain very expensive, albeit marginally less so than a month ago thanks to a higher equity risk premium. We think that earnings expectations are too bullish – pricing in steady-as-she goes economic growth rather than the slowdown and faltering pricing power that we expect. Bonds look more expensive too after pricing in an aggressive series of official rate cuts. For instance, the yield on US 10-year Treasury bonds is now 30 basis points below our fair value estimate. Cash, by contrast, looks good value.

Our technical indicators show that sentiment towards US equities is at strong levels, with retail investors strongly bullish. Positioning on S&P 500 futures is off its peak levels but remains elevated. At the same time, speculators have increased their short positions on bond futures. After the spike in US equity market volatility earlier in the month, it fell back at its fastest pace ever, back to long-term trend. 

Equities regions and sectors: banking on financials

Equities have had a roller coaster summer thanks to wildly shifting views about the global economy and corporate earnings, as well as about the likely path of interest rates.

The next few months are also unlikely to be smooth sailing, not least because investors will have to contend with the beginning of a rate-cutting cycle from the Fed and the US election in November. Both have the capacity to cause a stark divergence in the performance of individual equity sectors.

Financial stocks are among the bright spots. Despite lower bond yields, the sector should benefit from a steeper yield curve – a dynamic which means net interest income for banks remains supported. Earnings should also pick up on the back of strong loan growth, as central banks ease policy against a benign macroeconomic backdrop. Then there is the potential for US elections to bring about deregulation of the banking sector. Fundamentals are also favourable, with valuations still cheap and earnings momentum very strong (see Fig. 3). Financials recorded the highest percentage increase in second quarter earnings among S&P 500 sectors, according to Lipper Alpha Insight.  Add in healthy dividends and share buybacks, and we believe the arguments stack up in favour of upgrading financials to overweight.

We also like communications services companies, which are supported by exposure to secular trends, such as advances in artificial intelligence. Indeed, one of the messages from the last earnings season has been that tech capital expenditure is holding up, with companies seeing under-investment as a greater risk than over-investment. Higher than average buybacks (at above 3 per cent net buyback yield for the sector versus the market at below 2 per cent)provide an additional tailwind for the sector.

Alongside that, though, we retain some defensive positions to protect against the possibility of continued market volatility, risks to economic growth and uncertainty over future US policy ahead of the elections.

For us, that includes an overweight in utilities – a sector which offers defensive characteristics and stable earnings at an attractive valuation. These qualities will come to fore in the event of a consumption-led slowdown in economic growth.

Among regions, our overweight in Switzerland – home to an unusually high number of quality companies with stable earnings – offers some additional protection against the possibility of weaker economic conditions. Swiss companies also trade at attractive valuations considering their superior profitability.

We also continue to see potential in Japanese stocks. The market displays the strongest earnings momentum of all the regions in our model, alongside being one of the few economies where we expect growth to pick up significantly in 2025.

The path may not be a smooth one: Japanese stocks have been particularly volatile in recent weeks -- including a one day 12 per cent drawdown followed by a complete recovery in the following two days. But, fundamentally, they remain supported by corporate governance reforms, with tangible steps being made toward increasing shareholder payouts.

We are neutral on US equities. On the positive side, any recent gains in S&P 500 Index have been increasingly broad-based rather than led by a handful of large cap stocks. However, the fundamentals are less supportive. We expect US economic growth to slow to 1.5 per cent in 2025 from 2.4 per cent this year, and also see scope for significant disappointment in earnings over the medium term. Our top-down model points to 2025 earnings growth of just 5.2 per cent in the world’s biggest equity market – a third of the pace currently expected by bottom-up analysts according to I/B/E/S. 

Fixed income and currencies: scaling back Treasuries,  sticking with gold

A recent run of weak US economic data has fanned expectations for a more aggressive monetary easing cycle from the Fed.

Bond markets show that investors are now betting on US interest rates falling by as much as 200 basis points by the middle of next year.

However, this scenario is at odds with our own view that the US economy will see a soft landing and that price pressures will remain elevated for some time before inflation eventually reaches the Fed’s 2 per cent target by end-2025.

We therefore see little reason for the Fed to cut rates by more than what it has already signalled. We continue to expect the central bank to start its easing cycle in September with a 25 basis point cut, for total of five cuts by June next year.

Against this backdrop, we downgrade US Treasuries to neutral. The benchmark 10-year yield is some 30 basis points below our year-end fair value estimate of 4 per cent. As Fig. 4 shows, bond yields, relative to nominal GDP growth, are no longer attractive having fallen again after hitting levels above zero for the first time in more than 10 years. 

That said, inflation-protected Treasury bonds (TIPS) remain a good store of value and their valuations appear more attractive, especially given lingering risks of inflation over the medium-term horizon.

We also stay neutral on credit. While yields are still attractive, we see limited scope for spread tightening given slowing economic momentum.

We retain an underweight position in Swiss government bonds, which remain one of the most expensive fixed income asset classes on our model and offer a low yield of just 0.5 per cent.

Our conviction for gold is unchanged. The precious metal may have hit a record high – yet we don’t think conditions will change in a way that takes the shine off the precious metal. 

An imminent start to an easing cycle by the Fed reduces the opportunity cost of holding a non-yielding asset like gold. We are already seeing early signs of a pick-up in demand from investors.

According to Bloomberg, gold holdings of exchange-traded funds have troughed at just above 80 million ounces after falling from the mid-2020 peak of above 110 million.

While our valuation analysis suggests gold is not cheap, demand has been strong from price-insensitive buyers, such as emerging market central banks, in recent years.

What is more, gold continues to be an effective hedge against heightened geopolitical concerns, uncertainty over the US presidential election and any renewed worries over US debt and fiscal deficit.

Gold represents a core investment in a diversified portfolio, rather than a tactical trade. While we are entering a seasonally weak patch, we prefer to use any weakness to add to our strategic allocation.

In currencies, we upgrade the Swiss franc to neutral. With the world’s major central banks starting to start easing monetary policy, reducing the gap between global and Swiss interest rates, the currency should begin to attract inflows from carry trades being unwound.

We remain neutral on the yen. While the Japanese currency is likely to benefit from gradual interest rate hikes by the Bank of Japan (BOJ) in the long term, positioning is getting stretched – global investors are long the currency for the first time since 2021.

What is more, in the near term, we think the BOJ will adopt a cautious stance following the recent volatility and yen strength, given that the dollar trading below mid-JPY140 would begin to hurt Japanese corporate profitability and increase imported inflation.

Global markets overview: stocks recover, gold shines

Global stocks outperformed bonds in August, ending the month up nearly 2 per cent after recovering from an aggressive panic sell-off earlier in the month.

Concerns about a possible US recession, coupled with an interest rate hike by the Bank of Japan, drove heavy selling of risky assets and the unwinding of short yen positions.

US stocks rose 2.4 per cent, lifted towards the end of the month by growing expectations that the Fed would soon start its easier monetary policy cycle.

The bullish mood was evident in the exchange-traded funds market, with ETFs tracking government debt, corporate credit and equities rising in tandem for four straight months. This is the longest stretch of coordinated inflows since at least 2007.

Japanese stocks were the worst performers with a loss of 2.7 per cent in local currency terms, having failed to find their footing after having suffered the sharpest single-day rout since the 1987 Black Monday crash.

Euro zone and UK stocks enjoyed moderate gains of around 1 per cent in local currency terms, also supported by expectations for easier monetary policy. In sectors, real estate, healthcare and consumer staples were biggest winners globally, each rising more than 4 per cent, while energy companies fell more than 1 per cent.

Gold ended the month up more than 3 per cent having hit an all-time high during the month (see Fig. 5). 

In the sovereign bond market, US Treasuries rose 1.4 per cent as Fed policymakers affirmed the need for interest rate cuts to avert a recession.

Japanese government bonds also saw strong inflows, ending the month up 1.5 per cent as the BOJ said it would not hike interest rates when markets are unstable. Emerging market local currency debt rallied as the dollar weakened. 

The prospect for the lower cost of borrowing and moderate economic growth boosted corporate credit, with investment grade bonds and high yield debt rising on both sides of the Atlantic.

In currencies, the dollar fell more than 2 per cent against major currencies, with losses particularly pronounced against the Australian dollar and the Swiss franc. The euro, yen and sterling rose around 2 per cent.