Barometer: Scaling back IT but still positive on stocks

Asset allocation: Conditions still favourable for stocks

How high can the market go? With global equities having rallied some 26 per cent over the past eight months, that is the question investors are grappling with. 

Supporting stocks, the economic outlook remains solid as fears of sticky inflation appear to have faded.

However, this positive fundamental backdrop has to be set against two potentially negative developments. First, there’s a fraught political backdrop in Europe. Snap parliamentary elections in France appear likely to leave the country in uncharted waters, with the hard right having decisively won the first round of the two-round ballot. A second countervailing force is investor positioning in stocks, which our indicators show is extremely bullish.

For all this, we still believe the balance of risks remains in favour of remaining overweight stocks, neutral bonds and underweight in cash.

Our business cycle indicators are in positive territory. The economic outlook is brightest for emerging markets, which are benefitting from higher commodity prices and improved global trade.

Things look more mixed for Europe, not least due to France’s parliamentary elections.  The vagaries of the country's two-round voting system mean the outcome is difficult to call, raising questions over the outlook for economic growth and fiscal spending.

Politics aside, our leading indicator for the region continues to improve, as does the inflation picture. We expect these trends to continue as the European Central Bank proceeds with gradual rate cuts.

In the US, meanwhile, recent data has been softer. We expect growth in the world’s largest economy to decelerate to around 1 per cent annualised by year end – around half its potential – thanks to weaker consumption and residential investment. 

Our global liquidity scores are neutral for riskier asset classes. Half of the central banks we monitor are on hold, 37 per cent are in easing mode and 13 per cent are tightening (most notably Japan). Should the proportion of central banks easing monetary policy continue to rise, this could translate into an improvement in economic conditions. Our analysis shows a fall in central bank interest rates tends to be followed by a rise in leading indicators with a lag of nine months. 

The liquidity backdrop thus supports our broadly positive stance on global equities.

Within equities, our valuation models support our preference for European stocks over US ones. While Europe is the second cheapest region in our model, the US is by far the most expensive one. 

Overall, some 80 per cent of the asset classes in our valuation model are trading above trend – something that has only happened three other times in the last decade.¹ This potentially suggests a high level of market complacency, supporting the case for holding safe havens as the Swiss franc, gold and US Treasuries. 

Technical indicators suggest that momentum remains positive for stocks and the market is not yet overbought. Equity inflows continue to be strong, (at some US44 billion over the last four weeks, see Fig. 2), defying weak seasonality.  

Equities regions and sectors: trimming IT

Since the start of the year, the S&P 500’s market capitalisation has increased USD5.8 trillion. Of that, USD 1.8 trillion, 31 per cent, has been down to semiconductor giant Nvidia alone. Nvidia itself is up 150 per cent over that time. All of which is beginning to make us uncomfortable, particularly about the IT sector’s vulnerabilities.

So while corporate earnings remain healthy overall, and we remain overweight equities as an asset class, we are cautious about how concentrated the market’s gains have been (see Fig. 3). We trim our position in IT, following a further 9.5 per cent gain for the sector on the month, which adds up to a 26 per cent rally for the year to date. Indeed, tech stocks appear overbought on our framework. But there are also reasons not to be underweight the sector – corporate earnings momentum remain strong, albeit largely driven by semiconductors, and there are risks that there could be a significant melt-up in these stocks, particularly if the US Federal Reserves sees fit to embrace interest rate cuts sooner than the market expects. 

We remain overweight utilities, which offer defensive characteristics and stable earnings at an attractive valuation, which can be beneficial as we get initial indications of a consumption-led slowdown. We are overweight communication services – earnings remain strong and it is one of the only sectors where buybacks are running at a higher rate than average. We remain underweight real estate – persistently high rates are putting pressure on the sector and analysts continue to downgrade its earnings.  

We leave our regional equities allocation unchanged. We remain overweight euro zone, Swiss and Japanese equities. Europe lagged other markets on news of a snap French election, as investors digested possibilities of unfriendly fiscal developments and potential challenges to European unity by France’s increasingly powerful far right. Nevertheless we remain overweight - the region offers access to a sustained cyclical recovery at an attractive valuation.

Swiss stocks in particular enjoy the support of positive corporate earnings dynamics, an attractive valuation, and exposure to an unusually high number of quality companies – those with solid earnings and prospects and low risk of default. Elsewhere, there are strong structural arguments in favour of Japanese stocks: we think Japanese equities will still benefit from corporate governance improvements, and from the combination of  still-easy monetary policy and a weaker yen. Earnings revisions are still healthy, albeit losing steam. As a consequence we remain overweight Japanese equities. 

Fixed income and currencies: gold not gilts

Political risk threatens to undermine some of the good inflationary news that’s been coming through. That’s most immediate in the UK and France, where general elections look to bring in this month new administrations inclined to expand government spending. At the same time, the upcoming US election is throwing up the prospect of a new Donald Trump administration.

With a Labour government likely to take over in the UK and the far right making electoral strides in France, the state of public finances are becoming a concern for investors. We downgrade UK bonds (gilts) to neutral from overweight, trimming risk ahead of the upcoming general election. True, valuation remains attractive – albeit less than last year – and market expectations are growing for the Bank of England to turn dovish after some benign inflation data. But no one is likely to soon forget the extremes of market volatility ignited by Liz Truss’ radical fiscal programme at the start of her short-lived tenure as prime minister.

Similarly, we remain neutral on euro zone bonds, though the prospect of a hung parliament in France could well mean that the ECB’s path towards easing policy isn’t derailed.

We see value in the US Treasury market particularly for inflation-linked bonds. The latest US inflation data suggests disinflation is largely on track, while long term inflation expectations remain well anchored. We are underweight Swiss bonds given their expensive valuations.

Separately, we remain overweight US investment grade credit. This corner of the market offers good value, not least because of robust corporate earnings and the possibility of the Fed easing policy sooner rather than later. Like US equities, US investment grade credit is supported by a healthy economy, but with the advantage of unusually high yields.

In currencies, we downgrade the Japanese yen to neutral from overweight. The cost of hedging yen positions is increasingly expensive, especially in light of the interest rate differential between Japan and other developed economies. The Bank of Japan is dragging its feet on tightening policy, wanting to ensure the economy doesn’t somehow slip back into deflation. The most likely catalyst for renewed yen strength is likely to be a marked deceleration of US growth or another global financial shock – circumstances under which money tends to flee to creditor countries like Japan and Switzerland.

We upgrade gold to overweight from neutral. The precious metal no longer looks overbought on our technical framework and is likely to perform well if new and fiscally profligate populist governments take power on both sides of the Atlantic.

Global markets overview: Political uncertainty rattles European markets

Equities outperformed bonds in June as a soft landing for the US economy was seen as the most likely outcome following the release of benign inflation figures that kept alive the prospect of US interest rate cuts this year.

US equities were among the outperformers in the developed market in a rally led by big tech.  Tech stocks rose more than 9 per cent on the month, bringing this year’s gains to over 26 per cent. Five big tech companies - Nvidia, Alphabet, Microsoft, Meta and Amazon – have alone been responsible for more than half of the S&P 500’s 15-percent return this year.

Elsewhere, Japanese stocks gained more than 1 per cent as a combination of corporate governance improvements, accommodative monetary policy and a weak yen attracted capital inflows.

In contrast, euro zone, UK and Swiss stocks lost ground as concerns about weak growth and political uncertainty weighed on investor sentiment.

Political developments were particularly influential in bond markets. French President Emmanuel Macron’s decision to call a snap election rattled markets. The growing possibility of a victory for the country's hard right sent French government bond yields higher as investors grew concerned at the prospect of a deterioration in the country's fiscal position. The sell-off pushed French government bonds' yield spread over their German counterparts bonds to the widest since since 2017. 

Nevertheless, government bonds ended the month slightly higher. Swiss bonds rose more than 2 per cent after the Swiss National Bank cut interest rates for the second time and signalled further easing. US Treasuries rose just over 1 per cent as cooling inflation raised expectations for a 25-basis point rate cut in September.

Emerging local currency sovereign debt ended the month with a loss of over 1 per cent, weighed by a stronger dollar. Corporate bonds were moderately higher across both sides of the Atlantic with investors preferring riskier parts of the market -- emerging corporate debt and US high yield bonds ended the month up nearly 1 per cent.