Barometer: summer slowdown

Asset allocation: paring back equities

Slowing economic growth, less supportive earnings dynamics and uncertainty about how the looming US presidential election will pan out prompted us to reduce equities to neutral from overweight. The fact that the US stock market, which dominates global indices, is uncomfortably expensive also figured in our thinking.

At the same time, we have upgraded our cash position to neutral from underweight; our view that the global economy is heading towards a soft landing – largely avoiding recession – is also consistent with remaining neutral on bonds.

Our downgrade of equities takes our portfolio further in the direction of reducing risk which we began last month by cutting our position on tech, the sector which we thought was most vulnerable to a correction. This further move is motivated by the desire to take some profits on an asset class which has continued to defy some economic warning signs, particularly in the US. 

In our view, a downturn in the economic surprise index – which indicates the extent to which economic data undershoots or surpasses consensus forecasts – has left equities vulnerable to correction (see Fig. 2).

Stocks had a storming 2023 and are up 13 per cent year-to-date, with many of those gains built on extremely narrow leadership – mostly the so-called Magnificent Seven tech stocks. More recently, however, concerns over the impact of tariffs, uncertainty over earnings and a pullback from momentum-driven trades have triggered losses in this very expensive sector, with investors rotating back into cheaper stocks like small caps. Smaller companies were particularly hard hit by the rate tightening cycle, which suggests they have the most to gain from monetary easing when the US Federal Reserve starts trimming the funds rate in the coming months.

The outlook for markets will be clouded during much of the rest of the year by political developments in the US. Vice President Kamala Harris, who has replaced President Joe Biden on the Democrat ticket is, by our reckoning, a continuity candidate. Her policies are unlikely to differ much from Biden’s, given that she’s second in command in the current administration. But she also lags Donald Trump in the polls, whose political manifesto suggests major changes, some very good for equities (corporate tax cuts), others not so much (trade wars, mass deportations of illegal workers).

Our cautious read of US market dynamics finds an echo in our business cycle readings for the US economy. We expect its growth to be below potential over the next four to five quarters. That will come courtesy of a levelling off in consumption as increases in real disposable incomes slow. Residential investment is also likely to ease back from a very high annualised growth rate of 13 per cent. That should put further downward pressure on inflation, opening the door for Fed rate cuts.

Euro zone manufacturing continues to struggle amid companies’ reluctance to invest. Instead, private consumption is the main engine of growth. The UK, by contrast, is showing strength that’s likely to be reinforced by the new Labour government. Japan is the only major developed economy likely to grow above trend in 2025, with consumption also leading the way. Meanwhile, we see the Chinese economy picking up, notwithstanding continued weakness in the property sector. The main driver there will also be consumption, though investment into the manufacturing sector will also support growth. The People’s Bank of China caught markets by surprise by cutting its medium-term lending facility at the end of July, in the same week when it reduced its loan prime rate to support growth. 

Our liquidity indicators show that central banks have moved to charting their own policy paths, subject to local conditions, rather than following a global trend, with 14 on hold, 12 easing policy and four tightening. The big question is how far any easing can go before reigniting inflation. Policy divergence could lead to the dispersion in market performance, lifting some local markets against a muted global backdrop.

Our asset valuation metrics are broadly unchanged on the month, with equities still looking very expensive, bonds as moderately expensive and cash as cheap. Some 90 per cent of asset classes we analyse are trading above trend, something that’s only happened three previous times during the past decade, suggesting a high degree of market complacency. 

Modest easing by the Fed is likely to flow relatively quickly into credit growth as banks show willingness to lend and borrowers are in a strong position to take on debt given robust private sector balance sheets. The picture is more confused in Europe, where the European Central Bank’s push to ease rates is blunted by its other policy of quantitative tightening. The Bank of Japan is likely to start its own quantitative tightening along with two rate hikes of 10 basis points each, hence normalising policy encouraged by labour market tightness and rising wages. 

Finally, our technical indicators show strong momentum in Japanese and emerging market ex-China equities, pointing to further gains and offsetting weakness in euro zone and UK markets. Our indicators also show strong seasonal support for bonds. Sentiment indicators for US equities show investor enthusiasm is high but not yet at the extreme levels that would point to a sharp correction. 

Equities regions and sectors: downgrading euro zone

Weaker corporate earnings, a slowing economy and heightened policy and political uncertainty explain why we cut our exposure to global equities; the same factors also inform our region and sector allocations.

The euro zone, for example, is now looking less than stellar on all counts. Economic performance is tepid, with the anticipated recovery underwhelming expectations as demonstrated by weaker-than-forecast June PMI readings. Corporate earnings prospects are similarly uninspiring. Our forecast, based on our macroeconomic projections, suggests profit growth of just 4.7 per cent this year – half the pace of the US. Then there is the heightened political uncertainty in the shape of a hung parliament in France.

Admittedly, valuations for euro zone stocks are attractive – it is the cheapest region relative to its 20-year history according to our model. But we think this fairly reflects the risks. We therefore downgrade European equities to neutral from overweight.

Our preferred equity markets are Switzerland and Japan.

Swiss stocks benefit from strong earnings dynamics and attractive valuations, as well as offering access to an unusually high number of quality companies – firms with stable revenue and profit growth. Japanese stock markets, meanwhile, are supported by strong secular trends, including improving corporate governance, an economy emerging out of a deflationary spiral, still accommodative monetary policy and a weak yen.

Among sectors, we remain overweight utility stocks, whose defensive characteristics, stable earnings prospects and cheap valuations are particularly attractive now that economic growth is slowing.

We are also overweight the communication services sector. Earnings prospects among such companies are relatively bright, and it is one of the few industries where share buybacks continue apace. Valuations have improved compared with other sectors, with communications services now scoring neutral on our model rather than expensive.

In contrast, we are cautious on the real estate sector, where earnings dynamics are poor and valuations are not as attractive as they were earlier in the year. Although interest rates are falling, the pace of cuts is likely to be modest, to the potential detriment of property markets.

Fixed income and currencies: banking on Treasuries

Bond investors have been on tenterhooks in recent weeks, and for once the culprit was not central bank policy but US politics – specifically growing expectations of a Donald Trump victory in the upcoming presidential election. Markets expect that a Trump presidency will mean tax cuts funded by more fiscal borrowing, leading to higher inflation.

However with recent benign inflation prints and central banks showing more willingness to ease, it is at the short-end that yields have been pushed down, leading to a steepening of the curve. We believe US Treasuries today are largely in line with our fair value estimates but nevertheless more attractive than other developed economy government bonds.

For those concerned about inflation, US inflation-linked bonds look particularly attractively valued. The 10 year TIPS yield at 1.95 percent is close to what we estimate as trend real GDP growth for the US; the fact that the gap between the two is the smallest since 2010 is indicative of good value. 

Moreover, US Treasury data indicates that demand for Treasuries among foreign private investors remains strong, which should support the market.

In contrast we are underweight Swiss government bonds, which are one of the most expensive fixed income asset classes on our model. At 0.5 per cent, 10 year Swiss government bond yields are 3.5 percentage points below those of Treasuries, compared to a long-term average gap of 2 percentage points.

Separately, having become less optimistic on corporate earnings prospects, we shift our stance on US investment grade bonds to neutral from overweight. From now on, companies will struggle to beat earnings forecasts to the same extent as the last few quarters. This is particularly true for the US due to slower economic growth, a stronger dollar and faltering pricing power.

Against this backdrop, we believe the yield pick-up currently offered by corporate bonds is too low. US investment grade credit now yields just 93 basis points more than US Treasuries, on an option-adjusted basis, compared with a 20-year average of 155 basis points (see Fig. 4).

In currency markets, we remain underweight the Swiss franc. It offers very low carry, and the Swiss National Bank (SNB) has recently voiced concern over strength of the currency. We expect the SNB to keep a dovish bias in order to offset flows from investors seeking refuge from the currency volatility triggered by political upheaval in France.

We also remain long gold. Valuations are stretched, but momentum is strong and gold’s safehaven status should come into its own in case of any further jitters in France or the US.

Global markets overview: equities' modest gain reflects overstretched positions

Both equities and bonds ended the month higher, with bonds slightly outperforming stocks as concerns about slowing economic growth and prospects for weaker corporate earnings prompted investors to pare back risks from their portfolios.

US stocks rose just over a modest 1 per cent as investors took profits on big technology names ahead of their quarterly earnings after their breakneck rally earlier in the year sent valuation to overstretched levels.

Jitters ahead of the US presidential election and rising US-China trade tensions also encouraged investors to lighten their positions.

Japanese stocks were the biggest underperformer as the Tokyo benchmark ended the month down 1 per cent. The market saw heavy foreign outflows in the week to July 26 as a stronger yen and a sell-off in global technology stocks prompted overseas investors to take profits. Foreign investors sold Japanese shares worth more than USD10 billion on a net basis in the week, the largest in 10 months.

Emerging European and Pacific Asian stocks rose more than 3 per cent.

IT and communication services lost the most among sectors after both groups recorded double-digit gains since January. Real estate, utilities and financials gained between 5-6 per cent, helped by prospects for lower interest rates.

Fixed income markets saw healthy gains across the board, with US Treasuries rising nearly 3 per cent as the Fed appeared to be near the end of a two-year battle against inflation, hinting at a September interest rate cut.

UK gilts rose 2 per cent in July as investors braced for an imminent interest rate cut from the Bank of England (which duly materialised in early August). The country’s consumer price inflation has eased to the BoE’s 2 per cent target after hitting a 41-year high above 11 per cent in October 2022.

Euro zone government bonds also rose around 2 per cent as investors expected the European Central Bank to reduce the cost of borrowing in September, building on its first rate cut in June.

In credit, US corporate bonds rose more than 2 per cent in both investment grade and high yield segments. The asset class has been supported by near historic low leverage and abundant cash on balance sheets.

In foreign exchange markets, the Japanese yen rose more than 7 per cent as confirmation of opposite interest rate trajectories for Japan and the US following the latest policy meetings put a sudden end to crowded short yen positions and prompted investors to buy back the yen en masse. With European currencies all rising against the dollar, the US currency lost 1.7 per cent on the month. This in turn supported gold, which rose more than 4 per cent.

Oil prices slid over 6 per cent as concerns intensified about weakening oil demand from China, the world’s largest crude importer, at a time when oil producers were likely to increase supplies.