Barometer: Emerging markets' turn to shine

Asset allocation: US easing boosts appeal of riskier assets

The US Federal Reserve cut interest rates by a larger-than-expected 50 basis points in September in a move that leaves us even more convinced that the US economy can avoid a recession and enjoy a soft landing.

As a result, we increase our exposure to riskier asset classes, upgrading equities to overweight and doing the same with emerging market stocks and debt. Emerging market assets are particularly attractive as the region stands to benefit the most from US monetary policy easing and a pick up in global trade.

We reduce cash to underweight.

Our stance in developed market bonds remains neutral, however. In many cases, government bond yields are too low, with returns likely to disappoint investors unless we see a recession – a scenario we think is unlikely. As Fig.2 shows, the bond market is discounting a far more dovish interest rate trajectory in 2025 than the Fed's own dot-plot.

Our business cycle analysis points to some deceleration in global economic activity.

The US economy is beginning to show signs of a slowdown after a period of exceptional resilience where it recorded above-potential growth in seven out of the last eight quarters.

In the coming months, consumption – which represents well over half of US GDP – should ease, especially in services, which will lead to a broader slowdown.

Conditions in the labour market – now the Fed’s main focus – are consistent with a GDP growth rate of some 2 per cent annualised, which is around the long-term potential. 

We see the European economy weakening further. Falling energy prices have failed to encourage more investment. Net exports – so far an engine of growth – are now at risk as China struggles to recover. We are more positive on the UK, which is benefiting from a strong services and industrial sector. The Bank of England is expected to cut interest rates twice this year, which should brighten economic prospects further. 

Japan is the only major developed economy that we expect to grow above trend in 2025 thanks to consumption. This will allow the Bank of Japan to continue to normalise its monetary policy.

In the emerging world, China’s growth remains anaemic with third-quarter GDP seen at 0.4 per cent on an annualised basis, in stark contrast to the 4-5 per cent clip seen in the first two quarters of this year. The People’s Bank of China’s latest, bigger-than-expected easing package should improve sentiment more effectively if it is accompanied by equally muscular fiscal measures.

However, economic activity in the rest of emerging markets is encouraging. Developing countries should capitalise on a recovery in global trade as the region is twice as sensitive to a pick up in world trade growth than developed economies.

Our liquidity indicators support being overweight equity. With central banks in countries accounting for more than two thirds of world GDP now cutting interest rates, monetary conditions are loosening in a way that should underpin riskier asset classes. 

We expect the Fed to reduce interest rates five more times – a considerable easing but fewer cuts than the market is currently pricing in. We expect the European Central Bank to catch up with  its counterparts and cut interest rates at every meeting to reach a terminal rate of 2 per cent.

Our valuation models show bonds are becoming very expensive. The likelihood of a soft landing for the US economy make the pace of easing currently priced by the market too aggressive. Equities remain expensive, but their valuations are not in bubble territory.

Our technical indicator shows equities are likely to be supported into end-2024 thanks to seasonality, the tendency for stocks  to perform well in the final few months of the year.

Momentum is also positive, with the US attracting the bulk of equity portfolio inflows. Japanese equities also saw good inflows but primarily from domestic investors as foreigners cut their holdings.

In fixed income, emerging hard currency bonds started to attract flows as the Fed cut interest rates.

Equities regions and sectors: emerging attractions

The US Fed’s meaty rate cut heralds a new period of easier money, promising to revitalise emerging markets in particular. As a result we upgrade emerging market equities, excluding China, to overweight from neutral.

Emerging market equities are very cheap while a number of markets showing healthy earnings dynamics. Overall, emerging economies are  growing faster than the developed world, inflation dynamics are supportive and the US easing in a non-recessionary environment – enough in our view to offset concerns over US election risks (see Fig. 3). Our metrics show that earnings momentum is strongest for emerging markets and Japan – based on changes to 12-month forward earnings per share forecasts and market breadth. 

Notwithstanding Beijing’s latest efforts to lift the country out of its economic malaise with a number of fiscal and monetary measures, we prefer the rest of emerging markets to China. For one thing, China’s problems run deep and need structural change rather than the sort of short-term fixes being offered.  While domestic equities have reacted strongly to these measures, the sustainability of the rally depends on the implementation and follow-through from the authorities. Furthermore, going into the home stretch of the US election cycle we avoid adding exposure to assets most directly impacted by increased tariffs and trade uncertainty.

In developed markets,  remain overweight Japanese stocks. Japanese corporate earnings are showing better momentum than elsewhere and the market remains attractively valued. Overall, the market  offers a structurally sound investment case as the economy emerges from deflation and amid governance changes that should encourage further efforts to improve shareholder value. Any further yen appreciation is likely to be moderate, which should limit currency risks both for firms and investors. Next year, the Japanese economy is expected to grow some 1.4 per cent, double its potential.  

We maintain exposure to Swiss stocks - the market is rich wtih companies trading at very attractive valuation and offering stable earnings; we also like exposure to the market’s defensive qualities as a hedge against our central scenario of a soft-landing.

Separately, we downgrade communication services to neutral from overweight. The sector has outperformed the rest of the market by 23 percentage points, year to date, powered by US tech firms. But the  rally now risks running out of steam.  Corporate earnings are no longer a clear tailwind, valuations are  neutral at best, and technicals have turned negative. We remain overweight financials, which we expect to benefit from a steeper yield curve as the Fed cuts rates further, and hopes of  deregulation. Bank earnings are also strong. We remain overweight utilities, which we value for their defensive characteristics, stable earnings and attractive valuations. We remain underweight real estate - although the sector should eventually benefit from lower interest rates, it remains expensive and demand for office buildings has yet to rebound.

Fixed income and currencies: upgrading emerging market debt

With US rate cuts now a reality, the fixed income landscape is shifting. We expect emerging market bonds to be a key beneficiary of the Fed's shift in policy. 

The higher yields on offer in the developing world will become ever more attractive. Indeed, we have already seen a resumption of flows into the asset class in recent weeks, following the Fed’s first rate cut. What is more, US rate cuts will allow emerging markets to ease their own monetary policies, further boosting economies where inflation has been slowing and financial stability isn't a major worry. 

The conditons look particularly favourable for emerging market local currency bonds, which we upgrade to overweight in the expectation that emerigng market currencies will gain against the dollar.

Dollar-denominated emerging market corporate bonds should also do well. Our economists have a positive view on emerging economies, and expect to see business activity boosted by a recovery in global trade. Any rises in commodity prices could prove an additional boon. We therefore upgrade emerging corproate bonds to overweight. 

In developed markets, we are underweight Swiss bonds, which we believe look rich (on our valuation measures they have been this expensive relative to other government bonds only 30 per cent of the time). Even if the Swiss National Bank responds to slowing economic momentum by cutting interest rates, the central bank's capacity to ease monetary policy is limited given how low rates already are. 

We remain neutral on US Treasuries, which look fairly valued relative to their 20-year history. Foreign investor demand for US government bonds remains strong, but we would like to see more clarity on the likely outcome of the US election before deciding whether to change our stance. That said, we still see some value in inflation-linked Treasuries, or TIPS. These could offer useful protection if US inflation proves stickier than expected over the medium term (particularly in the face of rate cuts).

At first glance, developed market corporate bonds look an attractive asset class at a time when economic growth is modest an inflation is falling. But on closer inspection, valuations look fair to expensive – we see limited scope for bond yields to fall further and spreads remain very tight by historical standards. (US investment grade spreads are at 92 basis points versus their 10 year average of 130, for example.) Our positioning across developed market credit is therefore neutral, both in investment grade and high yield.

In the currency markets, we are neutral on the dollar versus almost all major developed market currencies as a closely-fought US election clouds the near-term outlook for the greenback.

One exception is the euro, which we downgrade to underweight in the face of a marked slowdown in the currency bloc’s economic momentum (next year, we now expect growth of just 1.3 per cent, down from 1.5 per cent a month ago). The ECB has remained hawkish even as it has cut interest rates. But we believe the central bank will soon turn dovish as inflation continues to ease resulting in further rate cuts that could place downward pressure on the euro.

We retain our overweight in gold, which continues to set new record highs despite increasingly stretched valuations and positioning (with net longs now at their highest since 2017). Rate cuts from the Fed – as well as the ECB and the Bank of England – reduce the opportunity cost of holding a non-yielding asset like gold, serving as a catalyst for a pickup in financial demand through ETF flows. While gold appears tactically overbought, we'd use any pullback to add to our strategic allocation.

Global markets overview: stimulating stocks

Chinese stocks rocketed higher in the last days of the month as investors responded to Beijing’s decision to jump-start the moribund economy with widespread monetary and fiscal stimulus. Emerging market Asia stocks gained a further 7 per cent on the month in local currency terms – with much of that coming from an 8.5 per cent single day gain by China’s CSI 300 blue chip index – for a 22.7 per cent rise on the year so far, which even outpaces the US market.

The Chinese authorities’ efforts came in the wake of the Fed’s 50 basis point cut in its funds rate, the starting gun for what is expected to be a steady process of monetary easing. US equities – and to a degree, global equities generally – took encouragement from the fact that notwithstanding the size of the cut, the economy looks destined for a soft landing at worst. US stocks gained 2.2 per cent on the month – up 21.7 per cent year to date and a series of fresh record highs (see Fig. 5) – and global equities 2.0 per cent.

Within sectors, consumer discretionary stocks gained 7 per cent on the month, boosted by a more benign outlook for the global economy. Energy stocks, on the other hand, slumped 3.5 per cent as oil prices continued to fall, in part on strong inventories data – oil is down more than 7 per cent on the year so far.

The monetary measures on both sides of the Pacific were good news for bonds as well. Global bonds were up some 1 per cent on the month, with emerging market local bonds doing particularly well, gaining more than 3 per cent, while emerging markets hard currency bonds are now up by just above 8.5 per cent on the year. Corporate debt rose across the board, emerging and developed, high yield and investment grade, gaining between 1 and 1.7 per cent on the month.

Currencies picked up ground against the dollar, which lost almost 1 per cent on the month, with non-oil commodity currencies like the Brazilian real and Australian dollar doing particularly well. Gold prices picked up another 5 per cent to register a 27.5 per cent gain on the year so far.