Barometer: Sticking with stocks

Asset allocation: resisting the urge to take profits

With stock markets having enjoyed a banner year, it is only natural for investors that have profited from the rally to think seriously about locking in their gains. They should resist that temptation, for now. True, there is a strong argument for reducing exposure to equities – while fixating on the business-friendly policies that US president-elect Donald Trump has pledged to deliver, markets have failed to give due consideration to the measures that might make corporations wince. Valuations – which are high by historical standards by most yardsticks – also suggest there is limited scope for further gains.

But the case for lightening up on equities is less convincing when economic and credit conditions are taken into account: in surveying the investment landscape through this lens, we’re convinced stocks can continue their positive run over the near term. So while we will be keeping an eye on the many risks that might unsettle stock markets in the first few months of 2025, we remain overweight equities, neutral bonds and underweight cash.

Our business cycle readings suggest economic conditions will remain buoyant enough to boost companies’ top and bottom lines over the coming months. Particularly encouraging is the fact that central banks are cutting interest rates while leading economic indicators are mostly in positive territory. By our reckoning, the combination of falling rates and higher GDP growth occurs only 10 per cent of the time, and is always positive for stocks.

Another encouraging observation to draw from our analysis is that the US economy appears set for a soft landing – avoiding a sharp slowdown that many investors had feared was likely. We expect GDP growth to ease steadily towards the country’s long-term potential rate of 2 per cent per year over the course of 2025. Such a scenario would also see the US Federal Reserve cutting rates less steeply than the market currently envisages. We don’t see US interest rates falling much below 4.5 per cent, which equates to at most just one more cut of 25 basis points.

Economic conditions in Europe are less encouraging, however, not least because political upheaval in both Germany and France is weighing on business and consumer sentiment. Helping shore up growth in the region, though, will be a decline in interest rates – we expect the European Central Bank to cut borrowing costs to 1.75 per cent if not lower over the next several months.

Our liquidity gauges indicate further gains for riskier asset classes. The positive impulse – which tends to bring about an expansion in stocks’ earnings multiples – largely reflects continued monetary easing from central banks worldwide. Twenty of the world’s 30 major central banks are cutting rates and only three are hiking. Looking ahead, even if we believe interest rates in the US are unlikely to fall much further, China’s recent shift from a “prudent” monetary stance to a “moderately loose” one should maintain the flow of credit to the broader economy.

Although we are positive on the outlook for stocks, we can’t ignore the fact that valuations represent a red flag. Trading at some 22 times forward earnings – 15 per cent above our estimate for across the cycle fair-value – US equities look particularly expensive. The same goes for cyclical stocks, not least when they’re compared to defensive sectors. Another potentially bearish valuation signal is the equity risk premium, a proxy for which is the gap between earnings yields and the yield on 10-year US government bonds in inflation-adjusted terms. Whenever the differential moves below 2 percentage points, it tends to foreshadow a sell-off in equities (see Fig. 2). Currently, equities have 8 per cent upside before hitting that threshold.

Technical indicators, by contrast, are positive for riskier asset classes. Surveys show investor positioning in stocks has become less bullish in recent weeks – equities are no longer “overbought”, which is a positive contrarian signal. At the same time, equity inflows remain strong with record flows into the US market, and seasonality is supportive of further allocation to the asset class.

Equities regions and sectors: more gains for the US

US equities are looking increasingly expensive, but there’s enough good news to support them for the time being. With stocks offfering an 18 per cent return on equity, corporate earnings growth dynamics remaining strong, a resilient domestic economy and improved sentiment ahead of Trump’s presidency, the signals remain positive.

But rich valuations suggest headroom for addtional gains is  diminishing in the absence of a surge in US economic growth – coming from an uptick in real output and productivity. That said the tell-tale signs of bubble-like market conditions – euphoric investor sentiment, overextended leverage and feverish merger and acquistion activity – are missing. The high concentration of gains among a handful of stocks is a concern (see Fig. 3). But, overall, we think there’s probably another 10 per cent upside for the US market before the prospect of a major correction becomes a significant worry.

As a result we maintain our overweight stance on US stocks, which should also help underpin global equity markets. Excluding China, we think emerging market stocks also look good value. They performed relatively well last year – beating European stocks – and, barring extreme anti-trade measures from Trump, they should continue to do well. 

We upgrade communication services to overweight from neutral. That’s because the sector is seeing positive earnings momentum even as the rest of market is recording a pullback in sentiment, and despite offering exposure to structural growth themes such as the artificial intelligence boom, valuations are not extreme. Moreover, we are positive on both Alphabet (Google) and Meta, which together make up some 50 per cent of the global sector index. Both companies have a demonstrable track record of leadership in tech innovation. 

We also raise real estate to neutral from underweight. As central banks ease policy, real assets look increasingly attractive. With falling real yields, investors are likely to look for better returns than they’re generating on cash parked in money markets. Real estate, which has been beaten down over recent years looks a good alternative, particularly given how expensive stocks are. Here, developments in the Swiss property market look instructive. With the Swiss central bank expected to return rates to negative territory, the Swiss real estate index has rallied – up near 20 per cent on the year. That could well prove a precedent for the sector more generally.

We remain positive on financials, one of the big beneficiaries of the Trump trade, though we could see ourselves trimming that position over the coming months. We are also positive on utilities, notwithstanding the sector’s underperformance last year. Electricity consumption is likely to rise with demand from AI and the shift away from fossil fuels. At the same time, the sector represents a hedge against the equity market’s strong cyclicality.

Fixed income and currencies: going for gold

Investors may be forgiven for thinking that the 2024 rally was all about tech stocks and US equities. But they were not the only stars. Gold had its best year since 2010 and we believe there are good reasons to retain exposure within a balanced portfolio.

With the Republicans in charge of both the House of Representatives and the Senate in the US, we are likely to see a large-scale fiscal spending programme. That will fuel concerns about inflation and the sustainability of the US debt burden – both supportive factors for gold given its status as a real asset and a safe haven. With lower interest rates, we also see potential for a pick-up in demand for the precious metal among retail investors. 

Last but not least, gold continues to enjoy structural demand from emerging market central banks, who – crucially – are not particularly price sensitive. For these reasons, we believe markets will continue to overlook valuations (which are some of the most expensive we’ve seen in the past two decades), and gold will remain a vital hedge against possible stagflation and dollar debasement in the coming months.

In fixed income, meanwhile, our preference is for emerging market bonds – across both local currency debt and credit. Our leading indicator for business activity in the emerging world is back in positive territory, supported by positive global trade dynamics. We expect the growth gap between emerging and developed economies will widen (to 1.7 percentage points in 2025 from 1.5 in 2024), a development which has historically been positive for emerging market bonds.

Adjusted for inflation, emerging market bonds look especially attractive and are likely to become more so as we see more interest rate cuts in developed economies, especially in Europe.

Elsewhere, the hunt for yield could benefit higher yielding sections of the developed credit market. We favour European high yield over its US counterpart. Valuations are more favourable and the asset class should benefit from what we expect to be a comparatively aggressive and prolonged ECB easing cycle. The euro zone’s terminal policy rate, as priced in by markets, is expected to be some 150 basis points lower than that of the US, compared to a long run average gap of around 90 basis points (see Fig. 4).

We are underweight Swiss bonds, as their valuations are expensive, and markets are already pricing in a chance of interest rates falling below zero. This limits the extent to which yields on shorter-maturity bonds can move lower from current levels.

Our stance on US Treasuries is neutral. While we expect growth in the world’s largest economy to slow to 1.9 per cent in 2025 (from last year’s 2.7 per cent), this is balanced by risks associated with further progress on disinflation stalling. Indeed, at its most recent meeting the Fed has pushed back on the market’s unrealistic expectations regarding the depth of the easing cycle. In our view this removes the tail-risk of it easing too far and being forced to make a painful U-turn.

For the dollar, the outlook is mixed. While the prospect of new trade tariffs from the Trump administration is likely to prove supportive, valuations for the currency look extremely stretched, and the newly elected US president has a track record of talking down the greenback. We therefore remain neutral for now.

Global markets overview: a volatile end to 2024

It was a stormy end to a storming year, with equity markets suffering a volatile December but nonetheless making outsized 12-month gains. In local currency terms, equities lost 0.5 per cent on the month, but managed a 22 per cent gain on the year.

Some of December’s performance will undoubtedly have been related to year-end profit taking and other technical factors. But, with two years running of 20 per cent plus gains for US equities, there’s also concern about stocks running out of steam. Market concentration is a particular worry. The US market makes up some 70 per cent of the global equity index, while a handful of stocks, the more-or-less magnificent 7, account for the lion’s share of gains.

US equities dipped 1.1 per cent on the month in December, but were up 27 per cent on the year, almost exactly matching the previous year’s performance. Dollar strength (see Fig. 5) managed to support a few other markets, particularly Japan’s and that of emerging markets, with Japanese equities gaining 5 per cent on the month in yen terms, while emerging equities were up 1.7 per cent. The yen dropped more than 5 per cent on the month and lost nearly 11 per cent on the year.

One source of pressure for equities was the upward drift in bond yields. Global bonds lost 1.5 per cent in December in local currency terms for a marginal 0.1 per cent dip on the year – in dollar terms both looked worse on account of the greenback’s relentless strength. The dollar was up 2.1 per cent on the month, thanks to the Fed’s hawkish shift and the Trump effect, and 6.6 per cent on the year.

Among sovereign bonds, the biggest monthly loser was US Treasuries, down 2.9 per cent. The US economy’s surprising resilience and expectations that Trumpian trade and tax policies will be inflationary have left investors chopping back their expectations for Fed rate reductions. On the other hand, the same forces influencing equities have also driven corporate credit, sparking year-end volatility in a market that did well for 2024 overall. European high yield was the big winner, gaining 0.6 per cent on the month and 8.6 per cent on the year. Other parts of the market did less well, with US investment grade dipping 2 per cent on the month.

Stronger growth expectations boosted commodities, up 2 per cent on the month for a near 8 per cent gain on the year, and even helped to cut the oil market’s losses. And while gold dipped 1.6 per cent on the month, it was one of 2024’s biggest winners, up a shade under 27 per cent.