Barometer: Rally appears set to continue into year end

Asset allocation: optimism prevails into year-end

As a turbulent year draws to a close, optimism is in the air for equity markets. Liquidity conditions are very supportive, economic conditions are improving, and corporate earnings remain strong. Add in favourable seasonality – stocks’ tendency to rally in the fourth quarter – and we see enough positive signals to retain our overweight on global equities through the final weeks of 2025.

Still, risky assets offer unusually small premia over safe ones and valuations are elevated, which means equities do not have much of a cushion against shocks. In other words, it pays to be selective, both within equities and other asset classes.

So while we remain overweight equities, we are more enthusiastic about emerging markets than US stocks. We also downgrade US Treasuries to underweight as yields look to have fallen too far. With headline inflation hovering near 3%, we believe markets may have overestimated the likely extent of interest rate cuts from the US Federal Reserve. At the same time, the potential for stronger-than-expected growth could push US yields back up.

Indeed, our business cycle indicators show that economic conditions have improved over the past month, with the US, the UK and Switzerland all performing above our earlier expectations.

We’ve consequently revised up our US GDP growth forecasts by 0.2 percentage points to 1.8% for this year and 1.5% for 2026 – broadly in line with consensus. Although US consumer sentiment is weak and the labour market has lost momentum, regional surveys point to healthy economic activity while the housing sector seems to be on track for a gradual recovery.

Our outlook on emerging markets remains upbeat. Inflation is mostly contained, enabling many central banks across the emerging world to ease monetary policy and support growth. Global exports have rebounded to above pre-pandemic levels, and trade between developing countries is particularly strong. This supports our overweight stance on emerging market equities, local currency bonds and corporate credit.

Global liquidity conditions are also positive, with 83% of the world’s central banks currently in easing mode. Private sector liquidity is also strong, fuelled by an AI-driven corporate spending spree and a pick-up in bank lending.

In the US, we expect just one more quarter point rate cut from the Fed. Even though investors have been fretting about the threat to the Fed’s independence, we do not see this as likely in the near-term, and therefore hold a much more hawkish view on rates than financial markets, which are pricing around 80 basis points of cuts by the end of next year. 

Elsewhere, the European Central Bank is on hold for now but the risks are skewed in favour of one more cut in the coming months. Europe is enjoying the stimulus from the eight rate cuts which the ECB has delivered since June 2024, alongside the prospects of fiscal easing to come – a favourable environment for equities.

We are also relatively moderate in our expectations for easing in China. Weak domestic demand warrants a continuation of moderately loose monetary policy, but there seems little urgency for aggressive rate cuts due to robust exports and the recent ramp-up of fiscal support. We expect the People’s Bank of China to cut rates by a further 10 basis points and the reserve requirements ratio (RRR) by 50 basis points.

Japan remains one of the few major economies in tightening mode – we expect the Bank of Japan to hike at least once more in the coming months. The prospects of higher fiscal spending could bolster the case for more restrictive monetary policy, which in turn would prompt Japanese investors to move some of their money into domestic assets, to the benefit of the yen. If the yen persists in its current downtrend, the risk of an official intervention to stop the yen depreciation will become material.

Our valuation metrics suggest some caution is warranted. Risk premia are compressed and roughly nine out of 10 assets trade at valuations that are above the long-term trend. The situation is particularly acute in the US, where stocks’ price-to-sales ratio – at 3.5 times – has surpassed the peak seen in the late 1990s dot.com boom. At near 3%, our proxy for US equity risk premium¹ allows for a very limited buffer to any inflation or growth shocks (see Fig. 2). We therefore prefer to focus our equity allocations in other regions, and especially in emerging markets which boast attractive valuations, strong fundamentals and solid price and earnings momentum. Swiss equities are attractive for domestic investors – given their solid dividend income at a time when domestic bonds are yielding close to zero and the cost of currency hedging remains extremely high.

US aside, our overweight equities stance is supported by the absence of classic bubble markers such as high leverage or bloated earnings expectations. Our base case, therefore, is for single‑digit equity returns driven by earnings, alongside a modest valuation derating of around 7% over the next year.

Technical indicators support our overweight stance on global equities, with seasonality trends positive into year-end, and fast trend signals also supportive. Investor demand remains robust in the face of strong earnings and receding risks to growth. Furthermore, positioning is not overly stretched, with equity net call volumes pulling back from a recent peak. M&A flows also continue to be very strong.

Equities regions and sectors: strong earnings, bullish outlook

Companies in major stock markets are continuing to deliver strong earnings results, with more than 80 per cent of US stocks beating their earnings estimates. Despite a strong rally that has stretched valuations, we believe the outlook for corporate earnings remains positive.

We prefer markets outside the US, though, and for several reasons. One is valuations. US companies are trading at an elevated 23 times their forward earnings, a level that offers no buffer against the possibility of slowing growth, higher inflation or weakened US institutional credibility. What is more, on a price-to-sales basis, US stock valuations are surpassing levels seen during the dot-com bubble. That said, we refrain from turning underweight and retain our neutral stance. This is because company earnings in the US continue to outshine those in rest of the world and recent analyst revisions point to the trend being sustained.

We are much more enthusiastic about emerging market stocks, in which we maintain our overweight stance. Our preference here is to diversify our exposure within the broad emerging market universe rather than concentrating our positions in China, Korea and Taiwan – countries which have benefited from an artificial intelligence spending boom. India presents interesting opportunities as valuations appear reasonable relative to global equities. Latin America, especially Brazil, is also attractive as the region has significant scope of interest rate cuts. 

Swiss stocks, where we are also overweight, are supported by an improving macroeconomic outlook and attractive valuation. Crucially, we are seeing signs of improved performance of high-quality companies, which are significantly represented in the Swissbenchmark.

Our benchmark weight in euro zone stocks remains unchanged. While their valuations remain attractive, European stocks need stronger earnings growth and a transmission of fiscal stimulus into the real economy, especially as we have early evidence of softer money and credit growth. We expect corporate earnings growth in Europe to slow to below 4% next year from 4.2% in 2025, in a sharp contrast to the consensus estimate for nearly 15%. We prefer to remain selective and buy the region’s industrials, financials and mid-cap stocks, which have outperformed the S&P 500 index over the past two years.

At the sector level, technology and communication services remain our core overweight positions as they benefit from a boom in AI-related capital spending and continue to deliver strong earnings.

We retain an overweight stance in financials as the operating environment and regulatory outlook is supportive, and valuations remain attractive.

Healthcare, in which we hold a neutral stance, bears close monitoring as the sector may benefit from fading policy uncertainty on drug pricing and tariffs, not to mention the growing investment from AI companies into life science tools, medical technology and diagnostics.

Fixed income and currencies: trimming Treasuries

We cut US Treasuries to underweight from neutral, in response to what we believe are the market’s exaggerated expectations for Fed rate cuts and the potential for US inflation to surprise on the upside in the next few months amid resilient US growth.

The Fed’s decision to halt its quantitative tightening programme and to cut rates by a quarter point at its October meeting was well flagged. But despite somewhat hawkish rhetoric at the meeting – that a further cut in December isn’t a done deal – we still think that the market is overly optimistic on how low rates are likely to go. The market is pricing in cuts of 3.5 percentage points by the end of 2026 against our expectations of just one single quarter point cut.

There’s growing speculation that over the coming months, President Trump will manage to stack the Fed’s board with his own people, which would threaten to erode the central bank’s independence and lead to much lower rates than are warranted. We think, for now, that’s a relatively unlikely outcome.

At the same time, the US economy is resilient – notwithstanding some labour market weakening – and that inflationary pressures shouldn’t be underestimated. That is likely to be underpinned by banks’ increasing willingness to lend as rates come down. Indeed, the US economy is looking increasingly healthy relative to the euro zone’s, suggesting the gap in yields between US and German government bonds is overdone (see Fig. 4).

Further supporting our decision is that Treasuries look expensive relative to recent nominal growth trends. Over the long term, government long-term bond yields and nominal growth tend to be broadly aligned – but the current 4% yield on 10-year Treasury bonds is well below the current nominal growth rate of the US economy, which, according to consensus is close to 5%.

Meanwhile, credit spreads are at cyclical lows, with investors being offered very little extra yield to compensate for potential market shocks. So far, though, there has only really been signs of stress in the private credit market, which has touched off brief bouts of volatility in public markets. However, we remain overweight euro zone high yield bonds thanks to their attractive volatility-adjusted yields compared to their US counterparts.

Although emerging market currencies are less cheap than they have been, there is still value in this part of the market – with real yields in the 5-10% range in Latin America. Developing economy fundamentals remain benign: growth is proving more resilient than in developed economies, inflation rates are receding and dollar weakness continues to be a significant tailwind. All of which continues to underpin our overweight in emerging market local currency debt (ex-China) and in emerging market corporate credit.

We anticipate that the dollar will depreciate further and as a consequence retain our overweight in the euro and Swiss franc, notwithstanding negative Swiss rates. We maintain our full overweight in gold. Though we note the precious metal’s steep climb takes its valuation to lofty levels, the fundamentals continue to be supportive: real yields are coming down, the dollar continues to weaken and there’s the real risk of significant expansions in public sector deficits across the developed world.

Global markets review: EM shines bright

Emerging market stocks were again the stellar performers in a month that saw strong returns for equities generally. EM equities rose some 4.6% on the month in local currency terms, with Asian stocks leading the way with a more than 5% gain, while global equities generally were up 2.3%.

The emerging universe is benefiting from solid economic fundamentals. So far, less developed countries have managed to buck the impact of President Trump’s tariffs. EM Asia saw the biggest local currency gains on the year so far, up 32%, but Latin America wasn’t far behind at 30% – the former showing nearly double the US market’s performance. In dollar terms, EM markets registered stronger gains still.

Countries with big tech sectors, like South Korea, have particularly benefited from the AI boom, which has broadened out to critical players in the global supply chain with investors keen to diversify from concentrated positions in the US. The IT sector overall gained 7.6% on the month. Unusually, EM managed to shrug off a lacklustre performance of materials and energy stocks during the month, the former down some 1% and the latter, a sectoral laggard so far this year, up just 1% – EM has in past cycles tended to track commodities markets.

EM bonds also did relatively well during the month, also on strong fundamentals. Locally denominated debt was up 0.5% for a near 16% gain on the start of the year, while dollar-denominated debt gained 2.1%. Here, however, the strongest performer was UK government bonds, or gilts, up nearly 3% on the month amid signs of slowing inflation, that tight monetary policy was finally beginning to nudge inflation back towards target, and in anticipation of a fiscally hawkish government budget.

In corporate credit, EM once again delivered positive returns, up 0.7% on the month in local terms. Here, European and US high yield were laggards amid some signs of stress in the riskier end of the corporate debt market, not least private credit.

Though dollar weakness has generally benefited EM during the year, the greenback managed to claw back ground against both its developed and emerging counterparts during October. A somewhat more hawkish turn by the Fed following its latest policy setting meeting, helped to underpin the US currency.