Barometer: Emerging markets more attractive than expensive US

Asset allocation: looks like Goldilocks

Once again, there’s a Goldilocks feel to the markets. Investors are growing less worried about a slowing US economy, yet there’s justification enough in weakening employment data for the US Federal Reserve to cut interest rates next month. At the same time, inflation seems to be less of a pressing concern, to judge by sentiment surveys (see Fig. 2).

Yet with valuations at less attractive levels, we remain neutral equities, bonds and cash; we do however see numerous tactical investment opportunities across regional stock markets, sectors and fixed income asset classes.

Equity markets are trading at levels that suggest risks to growth or of further negative policy shocks are more than offset by strong corporate earnings. To be sure, market optimism on earnings has been underpinned by a solid reporting season, but stocks look expensive and there’s very little scope for disappointment in the case of a negative lagged impact from President Donald Trump’s tariff campaign. And while bond investors have factored in some downside risks associated with Trump’s anti-Fed attacks – yields on longer-dated bonds have risen, steepening the yield curve, we don’t think they’ve properly accounted for the prospect of a pick-up inflation in the near term.

On balance, our global business activity indicator has turned positive. The US economy’s prospects have improved, casting some doubt over our previous expectation for a significant slowdown in an environment of rising inflation. Stagflation risks do remain, but growth is proving relatively resilient while the impact of tariffs on inflation is likely to be more drawn out than we’d expected. Slowing personal consumption and weak residential investment remain concerns.

At the same time, we also see positive signs from the euro zone. Sentiment indicators have been improving and domestic demand is poised to pick up as consumers look to spend excess savings. Longer term, growth will further be supported by Germany’s decision to ramp up public spending.

Elsewhere, Japan’s economic outlook is mixed, with growth being underpinned by strong exports while domestic demand remains muted. Heightened political uncertainty  - there are growing calls for the prime minister to resign - casts a cloud over the economy as it is likely to limit fiscal stimulus and structural reform. The Chinese economy, meanwhile, suffered a significant decline during the summer, following a 44% collapse in exports to the US.

Of the 30 major central banks, 24 are easing and just one is tightening monetary policy. With the Fed expected to cut rates in September, December and again next March, our liquidity indicators remain positive for riskier asset classes. For now, the Fed’s expected cuts look to be justified by recent employment data, which justify its shift to primarily focusing on protecting growth rather than fighting inflation. However, should a Trump Fed keep slashing rates on political grounds – especially against a backdrop of massive fiscal deficits and in which bank deregulation is spurring credit growth – the market would probably start to worry about runaway inflation. China, meanwhile, is finally coming to terms with its debt deleveraging and deflation pressures, with the central bank loosening its monetary stance and the government generally looking for broader policy coordination. And with Japan’s services inflation softening, there’s no particular pressure on the Bank of Japan to speed up interest rate hikes. 

Our valuation indicators show that bonds and equities remain expensive. While both euro zone and Japanese equities were extremely cheap not long ago, they are looking less so now. Equities have however been supported by a very sharp tech-led rebound in US earnings – one of the biggest outside of recessions. Still, given very expensive valuations, we expect an 8% contraction in global equities' price-earnings multiples over the coming 12 months.  Quality stocks, which have underperformed during the past 18 months (in part because they’d become an overcrowded trade when investors were worried about the global outlook) are once again starting to look attractive. In fixed income, inflation-linked bonds look attractive, as do gilts.

Our technical indicators remain positive for equities, supported by a broadening out of the market rally from the tech sector. Despite the US market’s heady gains over recent months, aggregate investor sentiment and positioning indicators in equities are not at extremely bullish levels.  The one obvious exception is Japanese equities, which are overbought.  Japanese and Chinese bonds look oversold.

Equities regions and sectors: faith in EM, Swiss stocks

Emerging market (EM) stocks remain a bright spot in global markets. They have proved resilient in the face of US tariffs as robust domestic consumption has helped cushion the impact of trade disruption. The emerging world has a GDP growth advantage of around 2 per centage points over developed economies – the largest since early 2000s.

We believe EM stocks are poised to deliver attractive returns in the coming months and expect firms based in emerging economies to deliver earnings growth of above 10 per cent both this year and next, comfortably above their developed market peers. EM stocks also benefit from attractive valuations – their forward PE ratio stands at around 13 on average, an unjustifiable 33% below that of developed markets. The prospect for a structural dollar decline is also beneficial as it improves export competitiveness and encourages foreign invesment inflow.

We’re optimistic on Chinese stocks, too, despite a recent slowdown in the economy. A 44 % collapse in exports to the US from March to July may have grabbed headlines, but the country’s exports to the US represents only about 3% of China’s GDP and are no longer a major source of growth. Beijing also has room to further support the economy with more coordinated stimulus.

Taking this into account, we maintain our overweight stance across emerging markets.

Our overweight position in Swiss stocks is also unchanged. The country's market has a plenty of high-quality stocks in sectors like pharmaceuticals and luxury goods, whose defensive characteristics are attractive given the potentially stagflationary impact of US tariff policies. Moreover, some Swiss companies are expanding US manufacturing and R&D facilities and diversifying supply chains, an effort that should help mitigate trade risks especially after the punitive 39% tariff imposed by the US.

Overall, Swiss stocks have attractive valuations and offer a good hedge for investors against a decline in world GDP growth. 

We are neutral US stocks. Analyst forecasts for US corporate earnings have been improving, driving a V-shape recovery in profits estimates globally from an earlier decline triggered by the Liberation Day tariff shock in April. Yet this improvement has not been reflected in manufacturing indicators (see Fig. 3).

At the same time, the US stock market’s rally is taking valuations to lofty levels, leaving no buffer in should tariff-induced stagflation take hold. The market’s price-to-earnings-ratio is hovering around 22 on average, back at cyclical highs. 

At a sector level, quality stocks – the likes of consumer staples and pharmaceuticals – present an attractive investment opportunity as their valuations have fallen to fair levels after underperforming the broader market for 18 months. At current prices, they may offer an effective hedge for investors in an environment of moderate economic growth and unpredictable US policy developments.

Utilities stocks, in which we hold an overweight position, also offer defensive qualities and benefit from structural growth in electricity demand.

We also like the communication services sector. While valuations remain challenging, earnings are stable. The sector’s estimated investment in artificial intelligence and data infrastructure of around USD400 billion this year should also start to bear fruit. 

Financial stocks, meanwhile, are poised to benefit from a steeper yield curve and potential deregulation from the Trump administration. For these reasons, we are overweight the sector.

Fixed income and currencies: too sanguine about inflation

Bonds are underpricing inflation risk, particularly in the US. In our view, markets have become too complacent both about upward pressure on components of US core consumer price inflation and the possibility that Trump administration tariffs will have inflationary effects in the near term.

They are also too sanguine about the risk to the Fed’s independence. Trump’s routine attacks on the central bank and efforts to alter the composition of its board suggest that the Fed of the future will be under much more political control.  That’s to say, that monetary policy will be forced to accommodate the government’s deficits and thus risk higher inflation. 

To be sure, ‘Liberation Day’ – the day Trump announced his big tariffs – triggered a big jump in the term premium – the amount of additional yield investors require for holding longer dated bonds. That perhaps was unsurprising: bond investors don’t tend to like policies that create significant uncertainty about future inflation. But since then, the term premium has levelled off, suggesting the market has made its peace with Trump’s tariffs (see Fig. 4).

Given continued uncertainty over the direction of US policy, we reiterate our neutral stance on all major government bond markets, but remain vigilant about the risk of inflation shocks. Our only overweight is in local currency emerging market government bonds, excluding China, which continue to benefit from dollar weakness as well as benign domestic economic fundamentals and high relative real rates.

Our overweight position in emerging market corporate bonds, meanwhile, reflects our view that EM growth remains more resilient than developed markets. Furthermore, we remain overweight in euro zone high yield bonds due to attractive volatility-adjusted yields and a more favourable growth/inflation mix compared to their US equivalents.

Developed credit markets are currently witnessing a tightening of yield spreads due to strong demand, not least for new investment grade bond issues. Expectations that default rates will remain low – corporate earnings have been strong and leverage is moderate – supports the positive outlook for credit.

Separately, with much of the impact of Trump’s policy measures concentrated on the dollar, we expect it to weaken further. As a result, we maintain our overweight position in the euro and Swiss franc and our full overweight in gold, which continues to be a major hedge against both inflation and concerns about excessive debt levels.

Global markets review: AI fever arrives in China

Equities outperformed bonds in August as expectations of interest rate cuts from major central banks and the ongoing strength of US tech stocks riding the AI wave lifted markets.  

US stocks ended the month up some 2 per cent although the rally lost some momentum amid concerns that the Fed's independence was at risk. 

Tokyo stocks also hit record highs as a weaker yen lifted stocks of
automakers and other retailers with a global presence. Swiss stocks rose more than 3 per cent, drawing safe-haven demand.

Chinese blue-chip stocks rose more than 10% last month (see Fig. 5) as Beijing’s plans to increase production of advanced chips fanned expectations of a home-grown AI boom, unlocking domestic savings and channeling stimulus-driven liquidity into equity markets.

Other emerging markets fared well, helped by a weaker dollar. Latin
American stocks outperformed with a gain of more than 6 per cent as the region benefited from demand for basic materials,mirroring gains in the materials sector.

In other sectors, utilities were the only industry in red while communication services, health care and consumer discretionary enjoyed gains of 3-4 per cent.

In fixed income, EM local currency bonds gained, ending the month up more than 2 per cent. EM hard currency and corporate bonds also rose. Government bonds in the euro zone, UK and Japan fell. In credit, most asset classes ended the month in flat, except for US high yield bonds which rose 1 per cent.

Gold rose more than 4 per cent on the month, bringing gains this year to over 30 per cent. The precious metal attracted safe-haven demand from investors seeking to hedge their portfolio in the face of geopolitical uncertainty and attacks on US institutional credibility.