Barometer: Equities enter slightly calmer waters

Asset allocation: resilient emerging markets, lower rates underpin stocks

It would be reasonable to assume that the escalating conflict between Israel and Iran adds to the risks facing global markets. But investors have remained calm, refusing to engage in a panic sell-off.

There is some justification for that.

The resilience of emerging market economies, expectations for interest rate cuts from major central banks and hopes for continued growth in technology and artificial intelligence in particular are strong arguments for maintaining an optimistic stance.

Even so, there are dark clouds on the horizon. The US’ major trading partners still have no clarity on any trade deal ahead of the expiry of the Trump administration’s 90-day tariff pause on July 9. The conflicts in the Middle East and Ukraine are far from being resolved. And the US economy faces the very real prospect of a stagflationary shock while global corporate earnings are likely to disappoint expectations.

Taking all these factors into account, we have become less concerned about the short-term outlook for risky assets than a month ago; we have thus upgraded equities from underweight to neutral and hold benchmark weightings in both bonds and cash.

Our business cycle analysis shows a growing gap in the economic outlook between developed and emerging countries, with weakness in the US weighing heavily on global activity. US business surveys point to lacklustre growth in manufacturing and consumption at a time when price pressures remain elevated: inflation is unlikely to peak before early next year.

Recent data showed that US real consumer spending has been falling over the past five months – something that has rarely happened outside of recessions. Continuing jobless claims are creeping higher, and so are delinquency rates. What is more, corporate investment is being delayed because of the high cost of borrowing and political uncertainty.

The rest of developed world is faring somewhat better but an escalation of trade tensions with the US remains a risk.

In the euro zone, domestic demand is supported by rising spending from consumers, who have as much as 15% of their disposable income in savings. Fiscal stimulus measures, including Germany’s EUR46-billion tax relief package, should also help boost growth.

Manufacturing activity in the UK and Switzerland remain weak, however, but future interest rate cuts should help cushion those economies as the year progresses.

Elsewhere, the Japanese economy is growing above potential thanks to household consumption and positive capital spending, yet domestic political risks stemming from soaring rice prices ahead of the July upper house election might store up problems for the months ahead. 

China’s economy presents a mixed picture, with weak exports and a contraction in industrial output offsetting rising consumption and credit growth. The property market is showing tentative signs of stabilisation and further policy stimulus – in the form of interest rate cuts and public spending - should help boost domestic demand.

Other emerging markets remain resilient, benefiting from improving industrial production, rising commodity prices and cuts in interest rates. Growth differentials between emerging economies and their developed peers have risen to 280 basis points, their highest levels since early 2000s, from around 10 basis points just a few years ago; we expect this gap to widen further to 290 basis points next year, lifting emerging market assets in the coming year.

Our liquidity analysis supports our positive stance on emerging markets. Disinflationary pressures are giving emerging central banks further room to ease their monetary policy. Coordinated monetary and fiscal easing in China, in particular, likely to buffer negative effects from trade tensions.

The US liquidity picture is mixed. Although the US Federal Reserve is in a wait-and-see mode, the private sector is providing credit with US banks extending loans.

Globally, 70% of central banks are cutting rates – almost unprecedented outside of recessions. While the pace of monetary easing is slowing, a growing number of countries is lowering borrowing costs.

Our valuation models show the gap between stocks' earnings yields and bond yields has fallen to its lowest in 25 years in the US, suggesting that investors are less incentivised to hold equities over bonds than before.

Adding to the bearish signals for US equities is the fact that corporate earnings are likely to disappoint: our estimates for the US corporate earnings growth rate has fallen close to zero, compared with consensus analyst forecasts of 9 per cent. That said, the outlook for certain sectors remains strong thanks to what are supersized AI-related investments, which remain on course to as much as triple to USD1 trillion by the end of the decade.

Finally, our technical indicators support the view that the current uptrend in equities may continue for a bit longer. Sentiment indicators towards - and portfolio flows into stocks - have recovered but do not show any sign of investors’ euphoria – with portfolio managers’ survey pointing to still light positioning in equities. Trend indicators are strong, more than offsetting negative seasonality.

Equities regions and sectors: emerging potential

In equities, we see some of the best potential in emerging markets.

The growth outlook is favourable: our economic indicators are positive across emerging Asia, Latin America and EMEA, in contrast to the weak readings for most of the developed world, particularly for the US. Valuations for emerging equities are also attractive (12-month price-to-earnings discount is more than 30% versus the MSCI All-Country World Index), and the recent drop in the dollar – which we expect to continue – offers another tailwind. Furthermore, we see a strong price momentum supported by increasing inflows into the asset class.

In developed markets, we see value in Swiss equities, which score “very cheap” according to our models and which offer defensive qualities – a valuable trait at a time when the world is witnessing intense geopolitical upheaval and valuations for cyclical sectors appear stretched globally.

The US stock market, conversely, remains the most expensive region. With the S&P 500 trading at an equity risk premium of 3.7% compared to a long-term average of 4.8% (see Fig. 3), the market is pricing in a return to a much calmer economic and political climate.

This seems optimistic. Add in the prospects for slower growth and reductions in analysts’ corporate earnings forecasts, and we feel that there is limited potential for further upside in US stocks from here – even more so after the recent rally.

In Europe, there are some bright spots, notably plans for extensive public investment and Germany’s corporate tax reform. Domestic demand is improving and consumer savings are significant (at 15% of disposable income). However, we have not yet fully reflected the impact of these fiscal initiatives in our projections due to implementation risks and ongoing trade uncertainties. An escalation of trade tensions with the US remains a risk to European businesses. We therefore believe it is too soon to upgrade European stocks and remain neutral for now.

Among sectors, our overweight positions include communication services. While valuations are challenging (it’s the second most expensive sector by our calculations, after industrials), company earnings are stable and the expansion of AI remains a positive long-term trend for the tech industry as a whole.

We also like financials and utilities stocks. The former are poised to benefit from a steeper yield curve and potential deregulation under the Trump administration. The latter offer defensive characteristics and benefit from structural trends such as increasing demand for electricity to power data centres and AI. 

Fixed income and currencies: dollar down

In what has been a volatile first half of 2025 for bond and currency markets, dollar weakness has been one of the few persistent trends. Since January, the greenback has fallen by some 10% versus a trade-weighted basket of currencies, and we expect this depreciation to continue as worries mount over the US’s trade and fiscal policies, as well as signs that the US economy is losing some steam.

We believe the golden era of US economic and geopolitical leadership – so-called “US exceptionalism” – is coming to an end (see our Secular Outlook 2025 for more detail). This, in turn, should lead to a long-term decline in the value of the dollar. We are seeing the first signs of this shift with the breakdown in the relationship between the dollar and US Treasuries.

Historically, yields on US sovereign bonds have moved in the opposite direction to the currency: whenever turbulence hit, investors worldwide would gravitate to the perceived safety of US Treasuries and the dollar, sending yields lower and the greenback higher.

However, since Trump’s Liberation Day tariff announcements that link has broken down. Yields have risen while the dollar has weakened, arguably signalling a structural change in the perception of the dollar as a safe haven. We express our bearish view on the greenback via an overweight in developed market currencies – euro, sterling, Japanese yen and Swiss franc.

We also retain an overweight on gold. Although it is by far the most expensive asset class in our model, we believe gold will serve as valuable protection from the economic and market upheaval that’s sure to ensue as we transition from a unipolar world dominated by the US to one in which Europe and China have bigger roles to play.

A weaker dollar bodes well for emerging market bonds. Which is partly why we remain overweight in emerging market local currency government debt – alongside benign domestic fundamentals, cheap currencies and relatively high real rates (see Fig. 4). Developing world currencies trade one standard deviation below their equilibrium versus the dollar, according to our models. We would expect that gap to narrow as the growth differential between the US and developing world widens.

Greater resilience of developing economies versus their developed counterparts also bodes well for emerging market corporate bonds, in which we remain overweight.

In developed markets, corporate bond spreads have narrowed back to close to their tightest levels in the current cycle. However, we still see potential in European high yield. This reflects the possibility of positive economic surprises (thanks to ambitious fiscal spending plans and reform agenda) and better growth/inflation mix relative to US high yield. Euro zone high yield bonds offer an inflation-adjusted yield of about 4% after inflation, low duration of around three years and default rates below average thanks to the economic recovery.

Global markets review: tech stocks back in vogue

Global financial markets ended the volatile first six months of the year with a rally in risky assets, with the S&P 500 index equities hitting record highs and tech stocks staging a big comeback.

Investors managed to shrug off concerns about unresolved trade tensions and simmering conflicts in the Middle East and Ukraine and took heart from the resilient global economy, especially among emerging markets, and the prospect of monetary policy easing from major central banks. However, geopolitical concerns and the possibility of supply disruptions in the Gulf lifted oil prices, which rose nearly 8 per cent in the month.

Global stocks rose nearly 4% in June outperforming bonds which added 2%. The US was the best performing region in developed markets, rising more than 5 per cent. IT and communication services were the biggest gainers as optimism intensified over the AI boom. Nvidia has rebounded more than 60% after its April low to become the world’s most valuable company as many expect the chipmaker to ride a “Golden Wave” of AI adoption and grow its earnings.

Wall Street’s strong gains this month masks Europe’s renaissance in the first six months. European stocks ended the first half up more than 13 per cent, double the gains in the US. Monetary stimulus from the European Central Bank and Germany’s historic shift on fiscal expansion – worth hundreds of billions of euros – boosted expectations for stronger growth in the bloc.

Emerging market stocks were equally strong with Asian stocks adding 5.5 per cent thanks to hopes that Asian economies will reach trade agreements with the US. That prospect has become more certain after the US and China sealed a deal to de-escalate tensions – without offering details – and President Donald Trump said there may be a separate deal with India. The AI boom is also lifting tech stocks in Taiwan, South Korea and China.

Emerging markets attracted capital to their bond markets as well, with local, hard currency and corporate bonds rising between 2-2.8 per cent thanks to a weaker dollar.

In bonds, the Treasury saw its biggest first-half gain in five years, overcoming a ratings downgrade by Moody’s. Concerns over the tariffs’ impact on the US economy and expectations for the Federal Reserve to cut interest rates boosted demand for the asset class.

Some saw a possibility that increasingly popular stablecoins – digital tokens pegged to the dollar – could fuel demand for short-term US Treasuries from issuers who are required to hold them as reserves for liquidity and risk management.

The dollar lost 2.5 per cent in the month, bringing this year’s loss to
over 10 per cent. The euro and Swiss franc were major beneficiaries from the greenback’s demise in July, while some emerging market currencies like the Brazilian real also gained strongly.

The dollar’s decline in the first six months, coupled with geopolitical concerns, drove gold to dizzying heights, with the precious metal wrapping up the mid-way point of 2025 at up 25 per cent.