Barometer: Equity rally to roll on as stagflation risks recede

Asset allocation: Staying positive on equities

Equity markets have recovered strongly from the sell-off triggered by the US’s decision in late February to go to war against Iran. Healthy economic growth, strong corporate earnings and hopes for an AI-inspired increase in productivity have helped propel stocks higher in recent weeks.

Even so, the magnitude of the rally – not least the searing 80% quarterly gain in the Philadelphia Stock Exchange Semiconductor Index – is encouraging a growing number of investors to take profits.

In our view, though, equities are not about to reverse course. There are strong arguments for a continuation of the rally. To begin with, the risk of stagflation that has haunted markets since the war began is receding. With the US and Iran now making firm progress towards a peace agreement and oil prices falling in response, we envisage that consensus expectations for economic growth will pick up and those for inflation to head lower. That would be a positive development for stocks (and bonds), reversing a trend that emerged in March (see Fig. 2).

History also suggests equities have further to run. Interest rates have begun to rise worldwide, but experience shows this is usually positive for stocks, particularly if monetary tightening is a reaction to improving growth.

In each of the five US monetary tightening cycles since 1987, US stocks have delivered returns of 4–16% in the twelve months following the first rate hike.¹

Fig. 1 - Monthly asset allocation grid

July 2026

None of this is to ignore the possibility of a shift in market dynamics over the near term.

Central banks’ tightening of the monetary reins will at some point weigh on sectors that are sensitive to higher borrowing costs.

What is more, the equity market’s gains remain concentrated among a handful of large tech companies, raising the possibility of a shift in the pattern of stocks’ returns. In other words, market conditions may soon warrant a reconfiguration of allocations. For now, though, we don't see a compelling reason to change our stance and remain overweight equities, limiting our tactical shifts to an upgrade of financial stocks. 

At the same time, we have raised our rating on fixed income to neutral and downgraded cash to underweight. Bond yields remain elevated despite the fall in the oil price, making fixed income a more effective hedge against any unexpected decline in economic growth or increased volatility in stocks.

Fig. 2 - Stagflationary impulse reaches its peak

G4 consensus GDP growth and inflation forecasts for 2026 (%)

Our business cycle indicators reinforce being overweight stocks. Although developed economies are growing at a pace that is below the long-term trend rate, it is encouraging to see that business investment continues to rise in both the US and Europe.

Another positive is that economic conditions in emerging markets are improving – thanks in part to better terms of trade.

Our liquidity indicators, meanwhile, clearly show that monetary stimulus outside China is being scaled back but, crucially, not at a pace that would threaten the market rally.

Our analysis shows excess liquidity – the rate of money supply growth relative to the pace of GDP growth – has contracted to a six-month annualised rate of -5.4% in the developed world, the tightest in two years but some distance from the levels seen during the global financial crisis of 2008 or the Covid shock.

In our view, the Fed is likely to leave borrowing costs unchanged throughout the year, but the risk that it will switch to raising interest rates by as much as 50 basis points is growing by the day.

Valuation gauges show equities have become more expensive, with Japanese and emerging Asia stocks having seen among the sharpest shifts.

Technology and industrials stand out as the most expensive stock sectors, reflecting their strong performance and earnings momentum, while communication services have become significantly cheaper. More broadly, the market exhibits a clear cyclical versus defensive split, with cyclical sectors now becoming expensive according to our model and defensive sectors looking cheap.

Fixed income looks fairly valued in general, but with government bonds better cheaper than corporate bonds.

In commodities, oil prices appear broadly aligned with current supply-demand fundamentals, having already adjusted to reflect the normalisation of conditions in the oil market in the wake of Iran-related disruptions.

When it comes to currencies, our indicators show the dollar may trend modestly stronger if the US economy continues to outgrow the rest of the developed world.

Our technical indicators show favourable trends for equities, particularly for emerging market stocks outside China. 

Equities regions and sectors: EM outperformance to extend into H2

Emerging market equities have closed the first six months of 2026 as the global market’s outperformers, registering gains of more than 23% in US dollar terms compared to some 9% for US and European stocks. We believe this pattern will continue over the near term at least.

Emerging economies, especially those in Asia, have weathered the energy crisis triggered by the Iran war, thanks in part to efforts made in recent years to reduce their economies’ sensitivity to oil. For example, in Korea, the oil intensity of the economy has more than halved to 0.41 barrel per KRW1 billion of GDP, compared with 0.9 barrel in 1995.²

At the same time, many of these markets have capitalised on a global AI boom and enjoyed blockbuster exports. Korea’s monthly trade surplus rose to a record 17% of GDP in May from just 1.7% in January 2025 as rising chip and memory prices have more than offset higher energy costs.

The longer-term case for emerging market equities is also improving. Emerging economies enjoy a superior growth profile compared with their developed counterparts. What's more, a growing number of emerging economies are reforming corporate governance and encouraging companies to raise dividend payments and repurchase shares. This matters as dividends accounted for 60% of the asset class's total returns over the last two decades. This, coupled with emerging economies' potential to outgrow the developed world, should help narrow emerging stocks’ discount to developed markets. This can be seen in Fig. 3, which shows a strong relationship between the US-EM economic growth rate gap and the differential in US-EM stocks' price to book ratios.  We therefore remain overweight emerging equities outside China. 

On Chinese stocks, we retain our neutral stance, partly due to economic factors. The country's real imports remain below the pre-Covid 10-year trend while real estate investment has been on a downward trend for nearly five years.

Fig. 3 - Emerging differentials

Emerging market price-to-book discount versus GDP growth differential to the US

In developed markets, we downgrade US equities to neutral. US stocks are becoming less compelling relative to other regions as the AI trade broadens out from US tech companies to firms operating in other countries.

What’s more, as the economy transitions to a mid-cycle phase, investors should prepare for an environment of higher interest rates and less abundant liquidity, which could weigh on earnings multiples for US stocks. We are neutral on all other developed equity markets.

In sectors, we upgrade financials to overweight.

Banks should benefit from higher interest rates, improved earnings dynamics and strong capital market activity, including a series of mega technology IPOs in the US.

Elsewhere, we remain overweight technology stocks. The pricing power of big tech companies remains robust, and is unlikely to be challenged by higher interest rates. Asian tech companies, in particular, offer attractive valuation with strong growth prospects.

Fixed income and currencies: search for carry

Bonds look set to re-emerge as an effective portfolio diversifier.

An indication that bonds may be increasingly attractive can be found in Fig. 4. It illustrates that yields – which have been moving more or less in lockstep with the oil price over the past few months – now seem to be operating with a lag. In other words, yields have not fallen by as much as the recent sharp drop in the oil price would suggest.  If this anomaly disappears – which we envisage is likely to happen over time – then bonds look attractive at current levels, and could help diversify risks in balanced portfolios.

Within bonds, our preference is to focus on asset classes offering higher carry. We see some of the best opportunities in emerging market local currency bonds – one of the cheapest fixed income asset classes on our valuation metrics. Cheapness is not always a good reason to buy, of course, but this time it coincides with strong fundamentals.

The developing world has shown remarkable resilience to the recent oil price shock, and the macroeconomic backdrop is improving, bolstered by demand for industrial metals and semiconductors.

We expect emerging economies to expand by 4.1% this year, above their long-run potential, and widening the growth gap versus the developed world to 270 basis points from 240 basis points in 2025.

Financial fundamentals have improved significantly since the global financial crisis, with lower external debt, stronger current account balances and more credible central bank policy.

Cheap valuations, thus, add to the arguments for remaining overweight. 

Fig. 4 - Value in bonds

Absolute change in oil (USD/bbl) and 1Y1Y rates (ppts)

In foreign exchange markets, we retain an overweight in the yen – the cheapest currency in our framework – albeit with more moderate conviction.

As the yen flirts with 40-year lows versus the dollar and yen short positions are at their most stretched since 2024, we also see a strong likelihood of central bank intervention to support the currency, with the potential of it being a joint Japan/US effort.

Against other currencies, we expect the dollar to remain broadly range-bound with a bias for strength in the short term, supported by US economic resilience. In the longer run, though, we see the world becoming gradually less reliant on the dollar.