Barometer: Follow the growth
Asset allocation: a return to complacency
The world’s economies have avoided recession, the US debt ceiling drama has faded from view and inflationary pressures continue to relent. On the surface at least, it is easy to rationalise the stock market recovery of the past six months.
But signs of complacency are creeping into asset prices, so we remain cautious. Financial markets are taking a leap of faith, discounting a sharp bounce in economic activity, for which we see scant evidence. Despite the easing of inflationary pressures, price rises remain sticky and, as hawkish central bankers keep warning, markets risk getting ahead of themselves in pricing in interest rate cuts. At the same time, the Chinese economy has started to flag.
As a result, we remain underweight equities. Valuations have crept back up again and much of the US market’s performance is concentrated in just seven mega-tech stocks. In part, that’s down to a mania for artificial intelligence (AI). AI is seen as the next wave of tech, with investors captivated by the latest iterations of large language models. ChatGPT and the like could indeeed trigger a step change in economic productivity, and therefore in growth and profits, but we’re not getting too excited yet. Meanwhile, the monetary tightening of the past year is still feeding through to developed economies, with the promise of more rate rises to come on both sides of the Atlantic.
Our caution means we also remain overweight bonds, particularly US Treasuries, which should benefit from the fact that the US Federal Reserve is further along the tightening curve than the European Central Bank.
Our business cycle indicators show muted economic growth for the developed world this year (1 per cent) but significant strength in the emerging world (4 per cent). The differential is above the long-term average of 2.5 percentage points. Nonetheless, developed economies are proving more resilient than many thought likely earlier this year; most should avoid outright recession.
The US in particular is being helped by a delay in the transmission of interest rate hikes to the broader economy and by resilient consumption. Japan is bucking the trend, with growth at above potential – we expect the economy to expand 1.5 per cent this year.
Although economic prospects for most emerging markets are brightening, China has lost some momentum. We have trimmed our growth forecast for the Chinese economy to 6 per cent from 6.6 per cent, but believe a more significant rebound is building, with monetary easing likely to support the housing market over the coming months.
Our liquidity indicators show a continued split between east and west. The Fed, ECB and Bank of England remain on a tightening course, while China and, to a lesser extent, Japan are easing. One concern is the trajectory of bank lending. It is already contracting in Italy and Spain and, although bank lending in the US has been largely resilient, activity is beginning to ease up there too.
Our valuation indicators suggest that equities are looking increasingly pricey – they’re expensive for the first time since April 2022 on our measures. A gap has opened up between earnings expectations and leading economic indicators (see Fig. 2). At some point that gap will have to close. Either the economy will rebound – which we think is unlikely – or equities will reprice. Meanwhile, bond valuations remain neutral.
Our technical indicators show positive trends for equities, though US and Japanese stocks look overbought. Market volatility remains low and there is a negative correlation between bonds and equities. At the same time, money market flows seem to be peaking, potentially a positive for risk assets.
Equities regions and sectors: Swiss bargain
Wall Street trundled back into bull market territory during June, but the move feels unconvincing. We remain cautious on equities, amid a broadly muted economic backdrop (see Asset Allocation section). But there are some segments where we see value. In addition to our overweight position in emerging market outside of Chinese equities, we raise Swiss equities to overweight from neutral.
Companies with low leverage and resilient profit margins look attractive at a time when economic growth is tepid. The Swiss market is home to many such firms. Adjusted for medium-term earnings expectations, Swiss equites trade on an abnormally low valuation (see Fig 3), which offers investors an attractive entry point.
We retain our positive stance on emerging market stocks. These markets benefit from improving monetary conditions, better economic growth prospects – both in absolute terms and relative to the developed world – and attractive valuations. As much of the developed world continues to raise interest rates in light of persistently sticky inflation, emerging economies, led by China, are once again able to ease monetary policy to stimulate growth. That’s thanks in part to relatively subdued inflationary pressures across the emerging universe.
We also raise our exposure to industrial stocks, moving them to neutral from underweight. We think the sector will benefit from growing capital expenditure, whether that’s from the green transition, national governments' desire to rebuild domestic supply chains or growing demand for automation.
Those positive long-term trends are offset in the short term by concerns over the current cycle, which while still resilient, is vulnerable to any economic downturn.
Elsewhere, we remain overweight technology and communications services – sectors that have durable profits, low leverage and good visibility on earnings growth. These stocks have also been playing catch-up with the wider market following last year’s sharp declines. At the same time, our defensive stance also favours consumer staples. We remain underweight financials and real estate - companies in both sectors will struggle to boost earnings at a time when rates are rising and the bond yield curve is inverted.
Fixed income and currencies: saved by the barbell
All roads in the fixed income market lead to the barbell strategy. With advanced economies slowing relative to their emerging market (EM) counterparts, there is a strong case for combining an overweight in mainstream government bonds with an overweight with riskier sovereign local currency EM debt.
Of all the developed markets, the US is arguably the country where we are most at ease with inflation dynamics. There, tighter monetary policy has succeeded in taming price pressures and could yet weigh on economic growth. Consequently, we expect the Fed to end its tightening campaign soon, with a hike in July likely to be its last (see Fig. 4). By year-end, we forecast that 10-year Treasury yields will come down to 3.5 per cent, if not lower. That makes current yields of around 3.8 per cent particularly compelling for a traditionally a defensive investment.
At the other end of the spectrum, we remain overweight EM local currency bonds. Inflation is easing as expected and investors stand to benefit from emerging central banks having been ahead of the curve this cycle; interest rate cuts are likely to come sooner in the emerging world than in the developed world This, and a likely appreciation of emerging currencies against the dollar, suggest EM local currency debt should do better than most other risky fixed income markets over the next several months.
Elsewhere, we are underweight Japanese government bonds – not least because we believe the country’s ultra-easy monetary policy stance is unlikely to be tenable for much longer. In our view, the Bank of Japan will soon be forced to abandon its signature yield curve control regime in the face of healthy domestic growth and inflation rates that have hit a 40-year high. (Japan is only G-10 economy where the average of PMI output and new orders is in expansionary territory).
In credit markets, our preference is for US investment grade bonds. Investors are currently able to lock in a yield in excess of 5 per cent on such securities, which is an attractive opportunity given that the balance sheets of high-quality corporate issuers remain strong and that US interest rates are unlikely to rise much higher.
Investment grade yields look particularly favourable when compared to the 8.5 per cent on offer in high yield. We believe the spread offered by non-investment grade bonds is far too low given the risk of defaults among speculative-grade issuers.
When it comes to currencies, we remain convinced that the dollar has peaked both in cyclical and secular terms. The overvaluation is significant (our models show the dollar is 20 per cent above its fair value versus a basket of currencies), US productivity growth is weak, fiscal policy is too loose and interest rate differentials are no longer supportive of the US currency.
As US rates peak, the dollar’s depreciation is likely to be particularly pronounced against low-yielding currencies, such as the Swiss franc. Gold should be another beneficiary over the medium-term, despite already stretched valuations.
Global markets overview: Riding on a AI wave
Equities enjoyed strong gains in the month, with the MSCI All-Country World Index hitting a 14-month high. Investors are increasingly confident that efforts by central banks, led by the Fed, to tame inflation are beginning to have the desired effect and that the global economy can avoid a sharp downturn.
Data showed clear evidence of moderating inflation in the US, with the May PCE price index registering its smallest year-on-year increase since April 2021 of 3.8 per cent. However, a surprise drop in initial jobless claims and strong first-quarter GDP data underscored US economic resilience, suggesting the Fed’s rate hike campaign may have to run for a little longer.
Industrials and consumer discretionary companies were the biggest gainers while energy and material stocks also fared well, thanks to fading recession worries.
IT stocks rose by more than 5 per cent in US dollar terms as a strong earnings forecast from chip company Nvidia triggered a rally. The tech-heavy Nasdaq Composite has risen by more than 30 per cent in the first half of 2023, its best performance in four decades.
Japan was the best performing equity region.
A solid economic recovery from a Covid downturn, moderately rising inflation and strong exports have combined to brighten the outlook for Japan Inc. Bank of America Global Research estimates that Japanese equity funds have seen some USD7.9 billion of inflows in the past four weeks, the most in any four-week period since April 2020.
In government bond markets, UK gilts were a weak spot after the central bank surprised markets with a larger-than-expected 50 basis point rate hike to 5 per cent.
With inflation proving persistent, investors expect interest rates to rise a further 100 bps in the next few months.
EM local currency debt outperformed its developed market peers, with a weaker dollar providing a strong boost.
Testifying to the strength of the asset class, the yield spread between JP Morgan EMBI composite and the Global Bond Index has fallen to a record low of 130 basis points, less than half of a median of 400 basis points of the past 20 years.
In currency markets, the yen fell to a record low in real terms, hitting a seven-month low beyond 145 per dollar at one point. In contrast to other central banks which have been tightening, the Bank of Japan maintained its ultra-easy monetary policy despite the country’s core CPI hit a 41-year high.
The dollar lost more than 1 per cent against major currencies after the Fed ended its run of 10 straight rate increases in June.