Barometer: Cautious on equities as US flip-flops on tariffs

Asset allocation: when uncertainty lingers, caution prevails

For a short while during May, President Trump distracted the markets from his rolling tariff announcements with his Big Beautiful Bill tax and spending bill. Unfortunately, his latest policy will do little to alleviate long-term economic uncertainty. Quite the opposite. For one thing, the fiscal plan will keep the US deficit running at around an annual 6.5%, which means the US government’s debt burden will continue to climb. Stagflation also remains a risk – consensus US GDP estimates have been coming down sharply during the past few months, while forecasts for inflation remain well above the US Federal Reserve’s target (see Fig. 2).

As a result, we maintain our underweight position in equities. Corporate earnings are continuing to weaken in developing economies, while there is considerable uncertainty about when they might start to pick back up again.

Equally concerning, economic weakness comes hand in hand with inflation that is persistently above central bank targets, which stops us from taking a bullish stance on bonds, especially given that the Fed is finding it hard to justify pre-emptive rate cuts. We also remain overweight cash.

Our business activity indicator for developed markets has turned up – notwithstanding signs of weakness in the US economy – while emerging markets have cooled a little albeit remaining firmly in expansion territory. The growth gap between emerging and developed markets is widening sharply (favouring emerging economies) – currently it is 2.5 percentage points, a bit above the average 2.3 percentage points since 2011, but we expect it to hit 3.5 percentage points by year end.

US economic activity is below average and short-term price pressures remain. New US import tariffs are likely to exacerbate both these negative trends, which will tie the Fed’s hands. Cutting rates pre-emptively to prevent the economy from weakening too much at a time when inflation is running well above the central bank’s 2% target runs the risk of triggering a more aggressive sell-off in long-dated Treasury bonds.

By contrast the euro zone’s economic prospects are improving. Disinflationary trends, in part driven by the weaker US dollar and cheaper energy prices, open up scope for the European Central Bank to cut rates two or three times during the rest of the year. Meanwhile, the strong Swiss franc also leaves the Swiss National Bank room to cut rates, potentially into negative territory.

In emerging markets, meanwhile, our indicators show China's GDP has been growing at above trend rates, though the trade war with the US is taking some steam out of the economy. But benefiting from plenty of fiscal headroom and ample domestic liquidity, China’s medium term economic prospects are improving, which bodes well for  other emerging nations.

Our liquidity indicators make it clear that a synchronised broad-based rate cutting cycle remains firmly in place. Of the world's 30 major central banks, 23 are easing and only 2 are tightening, and, with few exceptions, there’s little holding central banks back from easing policy further. The Bank of Japan, however, is likely to buck the trend, and we expect one further rate hike in this cycle.

Our valuation indicators suggest that bonds would look very cheap if trend growth starts to slow further.  The rebound in US equities makes other regions relatively cheap. US stocks are close to cyclically high valuations – the current price to earnings ratio is 21-times compared to an average since 1990 of 16.5-times. Our US earnings growth estimate is now close to flat and is likely to remain lacklustre in the absence of significant tax cuts or an improvement in the US economy. Analyst earnings sentiment for European stocks has recently nosedived and is now broadly in line with the US. Among sectors, healthcare looks beaten down and is now close to record relative attractiveness.

Our technical indicators register a positive signal for equities, with the trend recovering broadly across regions. At the same time we see the US dollar as modestly oversold.  

Equities regions and sectors: emerging markets stand apart

Emerging market stocks are in the ascendancy. Since the beginning of the year to the end of May, they have delivered a return of some 6% in local currency terms. That compares to just over 1% for US stocks, as measured by MSCI indices.  And there are several reasons investors should remain overweight the asset class.

First, there’s the ongoing decline in the dollar. A weak dollar has historically coincided with gains in emerging market stocks, partly because a depreciating greenback improves the relative attractiveness of assets outside the US. 

Second, emerging economies are benefiting from signs of an easing of trade tensions between the US and China. Ongoing discussions between Washington and Beijing suggest the world’s two largest economies will eventually settle on a trading arrangement that could prove favourable for emerging nations.

A third positive is China’s willingness to stimulate its economy. The fiscal and monetary support Chinese authorities have provided over the past few months has shored up industrial production, and should stimulate consumption growth lifting the overall asset class.

Ultimately, though, it is about economic outperformance. The gap in real GDP growth between emerging and developed economies has been rising in an almost uninterrupted manner since the end of 2023, and we expect it to grow to above 3 percentage points by the end of next year from just over 2 percentage points currently.

This should translate into increases in profits for emerging market companies. According to consensus analyst forecasts, corporate earnings in emerging markets will grow at a faster pace than both the US and Europe this year and next. As Fig. 3 shows, emerging market companies have seen upward earnings forecast revisions while their peers in the developed world, bar Japanese firms, have seen their profit estimates revised downwards.

We continue to hold an overweight position in Swiss equities, which we believe are shielded from the  effects of an imminent slowdown in the US economy.

The Swiss market’s distinguishing feature is that it contains a large number of companies in industries that are less sensitive to swings in the business cycle. Although healthcare firms - which form a large part of the Swiss equities indices - have been buffeted by US funding cuts and uncertainty over drugs pricing policies, they continue to deliver strong earnings - and we expect their profits to improve further in future. 

We have neutral or underweight positions in most other equity markets – we are underweight the US as we believe valuations are at odds with the country’s deteriorating economic prospects. US stocks’ price-earnings multiples look set to contract from a current level of 21 in a policy environment which is incentivising investors to reallocate more of their capital to domestic markets. 

When it comes to industry sectors, remain overweight financials, which are poised to benefit from a steeper yield curve and potential deregulation under the Trump administration. Banks and financial institutions possess healthy earnings dynamics and trade at reasonable valuations. 

Fixed income and currencies: dollar flops

President Trump’s policy flip-flops on tariffs and his deficit-boosting fiscal programme are weighing on the dollar.

The US currency has already lost 8% of its value since January as concerns intensify over policy credibility of the US government.

What is more, a simultaneous sell-off in the dollar and US Treasuries following the Liberation Day market turmoil represents a worrying phenomenon. The breakdown in the long-held relationship between the flagship US asset and its currency signals a deterioration in its haven status.

We expect the dollar to lose even more ground. Accordingly, we upgrade developed market currencies to overweight, expecting their steady appreciation in the coming months to help narrow a valuation gap against the US currency.

Our neutral stance on US Treasuries remains unchanged. The term premium – a component of US Treasury yields – has hit its highest level in over a decade, indicating that investors are demanding additional compensation to hold a long-term bond over and above the extended rate of economic growth and inflation. Even so, Treasuries should find some supported from interest rate cuts - the Fed is expected to lower rates once or twice more this year. 

A weaker dollar supports emerging market bonds. We remain overweight local currency bonds thanks to their benign domestic fundamentals, lower oil prices and high relative real rates. Our overweight in emerging market corporate bonds is based on the view that emerging economies will remain resilient, with their growth outpacing that of their developed peers. We also expect emerging market central banks, including the People’s Bank of China, to cut interest rates further to support the economy.

In credit, we maintain our overweight stance on European high yield bonds. The asset class benefits from a more attractive valuation than that of its US counterpart.

We are becoming even more enthusiastic about gold. The precious metal already enjoys strong structural demand from emerging market central banks, and it is likely to attract even more buying from investors who are keen to protect themselves from a weaker dollar, inflation risks and geopolitical uncertainty.

Global markets review: Equities bounce back

Global equities pushed higher last month, recovering their poise after April’s jitters over Trump’s tariffs.

The S&P 500 recorded its best monthly performance in over a year, and its best May since 1990 with gains in excess of 6%. This reflected strong corporate profits, with three-quarters of the companies beating first quarter earnings expectations, according to LSEG data. The S&P 500 was also lifted by rallies in IT and communication services sectors, which together make up two-fifths of the US benchmark.

Growth sectors generally performed well, and so did industrials, financials and consumer discretionary. Conversely, healthcare finished some 3% lower, with investors worried about Trump’s plans to lower prescription drug prices.

Regionally, equity gains were broad-based with every major region posting positive returns. Emerging market equities added over 3% in aggregate, boosted by a strong performance in Latin American stocks.

Euro zone stocks added nearly 6% in local currency terms as investors  responded positively to upbeat economic data. Industrial production grew by 2.2% in the first three months of the year, marking its first increase after seven quarters of contraction thanks to solid external demand, while manufacturing PMI reached its highest level since 2022. There was also some optimism that defence and other fiscal spending plans could support growth over the longer term.

In fixed income, concerns about a growing US budget deficit weighed on US Treasuries, which posted their first monthly loss of the year.

Japanese government bonds also had a tough time, with yields on long-dated paper flirting with record highs (see Fig. 5). This reflected concerns about demand for bonds at the long end of the curve. Japanese life insurance companies have already met most of the regulation-mandated requirements for holdings of such debt, while the Bank of Japan has started quantitative tightening and is thus slowly selling off its own stock of JGBs.

The dollar finished May broadly flat versus a basket of currencies,
consolidating its year-to-date losses of around 8%. Sterling scaled three -year highs versus the US currency thanks to better than expected economic data (including on retail sales) and improving trade links between the two countries.