The prospect of lower policy rates at the US Federal Reserve has given a fresh wind to equity markets. Most indices have largely made up their losses from the early August sell- off. Some are making new highs.
Most major equity markets are near to recovering the losses suffered during the summer sell-off and a few have moved beyond (see Exhibit 1). If your timing was fortunate and your holiday long enough, you could have returned from the beach to find the level of many equity indices close to where they were when you set up your Out of Office reply.
Not all indices have fully made up their losses, notably the NASDAQ 100 and MSCI Japan, but one needs to keep things in perspective. The 5% shortfall for the NASDAQ 100 still leaves it as one of the best performing markets year-to-date, with a return through August of 17%.
The gap for Japan, however, is more understandable, and perhaps more likely to last. The previous gains in the market were to a great degree a function of the prolonged weakening of the yen. This always seemed at risk from tighter monetary policy from the Bank of Japan. If anything it was surprising that the yen had not strengthened by more, and sooner.
When it finally did move, the jump was all the greater and all the more disruptive. The substantial yen carry-trade investments that had accumulated were quickly unwound, setting off more global market turmoil than had been expected.
With the US Federal Reserved (Fed) now poised to cut interest rates at its next policy meeting (on 17-18 September), perhaps by as much as 50bp, the outlook for the yen is for further gains, and hence for relative underperformance of Japanese equities.
Despite the recent extreme market volatility, earnings expectations have changed little. Most markets are forecast to show positive earnings growth this year. At the end of July, consensus estimates for earnings growth in 2024 versus 2023 were +16% for the NASDAQ 100, and +5% for the Russell Value index. Today those figures are +14% and +4%, respectively.
Forecasts for earnings growth have actually risen in some other markets (see Exhibit 2). There is thus little sign of a significant change in investors’ expectations for earnings resulting from tech company investments in artificial intelligence, nor of a recession that would weaken earnings more broadly.
Fundamentals – Growth
In our view, the balance between the fundamental and technical factors behind the sell-off was always weighted towards technical factors. The outlook we have for growth and inflation today differs little from July. Recent economic data supports that view.
Although slowing, US growth is still positive, and we see only a small risk that the slowdown goes as far as a recession. Markets have been comforted by better-than-expected housing data and the purchasing managers’ indices (PMI). While the US PMIs for manufacturing sectors are below 50, this is in keeping with the sector’s broader global weakness.
European data was mixed, as has been the case for many months. The recovery is continuing but not at as robust a pace as investors had hoped for. The services sector PMI improved meaningfully in France thanks to the boost from the Olympic Games, slightly in the UK, but declined in Germany. The manufacturing sector deteriorated in Germany, France and Spain, but improved in Italy and the UK (see Exhibit 3).
Fundamentals – Inflation
The July reading for the Fed’s preferred inflation gauge (the Personal Consumption Expenditure (PCE) Price Index), showed, as expected, no change in the benign inflation environment. The core yearly gain was 2.6%, but the month-on-month increase (at an annual rate) was just 2%, the Fed’s target. Eurozone inflation also decelerated, though it is at a higher level than in the US.
More importantly, at the Jackson Hole central banks’ symposium, Fed Chair Jerome Powell said “the time has come” to cut policy rates. The market needed little encouragement to price in around 100bp of cuts by the end of 2024.
All that glitters
Gold, which had already gained significantly this year thanks to its value as a hedge against inflation, budget deficits and geopolitical risk, has received a further boost from the weakening dollar, reflecting Fed communications about the path of policy rates.
Gold is the strongest conviction position for our multi-asset team.
Our asset class views
MULTI ASSET
- We remain slightly overweight equity, with a preference for US equities. The prospects for increased volatility lead us to focus our portfolio on core assets. We have cut our exposure to South Korean equities after the rebound following the initial August correction.
- We are slightly long duration. We have cut our long position on USD inflation-linked bonds, as well as our exposure to local currency emerging market debt. We also took profits on our underweight in Japanese sovereign bonds.
- Our conviction remains high on euro investment-grade credit, which continues to benefit from solid technical support.
- We remain overweight precious metals, and more specifically gold, which represents our strongest conviction.
FIXED INCOME
- The probability of a soft rather than hard landing in the US and Europe has increased recently. Central bankers are still data dependent and so have not provided clear visibility on the path of rate cuts. Current market pricing implies 100bp of cuts from the Federal Reserve in 2024. This has meant the yield curve is less negatively inverted and now close to being flat in the US and Germany.
- We believe that this pricing of rate cuts is too aggressive in the US. We have started to reduce our long duration positions in short maturities (two year). We prefer to focus on curve trades and still favour steepening trades until the Federal Reserve starts easing.
- The primary market in credit is extremely active. Demand is comfortably absorbing the bonds companies are offering. We favour positions benefitting from carry rather than anticipating any further spread compression.
- We are convinced that the timing for reinvesting in emerging market (EM) debt is getting closer with a first Fed cut approaching. In hard currency EM debt, we are looking to capture new opportunities across regions.
GLOBAL EQUITIES
We have a constructive view on global equities for 2024 underpinned by strong fundamentals with:
- Earnings recovery: earnings growth is set to resume in 2024 with consensus seeing double-digit earnings growth in the US market. This comes after near 0% growth in 2023 and importantly, more sectors are seeing a pick-up in EPS growth versus 2023 leading to a broadening of leadership. Indeed, the post COVID years have been characterised by desynchronisation between goods and services. We saw stark divergences in various end-markets with, for instance, a healthy recovery in air travel while rail volumes were still depressed owing in part to inventory normalisation in goods.
- Stronger economic growth: US growth strongly surprised on the upside in Q1 prompting upwards revisions to the full year number. Although growth has been slowing since, the economy is still expected to deliver around trend growth in 2024.
- This is constructive for equities, but we note that while recession risk has been reduced, geopolitical risk remains. As such we have been marginally adding to beta in our portfolio and are now slightly greater than one, and are adding to small- and mid-cap stocks. These should benefit from better economic prospects and monetary policy easing. Regionally, we prefer the US and Japan where earnings growth is stronger.
Disclaimer
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
