July Barometer of financial markets outlook

Asset allocation: Conditions still favourable for stocks

How high can the market go? With global equities having rallied some 26 per cent over the past eight months, that is the question investors are grappling with. 

Supporting stocks, the economic outlook remains solid as fears of sticky inflation appear to have faded.

However, this positive fundamental backdrop has to be set against two potentially negative developments. First, there’s a fraught political backdrop in Europe. Snap parliamentary elections in France appear likely to leave the country in uncharted waters, with the hard right having decisively won the first round of the two-round ballot. A second countervailing force is investor positioning in stocks, which our indicators show is extremely bullish.

For all this, we still believe the balance of risks remains in favour of remaining overweight stocks, neutral bonds and underweight in cash.

Equities regions and sectors: trimming IT

Since the start of the year, the S&P 500’s market capitalisation has increased USD5.8 trillion. Of that, USD 1.8 trillion, 31 per cent, has been down to semiconductor giant Nvidia alone. Nvidia itself is up 150 per cent over that time. All of which is beginning to make us uncomfortable, particularly about the IT sector’s vulnerabilities.

So while corporate earnings remain healthy overall, and we remain overweight equities as an asset class, we are cautious about how concentrated the market’s gains have been (see Fig. 3). We trim our position in IT, following a further 9.5 per cent gain for the sector on the month, which adds up to a 26 per cent rally for the year to date. Indeed, tech stocks appear overbought on our framework. But there are also reasons not to be underweight the sector – corporate earnings momentum remain strong, albeit largely driven by semiconductors, and there are risks that there could be a significant melt-up in these stocks, particularly if the US Federal Reserves sees fit to embrace interest rate cuts sooner than the market expects. 

Fixed income and currencies: gold not gilts

Political risk threatens to undermine some of the good inflationary news that’s been coming through. That’s most immediate in the UK and France, where general elections look to bring in this month new administrations inclined to expand government spending. At the same time, the upcoming US election is throwing up the prospect of a new Donald Trump administration.

With a Labour government likely to take over in the UK and the far right making electoral strides in France, the state of public finances are becoming a concern for investors. We downgrade UK bonds (gilts) to neutral from overweight, trimming risk ahead of the upcoming general election. True, valuation remains attractive – albeit less than last year – and market expectations are growing for the Bank of England to turn dovish after some benign inflation data. But no one is likely to soon forget the extremes of market volatility ignited by Liz Truss’ radical fiscal programme at the start of her short-lived tenure as prime minister.

Similarly, we remain neutral on euro zone bonds, though the prospect of a hung parliament in France could well mean that the ECB’s path towards easing policy isn’t derailed.

We see value in the US Treasury market particularly for inflation-linked bonds. The latest US inflation data suggests disinflation is largely on track, while long term inflation expectations remain well anchored. We are underweight Swiss bonds given their expensive valuations.

Global markets overview: Political uncertainty rattles European markets

Equities outperformed bonds in June as a soft landing for the US economy was seen as the most likely outcome following the release of benign inflation figures that kept alive the prospect of US interest rate cuts this year.

US equities were among the outperformers in the developed market in a rally led by big tech.  Tech stocks rose more than 9 per cent on the month, bringing this year’s gains to over 26 per cent. Five big tech companies - Nvidia, Alphabet, Microsoft, Meta and Amazon – have alone been responsible for more than half of the S&P 500’s 15-percent return this year.

Elsewhere, Japanese stocks gained more than 1 per cent as a combination of corporate governance improvements, accommodative monetary policy and a weak yen attracted capital inflows.

In contrast, euro zone, UK and Swiss stocks lost ground as concerns about weak growth and political uncertainty weighed on investor sentiment.

Political developments were particularly influential in bond markets. French President Emmanuel Macron’s decision to call a snap election rattled markets. The growing possibility of a victory for the country's hard right sent French government bond yields higher as investors grew concerned at the prospect of a deterioration in the country's fiscal position. The sell-off pushed French government bonds' yield spread over their German counterparts bonds to the widest since since 2017. 

Nevertheless, government bonds ended the month slightly higher. Swiss bonds rose more than 2 per cent after the Swiss National Bank cut interest rates for the second time and signalled further easing. US Treasuries rose just over 1 per cent as cooling inflation raised expectations for a 25-basis point rate cut in September.

Emerging local currency sovereign debt ended the month with a loss of over 1 per cent, weighed by a stronger dollar. Corporate bonds were moderately higher across both sides of the Atlantic with investors preferring riskier parts of the market -- emerging corporate debt and US high yield bonds ended the month up nearly 1 per cent.