August Barometer of financial markets outlook

Leading indicators for business activity are above neutral across most advanced economies and emerging Asia. We expect that the volatile news flow on the Iran war will keep oil prices fluctuating for the time being, before an eventual decline. While this will put some downward pressure on global growth and lead to higher inflation in the near term, the overall impact is expected to be smaller than in 2022 given lower energy intensity and continued investment, particularly funding linked to AI and the green transition.

Non-residential investment remains the key engine for the US economy, offsetting slowing disposable income growth and softer underlying consumer fundamentals.

In Europe, economic expansion continues to be constrained by the energy shock, but business and consumer sentiment indicators have stabilised and PMIs are showing a gradual improvement across both manufacturing and services. Domestic demand has proved relatively resilient, supported by still-elevated household savings and stable employment conditions.

Some of the best macro conditions can be found in emerging markets, thanks to stronger fundamentals, positive terms of trade and reduced vulnerability to oil price shocks. This should support relative outperformance of EM assets within both government bonds and equities.

Liquidity conditions also favour emerging markets, with conditions in much of the developed world becoming less accommodative.

Faced with growing inflationary pressures, a third of the 30 major central banks tracked by our liquidity model are in tightening mode, half are on hold, and the rest are easing. We expect one more rate hike from the European Central Bank this year, and see a risk of more tightening from the US Federal Reserve.

Valuations point to a broadening out of market leadership beyond the big-name tech stocks, creating more stable foundations for a potential next leg of the equity rally. The earnings backdrop is highly supportive. With around a quarter of S&P 500 companies having already reported their second quarter earnings, 85% have beaten analyst forecasts – compared to a long-term average of 68%, according to LSEG I/B/E/S data.

The outlook is also positive, with analyst forecasts for future earnings suggesting the proportion of S&P 500 companies seeing solid earnings growth will increase (see Fig. 2).

Global bonds are broadly fairly valued – in line with our neutral allocation. Gold still looks expensive relative to its 20-year history but could be attractive as a medium-term opportunity given the potential for lower real rates in the US.

Technical indicators are also in favour of the precious metal, with signs of its recent downward trend bottoming out and inflows from both retail investors and central banks.

Flows are also supportive for global equities, with some USD 129 billion of capital invested over the last four weeks. This is largely driven by dip-buying in emerging markets and tech.

We remain optimistic on that prospect. The AI cycle – the  infrastructure build-out and huge investment from hyperscalers – continues to provide a powerful boost for earnings growth, with the benefits increasingly extending beyond a handful of technology leaders and supporting profits across a broader range of industries, from industrials to utilities and selected areas of infrastructure.

The macroeconomic backdrop is also encouraging. AI-related investment, robust employment and wage growth, and continued strength in emerging Asia are sustaining growth across major economies. At the same time, inflationary pressures remain contained, reducing the risk of monetary tightening severe enough to derail the expansion.

While market leadership is broadening, we do not want to chase the rally indiscriminately. We prefer to be selective, concentrating our overweight positions in areas where we hold the strongest conviction.

Emerging markets excluding China remain our preferred region. We have seen some localised correction in Taiwan and South Korea, which reflects a pause in AI and semiconductor leadership after a period of exceptional outperformance. Outside of these markets, growth remains resilient and inflation remains contained. We expect emerging markets to deliver the highest earnings growth in the world this year at 56%, more than double that of their developed peers.

We remain neutral on the US. According to our calculations, 70% of US earnings growth comes from AI-related mega-cap stocks, by far the highest share in the world. While this concentration creates vulnerability in case sentiment towards AI weakens, it also means that the US remains the primary beneficiary of the AI supercycle. That said, valuations are unattractive, leaving little room for disappointment.

We are also neutral on the rest of the developed markets.

Although valuations are generally more attractive than for the US, earnings momentum remains weaker and the growth outlook more uneven. Moreover, many of these markets have limited sovereignty over technologies and companies driving the AI investment cycle, leaving them less well positioned to capture its benefits.

In sectors, technology remains overweight. While some investors are questioning whether earnings forecasts can keep up with lofty expectations, companies continue to deliver surprisingly strong earnings upgrades, which in turn justify the sector’s valuation premium. We take comfort that the recent rotation took place within the technology sector, rather than being a wholesale exodus, reinforcing our constructive but selective stance.

We are also overweight industrials and utilities, both of which are  increasingly benefiting from AI-related investment. Industrials continue to gain from infrastructure spending, while utilities are exposed to rising electricity demand from data centres and AI applications. Utilities also provide a source of earnings stability within an otherwise pro-risk portfolio.

Financials are another of our top picks. A higher-for-longer interest rate environment should support banks' net interest income, while resilient economic growth and healthy corporate balance sheets limit credit losses. 

In contrast, we are underweight in consumer sectors, whose fortunes primarily depend on household spending, which points to a less compelling source of earnings growth than business investment.

Value has returned to fixed income, particularly at the long end of the curve and in real rates, following the recent rise in yields.

Much of this is a response to a more optimistic economic outlook and expectations for AI-driven productivity gains. This is especially evident in the US, where the Economic Surprise Index, a measure of how economic data compare with expectations, has reached an all-time high outside of post-recessionary recovery periods.

Markets have responded by pricing in higher long-term real interest rates. Five-year, five-year forward real rates – a gauge of where investors expect inflation-adjusted policy rates to be over the longer term – have risen in both the US and Europe.

However, even after the recent move, they remain broadly consistent with what the Federal Reserve and European Central Bank estimate their own neutral rates to be. This suggests that real rates are higher but not obviously stretched.

Stronger growth is likely to keep inflation above target for longer than expected, while elevated borrowing needs and sustained capital expenditure should continue to put pressure on long-term rates.

In this environment, the case for extending duration remains unconvincing. We do not believe valuations alone justify a more positive stance. We therefore maintain a neutral allocation to both government bonds and credit.

In currencies, we downgrade the yen to neutral from overweight. The case for holding the currency as a defensive allocation has weakened as growth expectations improve and investor risk appetite remains high.

Global bonds lost 1.2% on the month, with yields pushing higher on expectations of interest rate hikes.

Yields on 30-year developed market government debt scaled historic peaks, with US Treasury yields hitting their highest level in 20 years, on UK gilt yields in 28 years, and on German bund yields in 15 years (see Fig. 5).

The selling of US Treasuries by foreign officials continued at a steady pace of some USD 40 bn per month, according to flows data.

Gold regained some poise after four months of losses. Fund manager surveys show that investors increasingly see value in the precious metal.

The dollar lost 1.3% against a trade-weighted basket of currencies. The Japanese yen bounced back from four decade lows following joint US-Japan intervention.

^{Information, opinions and estimates contained in this document reflect a judgement at the original date of publication and are subject to risks and uncertainties that could cause actual results to differ materially from those presented herein.}