October Barometer of financial markets outlook

Our business cycle indicators show resilient global growth.

The US economy is expanding at its potential rate of around 2%. Our composite indicator of capital investment is rising above its long-term average since 1990, driven by non-residential investment, especially among technology companies. AI-related spending has been increasing at an annualised pace of over 20% for the past two years, with the US Federal Reserve expecting a potential AI-driven productivity boom to lift the US GDP growth rate towards 4% in the coming decades.

This more than offsets some weakness in the US housing market.

Europe's economy, meanwhile, is supported by a broadening recovery in consumption, manufacturing and trade. We see evidence that the region’s public spending on renewables, defence and infrastructure, amounting to 15% of total EU GDP, is steadily being transmitted throughout the economy. Over time, we expect this fiscal boost to help the region's growth rate approach that of the US. Our analysis shows that European fiscal spending could eventually halve the US/Europe GDP growth gap. 

Japan is one of the stronger developed-market economies, as leading indicators, including manufacturing surveys and machinery orders, point to stronger industrial activity and capital spending.

China continues to lag behind, as weak domestic demand and subdued private consumption weigh on the world’s second-largest economy.

Emerging economies outside China, however, are benefiting from resilient global trade and strong investment in technology and manufacturing supply chains.

Our liquidity analysis shows that resilient growth has given major central banks the leeway to prioritise inflation-fighting. However, we see little evidence to suggest that this is the start of a sustained global tightening cycle, given that underlying core inflation dynamics remain benign.

Our valuation models support our view that current conditions do not justify reducing equity exposure, although stretched positions and the possibility of a downward revision to what are currently high earnings expectations remain risks.

Our composite equity risk premium in the US, a measure of the excess return investors earn over a risk-free rate from holding equities, stands at 250 basis points, almost half its historical average. We see this as a material constraint on medium-term returns rather than an immediate signal to sell equities altogether. However, a further 50-basis-point rise in US 10-year bond yields or a 10-15% expansion in the S&P 500's valuation multiple would push relative valuations into territory that has historically preceded sharp market corrections.

Elsewhere, our technical indicators support our overweight stance in equities, with hedge funds expected to deploy more of their cash holdings towards the year-end.

Among sectors, we continue to favour IT, which is supported by strong earnings growth, rising AI capex and improving earnings outlooks. According to our analysis, mega-cap AI companies still account for some 41% of total global corporate profits and for two-thirds of global earnings growth. Furthermore, valuations are now more compelling: for the first time since the start of the AI boom, these companies are trading at a discount to the broader market based on 12-month forward price-to-earnings ratios (see Fig. 3).

We also see potential in financials, which are set to benefit from higher interest rates and buoyant corporate borrowing.

The outlook for consumer discretionary stocks has also improved, with inflation on track to normalise next year and the US jobs market stabilising. We therefore upgrade the sector to neutral.

Conversely, we downgrade industrials to neutral, seeking to avoid outsized exposure to the most energy-intensive and rate-sensitive parts of the economy.

We also remain cautious on consumer staples, a sector that is disadvantaged both by being overly defensive in a relatively positive investment environment and by structural headwinds stemming from shifting consumer behaviour, to which incumbents have been slow to adapt.

To further guard against unexpected changes in the Fed’s policy framework, and further geopolitical upheaval, we also remain overweight in gold.

Offering greater value to investors seeking income, however, are emerging market local-currency bonds. Contrary to expectations, and previous experience, emerging economies have proved resilient following the outbreak of the US-Iran conflict. Growth has remained healthy, supported by solid domestic consumption and strong export growth. Emerging market currencies have also been less volatile than they have previously been during energy price spikes. At the same time, yields on local-currency bonds have increased by an average of just 60 basis points, as measured by the JPMorgan GBI-EM bond index. That’s a far smaller rise than the 100-basis-point-plus spike seen in US government bond markets, a testament to the asset class’s newfound stability.

Global equities ended the month weaker as investors grew nervous that major central banks would follow the Fed in tightening monetary policy, which could weigh on growth and the outlook for corporate earnings.

Interest rate-sensitive sectors, such as real estate and utilities, were among the biggest losers, while materials and consumer discretionary, which are more exposed to economic cycles, also declined. IT and communication services bucked the trend, as the sectors' strong earnings results and forecasts encouraged investors to increase their exposure. Energy stocks ended the month broadly flat.

US stocks ended the month broadly unchanged, while other developed-market equities were down around 1%. Latin American stocks were the best performers, rising by some 0.6% thanks to strong commodity prices. Asian stocks rose 0.3%, attracting inflows into their technology and advanced manufacturing sectors.

Oil prices rose nearly 18% during the month, bringing their gain for the year to more than 70%.

The dollar rose across the board after the Fed raised interest rates. The yen gained more than 1% after a volatile month that saw the currency strengthen on signals of intervention and then retreat in response to higher US yields. The euro, sterling and Swiss franc fell by around 2% against the dollar.

^{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.}