Markets quickly recover from growth scare
Global equities rose an unremarkable 0.1% in August*. Few would have expected this benign outcome earlier in the month, when the MSCI All Countries World Index fell 6% in a matter of days and Japanese stocks lost close to 20%. Since then, investors have been reassured by US economic data and the Federal Reserve’s suggestion that the “time has come” to cut US interest rates. Global equities have quickly returned towards all-time highs. While the latest bout of volatility may be over, there has been a change in market dynamic. US stocks other than the “Magnificent 7” have been performing better than the technology giants in recent weeks. This is in sharp contrast to the first half of the year, when the rest of the market struggled to keep pace with the technology sector. The sell-off has also resulted in something of a disconnect between equity and bond markets, with the latter anticipating a much sharper slowdown than the former.
How far will interest rates fall?
Since disappointing hiring figures sparked last month’s sell-off, subsequent data has painted a more positive picture of the US economy. Corporate earnings have also generally met or exceeded expectations, supporting the recovery in equities. However, bond markets are now anticipating that US interest rates will be cut by just over 2% by the end of 2025. Given that inflation remains a significant concern for the Federal Reserve, many economists view this as unlikely unless there is a more meaningful slowdown. Schroders’ economics team, for instance, expect the Fed to cut interest rates far more cautiously, with cumulative cuts of just 1 percent by the end of 2025. Cutting too far or too quickly could risk a second wave of inflation, forcing central banks to raise interest rates and destabilising both equity and bond markets.
US election too close to call
Kamala Harris has revitalised the Democrats’ prospects in November’s US election and polls suggest they have a roughly 50% chance of winning the election. From an economic perspective, a Harris victory may not significantly change the economic outlook, given her support for many of Joe Biden’s policies and the likelihood that she will have to contend with a divided Congress. A Trump victory could prompt a more significant change to the economic outlook. His focus on tax cuts and deregulation could mean growth is slightly higher than under Harris, while the promise of tariffs and anti-immigration policies could also result in higher inflation. Neither candidate has provided much reassurance on US government debt, which is on an unsustainable path. Both will be counting on the continued quiescence of the bond vigilantes.
Positioning
We took advantage of the sell-off in early August to slightly increase our global equity allocation. Our overall equity exposure remains broadly in line with our long-term strategic target. In our view, global growth remains relatively healthy, notwithstanding pockets of weakness in China and Europe, and should be supported by interest rate cuts in the US and Europe. At the same time, equity valuations remain high relative to other asset classes and, in the case of the US, relative to history. We remain overweight bonds, with a slight preference for shorter-dated bonds, given uncertainty around the pace and extent of interest rate cuts. We still like some alternative assets and have benefited from this year’s rally in gold and other commodities. However, the relative appeal of alternatives has fallen as interest rates have risen and we are now slightly underweight the asset class at a portfolio level.
*Market data from LSEG Workspace, in GBP terms
Key
🟢 Positive
🔵 Positive/Neutral
⚪ Neutral
🟠 Negative/Neutral
🔴 Negative
Outlook
| Economics | Interest rates have been declining, while growth appears to be improving. Additionally, retail sales are exhibiting a positive trend. A soft-landing (falling inflation and resilient growth) remains likely in the near-term. Reasonable job creation, significant household wealth and positive real wage growth should all be supportive.Headline inflation has fallen significantly and is close to target in the UK and Europe, but core inflation is likely to remain above central bank targets in the near term.Labour markets have started to soften but are likely to remain tight in the near term, particularly in the UK and Europe, adding pressure to wage inflation.A combination of soft inflation and growth concerns have caused markets to price in a considerable amount of rate cuts this year, however central banks may fall short of these expectations to avoid cutting too quickly. |
| Valuations | US large cap equities remain expensive based on traditional metrics, albeit cheaper than the last few months, but fundamentals are strong. Most other regions look fair value vs history, but expensive vs cash and bonds.Market earnings expectations have been positive and broadened beyond US mega cap growth.Credit spreads have widened during recent market volatility but remain tight relative to history.Government bond yields remain elevated relative to the last decade but have fallen over the last couple of months (particularly short dated) as anticipation of rate cuts grows.Valuations of both equities and credit remain vulnerable to a meaningful deterioration in corporate earnings. Investors are already rewarding companies less for earnings beats and punishing them more for misses. |
| Sentiment | Markets are starting to look beyond US mega cap technology. Breadth has risen significantly, while volatility has also picked up (but remains below long-term averages).Consumer sentiment remains in positive territory for most developed regions and close to 2-year highs in the UK and Europe. Sentiment weakened in the US in recent months but is now showing signs of improving. Sentiment in China remains weak.Business sentiment appears to have bottomed with most regions in positive territory, including small businesses which had been very weak. Sentiment in manufacturing sectors is more challenging; data has disappointed, particularly in Europe, although demand remains supportive.Improving consumer sentiment and business confidence should be supportive for markets, although the global manufacturing recovery appears to have stalled. |
| Risks | A resurgence in inflation, which would warrant continued hawkish central bank policy.Labour market weakness could challenge the developed market growth outlook.Potential spillover effects from slowing growth in China on the global economy.Escalation in geopolitical tensions, e.g. Middle East, Russia/Ukraine, US/China.Large number of elections taking place, with the US election likely to create volatility. Mounting levels of government debt, particularly in the US, pose a longer-term risk. |
Asset Classes
| Asset classes | Current positioning | Current views |
| Equities | ⚪ | We are neutral equity and have used recent market weakness as a buying opportunity. The benign growth environment coupled with falling interest rates should be supportive, however central banks may fall short of the market’s expectations to avoid cutting too quickly. Earnings have been reasonable so far this year, particularly for the US and Japan. US valuations remain expensive relative to history (albeit with strong fundamentals) whilst other regions are expensive vs bonds. |
| Bonds | 🔵 | In absolute terms, government bond yields look attractive relative to the last decade, despite having fallen more recently. We marginally prefer shorter duration assets, which should hold up better if inflation surprises to the upside. Within credit, we favour investment grade issuers, as well as asset backed securities where relative valuations are attractive given the strength of the consumer. |
| Alternatives | 🟠 | Select alternatives continue to offer diversification in a potentially volatile environment, albeit with a higher hurdle given yields available on bonds and cash. We favour assets with the ability to deliver less correlated returns to traditional markets and those which hedge against risk scenarios, such as gold and other commodities. |
| Cash | ⚪ | Although some central banks have started reducing interest rates, they remain attractive relative to recent history. Additionally, cash allows us to take advantage of tactical opportunities in potentially volatile markets. |
Equities
| Asset | Current positioning | Current views |
| Equities | ⚪ | We are neutral equity and have used recent market weakness as a buying opportunity. The benign growth environment coupled with falling interest rates should be supportive, however central banks may fall short of the market’s expectations to avoid cutting too quickly. Earnings have been reasonable so far this year, particularly for the US and Japan. US valuations remain expensive relative to history (albeit with strong fundamentals) whilst other regions are expensive vs bonds. |
| US | ⚪ | Growth momentum is slowing, with signs that restrictive monetary policy is weighing on demand. Inflation remains above target, but labour markets are showing signs of easing, making a September rate cut highly likely. Market performance has been broadening, with mega cap AI-related stocks suffering a recent pullback. Valuations still look expensive, albeit cheaper than recent months, but these companies typically have stronger fundamentals. |
| Europe | 🟠 | Weaker earnings expectations are now more consistent with the mixed economic backdrop, but forward-looking valuations have risen to slightly expensive as a result. Consumer confidence is at a two-year high (supported by a recent rate cut), but manufacturing continues to lag demand. Political risk remains elevated and may add to volatility. Given the risks, we favour targeted exposure rather than broad market. |
| Japan | 🔵 | Japanese earnings continue to be a bright spot, beating expectations and delivering growth ahead of most regions, while valuations are now below historical averages. Recent yen strength has created market volatility, however monetary policy is expected to normalise slowly alongside signs of sustained inflation and wage growth. Corporate governance reforms are accelerating and remain supportive over the medium term. |
| Asia/ Emerging markets | ⚪ | In China, falling domestic consumption and troubles in the property sector have led to a deterioration in economic data; however, investor sentiment is at lows and valuations are cheap. Elsewhere, growth prospects look more robust but remain highly dependent on the global cycle, whilst valuations also remain reasonable relative to history. |
| UK | 🔵 | The UK outlook is improving, with business and consumer confidence having picked up, however the UK Budget may weigh on future growth. Headline inflation has returned to target, but stronger demand is likely to add upward pressure to inflation. This is likely to prevent the Bank of England from cutting interest rates as far as the market currently expects. Valuations remain cheap, unlike most other developed markets. |
Bonds
| Asset | Curren positioning | Current views |
| Bonds | 🔵 | In absolute terms, government bond yields look attractive relative to the last decade, despite having fallen more recently. We marginally prefer shorter duration assets, which should hold up better if inflation surprises to the upside. Within credit, we favour investment grade issuers, as well as asset backed securities where relative valuations are attractive given the strength of the consumer. |
| Government bonds | ⚪ | Yields look attractive given the sizeable moves we have seen over the last couple of years. We prefer UK gilts given more attractive yields but remain cautious that investors are not being paid well, relative to history, to extend duration in the US or Europe. |
| Credit | 🟠 | Absolute yields continue to look attractive, but spreads are less supportive at current levels. We prefer shorter-duration and higher-quality (investment grade) corporate credit, as well as higher quality asset backed securities where we feel relative valuations are attractive given the strength of the consumer. |
| Inflation-linked | 🔵 | Valuations have become more attractive in recent months and many developed market real yields remain in positive territory. Breakevens now look cheap compared to our forecasts of inflation over the medium term. Inflation linked bonds continue to offer a hedge against more persistent inflation witnessed within developed markets. |
| Emerging markets | 🔵 | Emerging market growth prospects excluding China look relatively robust compared to developed markets, whilst central banks have commenced rates cuts (although this may be challenged by the timing of US rate cuts). Valuations remain reasonable relative to other credit markets but are starting to look rich vs history. |
Alternatives and cash
| Asset | Current positioning | Current views |
| Alternatives | 🟠 | Select alternatives continue to offer diversification in a potentially volatile environment, albeit with a higher hurdle given yields available on bonds and cash. We favour assets with the ability to deliver less correlated returns to traditional markets and those which hedge against risk scenarios, such as gold and other commodities. |
| Absolute Return | 🔴 | Select opportunities in equity long/short strategies given diversification characteristics. However, government bonds are now looking more attractively valued and may provide a better source of portfolio diversification over the medium term. |
| Liquid private real assets | ⚪ | Long-dated revenue streams and income characteristics remain attractive in select parts of the market. We see good opportunities in renewables, digital infrastructure, specialist property and exposure to private companies. Valuations are more attractive following recent market volatility. |
| Commodities | 🔵 | Broader commodities can hedge against further disruption to energy markets, although areas of the asset class are sensitive to slowing economic growth, particularly in China. Longer term, increasing demand from energy transition could support industrial metal prices against a backdrop of tight supply. |
| Gold | 🟢 | Gold should act as a hedge against growth or inflation shocks, whilst likely benefiting from US dollar weakness and falling real yields. Central bank buying is a long-term support, as is weakness in China’s property market, but strong performance over the last year may result in temporary pullbacks. |
Terms
Spread: the difference in yield between a non-government and government fixed income security.
Duration: approximate percentage change in the price of a bond for a 1% change in yield.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
