Robust earnings overshadowed by higher yields
Strong first-quarter earnings from the largest US technology companies pushed global stock markets back towards record highs late in May. Chip designer Nvidia, the third most valuable company in the world, was a standout performer after delivering another set of record results. This may have represented a near-term peak in optimism, however. The latest leg of the rally has once again been led by mega-cap technology, with results from the rest of the market doing less to justify a push to new highs. And even though the ECB is expected to cut interest rates early this month, markets are becoming slightly more concerned about the outlook for inflation and monetary policy. In the US, interest rate cuts are likely to be pushed back until later in the year, and potentially to 2025. As a result, government bond yields have risen back towards the highs of the year, putting pressure on equities. It is also still possible that the conviction of Donald Trump adds to the uncertainty around the approaching US election, even though there has not been a significant market reaction so far.
What does the election mean for UK markets?
Betting markets put the probability of a Labour majority at just over 80%, according to Schroders’ analysis the day after the election was called. This outcome should therefore not come as a huge surprise to financial markets. However, these odds still suggest a meaningful possibility of other results, such as a hung parliament, which would be more of a shock for investors. The election comes at an interesting juncture for UK equity markets, which are at the highest level in over twenty years. At the same time, valuations remain attractive, as suggested by very high levels of takeover activity. There is some speculation that a period of greater political stability following the election will tempt international and domestic investors back to UK markets. If this is the case, it is likely to play out over the medium term rather than in the immediate aftermath of the election.
A modest rebound in China
The UK is not the only stock market enjoying a slight turnaround in its fortunes this year. Chinese stocks have gained around 9% on a total return basis (based on the MSCI China Index), having ended 2023 at around half their peak level from 2021. The Chinese economy faces significant challenges, including the long-running slump in its property market and trade conflicts. However, the government is now taking more decisive measures to address the first of these issues. The central bank is setting up a RMB 300 billion ($42 billion) fund to support the purchase of unsold property for use as social housing. There is concern that the fund is not large enough. However, optimists point to the fact that this initiative has been spearheaded by the Communist Party Politburo and its scale could be increased. The key question for investors will be whether it leads to a sustainable improvement in consumer confidence. If it does, this year’s rally could have further to run.
Positioning
Our overall equity exposure is broadly in line with our long-term strategic targets. Robust corporate earnings and a probable peak in interest rates are supportive of the asset class. Valuations, by contrast, now look high relative to other asset classes and, in the case of the US, relative to history. Bond markets have been under pressure as interest rate cuts are delayed. With yields now at attractive levels, we remain overweight with a slight preference for shorter-dated bonds, given the uncertainty around the interest rate outlook. We still see appeal in alternatives 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. High levels of inflation in the UK have made meeting inflation-plus return targets more challenging in the near term. Despite this, we remain confident in the ability to meet inflation-plus targets over the longer term.
Key
🟢 Positive
⚪ Neutral
🔴 Negative
Outlook
| Economics | Interest rates are weighing on growth, but a soft-landing (falling inflation and resilient growth) looks likely in the near-term. Consumer demand remains resilient and broader financial conditions are supportive.Headline inflation has fallen significantly but core inflation is likely to remain above central bank targets in the near term, particularly in the US.Labour markets have started to soften but are likely to remain tight in the near term, adding pressure to wage inflation.Whilst sticky inflation and tight labour markets have reduced the expected number of rate cuts this year, central banks appear to be comfortable with cutting rates ahead of inflation falling back to target, if the general trend remains disinflationary. |
| Valuations | US large cap equities remain expensive based on traditional metrics, but fundamentals are strong. Most other regions look fair vs history, but expensive vs cash and bonds.Credit spreads – the difference in yields relative to government bonds – remain tight (especially in the US) although absolute yield levels remain reasonable.Government bond yields have risen significantly this year, offsetting falls in Q4, and remain elevated relative to the last decade.Valuations of both equities and credit remain vulnerable to a meaningful deterioration in corporate earnings. |
| Sentiment | Investors have become less positive over the last couple of months. Market volatility has risen from recent lows but remains well 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, however sentiment has weakened in the US due to worries about unemployment. Sentiment in China remains weak.Business sentiment appears to have bottomed with most regions moving into positive territory, although smaller businesses remain concerned about cost pressures.Improving consumer and business confidence should be supportive for markets, whilst a pullback in investor sentiment reduces the risk that markets have overstretched. |
| 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 having been increasing exposure over 2023. A peak in rates is supportive, but the risk of ‘higher for longer’ has increased due to sticky inflation. Earnings were robust in 2023 and 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/cash. |
| Bonds | 🟢 | Government bond yields look attractive relative to the last decade, having risen again this year. We marginally prefer shorter duration assets, which should hold up better if inflation surprises to the upside – as has been the case this year. We continue to prefer the credit of investment grade issuers, as well as higher quality asset backed securities where we feel 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 | ⚪ | Rising interest rates offer more attractive returns relative to recent history, whilst cash offers optionality in potentially volatile markets. |
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.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
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.
