Rotation in equity markets
Global equities remain close to all-time highs, but July came with some turbulence. The largest US tech stocks, which have been the key driver of markets this year, have been struggling in recent weeks: as of the end of July, the “Magnificent 7” stocks are on average down 10% from the highs of the year, but still up 34% in 2024. For now, the weakness reflects disappointment with the near-term outlook and an unwinding of a very crowded trade, rather than a loss of faith in prospects for Artificial Intelligence. Technology has not been the only large-cap sector under pressure: several big consumer-facing companies have seen their share prices fall after reporting that customers are becoming more cautious. However, there are also areas of strength in markets. Small-cap stocks, which have significantly lagged the broader market this year, have been a notable beneficiary of the flight from the largest companies. The prospect of US interest rate cuts may be particularly helpful for this segment of the market.
US and UK interest rates heading lower
After peaking at 9% in mid-2022, headline US inflation fell back to 3% last summer and then spent the best part of a year slightly above this level. It is now back at 3%, suggesting that the downward trend in US inflation may be resuming. In its latest statement, the Federal Reserved acknowledged the progress against inflation, along with signs of a slowing US employment market. Markets took this as a strong indication that the Fed will cut interest rates by 0.25% in September, and once more later in the year. However, there is a wider range of views around how far and how fast rates will fall in 2025. It’s a similar story in the UK. Lower headline inflation and softer labour markets have allowed the Bank of England to cut interest rates for the first time since March 2020. Yet it remains unclear how far rates will fall given that inflation in service sectors remains somewhat elevated.
Political focus shifts to the US
With the UK and French votes out of the way, investors can turn their attention to America’s upcoming election. There has been a lot to consider, following the attempted assassination of Donald Trump and the late change in the Democratic Party’s candidate for the presidency. While polls have moved significantly in the Democrats’ favour since Kamala Harris became the likely nominee, Trump remains marginally ahead in key swing states. As things stand, Schroders’ economics team expect that he will win the election. This could lead to stronger US growth and higher inflation, given Trump’s focus on cutting taxes and raising tariffs. However, quantifying the impact is difficult; Trump’s campaign has been light on detail and he has a mixed track record of delivering on policy commitments. Any impact is likely to be more apparent in the real economy in 2026, rather than 2025.
Positioning
Our overall equity exposure remains in line with our long-term strategic targets. The prospect of US interest rate cuts should be supportive for stock markets. However, valuations are 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 timing and pace of interest rate cuts. 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 underweight alternative assets.
Key
🟢 Positive
🔵 Positive/Neutral
⚪ Neutral
🟠 Negative/Neutral
🔴 Negative
Outlook
| Economics | Interest rates are increasingly weighing on growth, with consumer demand having slowed in the US, but 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, adding pressure to wage inflation.Sticky inflation and reasonable growth have reduced the expected number of interest rate cuts, but current expectations of two US & UK rate cuts this year look reasonable. |
| Valuations | US large cap equities remain expensive based on traditional metrics, but fundamentals are strong. Most other regions look fair value 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 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 | Market sentiment has shifted as investors are growing more negative towards US mega cap growth stocks. Breadth has risen significantly whilst 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, 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, including small businesses which had been very weak due to inflation concerns.Improving business confidence should be supportive for markets, although the mixed consumer picture may weigh on growth. |
| 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.Continued low market breadth is a risk for broad equity markets. |
Asset Classes
| Asset classes | Current positioning | Current views |
| Equities | ⚪ | We are neutral equity having increased exposure over 2023. A peak in interest 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, 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 | ⚪ | Interest rates offer more attractive returns relative to recent history, whilst cash allows us to take advantage of tactical opportunities in potentially volatile markets. |
Equities
| Asset | Current positioning | Current views |
| Equities | ⚪ | We are neutral equity having been increasing exposure over 2023. A peak in interest 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. |
| 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 likely. Market performance has been broadening, with mega cap AI-related stocks suffering a recent pullback. Valuations still look expensive, 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 2-year high (supported by a recent rate cut), but manufacturing continues to lag. Political risk is elevated and likely to cause near-term volatility. Given the risks, 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, although valuations are slightly expensive. Monetary policy is slowly normalising, alongside signs of sustained inflation and wage growth; however, the slow pace of interest rate rises has been pressuring the Yen (until recently). Corporate governance reforms are 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 remains mixed; business and consumer confidence have improved, but wage growth and services inflation remain elevated. We expect core inflation to remain above target given labour market tightness, but an easing in headline inflation should give the MPC confidence to cut rates in Q3. Valuations remain cheap, unlike most other developed markets. |
Bonds
| Asset | Curren positioning | Current views |
| Bonds | 🔵 | 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. 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.
