A mixed quarter for stocks and bonds
Global equities are once again being led higher by mega-cap US technology stocks, which continue to benefit from excitement about AI. Unlike in the first quarter, however, the rest of the market has not been performing nearly as well: excluding the largest tech companies, the S&P500 fell slightly in the second quarter. Government bonds also struggled as investors anticipate a slower pace of rate cuts. In the US, core inflation fell to 3.4%, the lowest level since 2021, keeping hopes of a September rate cut alive. However, US policymakers remain concerned about wage growth and price rises in some services sectors. Even though the ECB cut interest rates for the first time since the pandemic, its officials also remain wary of suggesting that rates will fall quickly. European government bond markets have also been impacted by political developments in France.
Elections on either side of Channel
The Rassemblement National (RN), won a third of the vote in the first round of the French parliamentary election. However, stock and bond markets responded positively to signs that other parties may be able to prevent the RN from forming a parliamentary majority. Ahead of the second round of voting on the 7th July, parties of the left and centre have indicated they may withdraw candidates in some seats to give each other a better chance of defeating the RN. A hung parliament is not conducive to long-term political stability, but it may mean less economic disruption in the short term. The outcome of the UK election looks far more predictable. However, the size of any Labour majority and the party’s early plans for the economy, will have implications for investors. Press reports suggest a new government may move quickly on planning reform, which could lead to more optimism about UK growth.
A blow for Biden
Joe Biden’s poor performance in the first of two scheduled TV debates gave rise to calls for him to stand aside as the Democrat’s presidential nominee. If he were to do so, a new candidate would have to be selected at the Democrat National Convention in August. For now, Biden appears to have seen off the challenge, though betting markets indicate his chances of beating Trump have fallen since the debate. This has coincided with a slight rise in US bond yields. It has been suggested that this reflects the increased probability of Trump implementing more inflationary policies, such as additional tariffs on imports and cutting taxes. Alongside the domestic implications, the path of the US election will also have a significant bearing on today’s complex geopolitics, given US involvement in wars in Ukraine and the Middle East.
Positioning
Our overall equity exposure remains in line with our long-term strategic targets. Robust corporate earnings and a peak in interest rates are supportive for the asset class. However, valuations are high relative to other asset classes and, in the case of the US, relative to history. Bond markets have been under some pressure as interest rates look set to remain “higher for longer.” With yields now at attractive levels, we remain overweight with a slight preference for shorter-dated bonds, given 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
🔵 Positive/Neutral
⚪ Neutral
🟠 Negative/Neutral
🔴 Negative
Outlook
| Economics | Interest rates are increasingly weighing on growth, with consumer demand slowing 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 a reasonable growth picture have reduced the expected number of interest rate cuts. The current market expectation of one to two US and UK rate cuts this year looks reasonable, although it’s a close call whether any materialise in the US. |
| 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 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 are bullish and market volatility is well below long term averages, but positioning is highly concentrated with market breadth at 6-month lows.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, having risen again this year. We marginally prefer shorter duration assets, which should hold up better if inflation surprises to the upside. 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 allows us to take advantage of tactical opportunities in potentially volatile markets. |
Equities
| Asset | Current positioning | Current views |
| Equities | ⚪ | We remain underweight equity in the near term, although we continue to look for opportunities to increase exposure. Corporate earnings have positively surprised to the upside in the recent reporting season. Valuations have re-rated driven by better sentiment and arguably do not reflect the risks to economic growth. Market leadership has been very narrow this year, particularly in the US which has been led by large cap technology companies. A broadening of market leadership would suggest the recovery could prove more sustainable. |
| US | ⚪ | Growth momentum is slowing, with signs that restrictive monetary policy is weighing on demand. Inflation remains above target, making it is a close call whether any rate cuts materialise this year. Market leadership is narrow, focussed on a subset of mega cap AI-related stocks. Valuations look expensive for those companies, but earnings are strong, whilst valuations outside of the mega-caps are more reasonable. |
| 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 is continuing to put pressure on the Yen. 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. 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, having risen again this year. We marginally prefer shorter maturity assets, which should hold up better if inflation surprises to the upside. 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. |
| Government bonds | ⚪ | Yields look attractive given the sizeable moves we have seen over the last couple of years, particularly given the repricing in central bank rate cut expectations year-to-date. 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, although 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 a growth or inflation shock and would benefit from US dollar weakness. Central bank buying is a positive long-term support, as is weakness in the Chinese property market, although strong recent performance 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.
