Rally back on track
Global equities are back at record highs, up 13.5% in the first nine months of the year.* US stocks continue to perform well, buoyed by the first interest rate cut from the Federal Reserve in over four years. However, it’s not just the US driving the move higher: Chinese stocks, which have lagged other markets since 2021, have jumped as investors hope that recent stimulus measures will revive economic growth. The latest leg of the equity market rally comes amid significant political and geopolitical uncertainty. The US election remains too close to call, although a rising stock market in the months before the vote has often (but not always) coincided with victory for the incumbent party. Meanwhile, the risk of a regional war in the Middle East appears to be rising, while the conflict in Ukraine may also be entering a new phase. We could see further escalation in the run-up to the election, or in its aftermath, creating short-term market volatility.
A big cut from the Federal Reserve
When the Fed has cut interest rates by half a percentage point in the past, it has tended to be when times get tough. It cut rates by 0.5% in early-2001 and late-2007, months before recessions. It did so again in March 2020, at the start of the global pandemic. Most economists expect the US to continue expanding over the coming year and many (including Schroders’) believe that inflation remains more of a threat than recession. So there was some surprise at the size of the Fed’s interest rate cut. However, after years of focusing on battling inflation, the US central bank was keen to send a strong signal that it had not forgotten the other half of its mandate: maximum employment. Since the decision, Fed chair Jerome Powell has suggested that subsequent rate cuts will be in quarter point steps, perhaps better reflecting the relatively benign economic reality.
China’s stimulus sparks stock market optimism
Over the summer, a larger-than-expected rate hike from the Bank of Japan prompted panicked selling in the country’s previously booming stock market. We have seen the near reverse in China. A central bank-led stimulus package has resulted in a stock market surge as investors rush back into an unloved market. The PBOC may well have been waiting for the Fed’s rate cut before announcing its plans, which were also designed to exceed expectations. In an unusually wide-ranging set of measures, China’s central bank cut its main policy rate, lowered bank reserve requirements and launched new financing facilities to support stock markets. However, the response in other markets exposed to Chinese activity – such as commodities or luxury goods companies – has been less dramatic. This suggests there is still some doubt about whether the stimulus package will sustainably boost growth or if further fiscal measures are needed.
Positioning
Our overall equity exposure remains broadly in line with our long-term strategic target. Global growth remains relatively healthy and should be supported by the shift to more supportive monetary policy in the US, China 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 preference for shorter-dated bonds, given uncertainty around the pace and extent of interest rate cuts, especially in the US. 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. However, we still like some alternative assets and have benefited from this year’s rally in gold and other commodities.
*Market data from LSEG Workspace, in GBP terms
Key
🟢 Positive
🔵 Positive/Neutral
⚪ Neutral
🟠 Negative/Neutral
🔴 Negative
Outlook
| Economics | Interest rates have been declining, which should be supportive for growth. A soft-landing (falling inflation and resilient growth) remains likely in the near-term. Significant household wealth and positive real wage growth should be supportive for consumers.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 softened but remain tight, particularly in the UK and Europe, adding potential pressure to wage inflation.A combination of soft inflation and growth concerns caused markets to price in a considerable amount of rate cuts this year, however central banks may fall short of these expectations to avoid reigniting inflation. |
| 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.Earnings growth estimates remain positive but are being revised down. Earnings strength is expected to broaden out beyond US mega cap growth next year.Credit spreads – the difference in yields relative to government bonds – have largely retraced August’s widening and 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 | Market breadth has widened beyond US mega cap growth, whilst volatility has risen. Consumer sentiment remains in positive territory for most developed regions but has weakened in the US in recent months due to labour market concerns. Sentiment in China remains very weak, although more stimulus measures continue to be announced.Business sentiment appears to have bottomed with most regions in positive territory, including small businesses which had been weak. However, sentiment in manufacturing sectors remains poor; data has disappointed, particularly in Europe, although demand remains supportive.Conditions remain supportive for consumers, but fears around unemployment and inflation may weigh on confidence. Improving business sentiment 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 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 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 further rates cut highly likely this year. 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 remains weak. Political risk remains elevated and may add to volatility. Given the risks, favour targeted exposure rather than broad market. |
| Japan | 🔵 | Earnings continue to be a bright spot, whilst valuations are now below historical averages. Recent yen strength has created market volatility whilst a change of Prime Minster is also adding to uncertainty, however monetary policy is still likely to normalise slowly alongside signs of sustained inflation and wage growth. Corporate governance reforms are accelerating and remain supportive. |
| Asia/ Emerging markets | ⚪ | Weak domestic consumption and troubles in the property sector have led to a deterioration in economic data. Stimulus measures have been announced, leading to an improvement in investor sentiment, although this is likely not yet sufficient to reignite consumption. Valuations remain cheap. Elsewhere, growth prospects look robust but remain highly dependent on the global cycle, whilst valuations are reasonable. |
| UK | 🔵 | The UK outlook is improving, with business and consumer confidence having picked up, but 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 are cheap, unlike most other developed markets. |
Bonds
| Asset | Current positioning | Current views |
| Bonds | 🔵 | In absolute terms, government bond yields look attractive, despite having fallen more recently. We 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 have fallen over the last few months but remain attractive relative to the last decade. 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 | 🔵 | Real yields have fallen in recent months but remain in positive territory for most developed markets. Market inflation expectations have also declined and now look low compared to our forecasts. Inflation linked bonds continue to offer a hedge against more persistent inflation within developed markets, which is a reasonable risk. |
| Emerging markets | 🔵 | Emerging market growth prospects excluding China look relatively robust compared to developed markets, whilst central banks have commenced rates 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 and trend following 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 | 🔵 | Broad 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.
