A healthier balance: major regions see lower inflation.

At True Potential, we work with world-class fund managers across the full spectrum of asset classes and markets.  We use their insights to inform our own outlook on global markets and economies. Here, we set out the key themes that we believe are currently driving markets.

• The economic cycle has now achieved a healthier balance, with inflation materially lower in all major regions. Employment remains high in G7 countries. Although the unemployment rate has risen in the US, the UK, Canada and France, this has largely been a consequence of slower hiring rather than job losses.

• In the UK and the Eurozone, households are continuing to build up their savings. Meanwhile, US consumers are pulling back on discretionary spending, as shown by slowing retail sales. Although manufacturing data has been mixed, with growth in the UK and contractions in the US and the Eurozone, global manufacturing is still at an expansionary level, helped by strength in emerging markets.

• In the US, equity valuations and earnings outlooks continue to reflect buoyant optimism. This is largely the result of a rally in global technology stocks driven by excitement about artificial intelligence. This led to US equities returning over 15% in the first half of the year on a market-cap weighted basis. However the Technology sector experienced volatility through July as we entered the latest earnings reporting season. More broadly, corporate profit margins are expanding globally. The strongest positive momentum in corporate earnings revisions is coming from the UK and Europe.

• In both the US and the UK, inflation was slightly higher than expected throughout the second quarter. Underlying US inflation is slowing, however, albeit gradually. This situation demands patience from investors and policymakers alike. Communication from central banks on forthcoming rate cuts implies a favourable outlook for future sovereign bond returns.

• We continue to favour overweight positions in equities and high-yield bonds.

Around the world 
In this section, we set out our views on the world’s main equity markets. As US household consumption moderates, expectations for economic growth in the rest of the world are modest. Nevertheless, aggregate employment is high across the developed world, and global manufacturing data is still positive, especially in emerging markets. The recent slowdown in services data in Europe (including the UK) may be down to seasonal factors. Importantly for equities, corporate earnings revisions have turned positive and are gaining momentum.

United States 
US stock market valuations remain somewhat elevated, given expectations for earnings growth over the next 12 months. The constituents of the S&P 500 index have been trading above the 90th percentile of their historical valuation range for several months. The end of July saw a sharp sell-off in technology stocks, including the ‘Magnificent Seven’ (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla). The technology-heavy Nasdaq index registering its worst day since October 2022. This was prompted by disappointing earnings reports from Tesla and Alphabet and the perception of improving prospects for smaller companies when the Federal Reserve cuts interest rates. Nevertheless, both the S&P 500 and the S&P 500 Equal Weight indices continue to trade at full valuations by historical standards.

US Core Consumer Price Inflation (CPI) fell to 3.3% in June, the lowest reading in over 3 years. Services inflation remains elevated, at 5%, although it too continues to decline. We still expect real GDP to average close to 2%, whilst inflation is likely to take some time to fall to the 2% target. There is growing confidence that a rate-cutting cycle will start towards the end of this quarter and we continue to favour high-quality, strongly cash-generative equities.

The main risks to our outlook would be if earnings growth were to remain narrowly concentrated in the ‘Magnificent Seven’ and if housing costs were to rise in the wake of a liquidity impulse.

Rest of the world 
Improving economic data around the world continues to challenge the notion of US exceptionalism. Other countries are showing signs of improving economic health and quiescent inflation, along with an acceleration in corporate earnings upgrades. The European Central Bank began to cut interest rates in June, and although the Bank of England kept rates unchanged in July, the UK is also likely to be able to cut interest rates before the US.

In Europe, while the recovery in economic data has somewhat stalled, there is growing momentum in positive revisions to corporate earnings. Germany’s CPI has fallen steadily over the past year and stood at 2.2% in June. After the first rate cut for eight years in June, the European Central Bank kept its benchmark interest rate unchanged in July. The market currently expects three further cuts this year, however.

In the UK, the Labour Party won a landslide victory in July’s general election. Inflation figures somewhat disappointed expectations, with CPI holding steady at 2% rather than falling further. Nevertheless, the inflation rate is within the Bank of England’s target range for the first time in four years. Although there is growing expectation that the Bank of England will start cutting rates in August, there is still no certainty on this; members of the Monetary Policy Committee described the decision as “finely balanced” at its June meeting. Our preference is still to be underweight UK equities and overweight gilts.

In China, we continue to see little evidence of a sufficient growth impulse or ability to stimulate demand and combat credit challenges in the property sector. Domestic equity indices are now flat or negative through 2024, reflecting growing investor concern around the economic recovery.

In True Potential’s view, we have become more cautious on Japan. The Japanese equity market has been boosted by the Bank of Japan’s reintroduction of monetary tightening after a 17-year hiatus, as well as by strong earnings growth and a weak yen. As in the US, the strength of the equity market has left many stocks looking fully valued. A sell-off in July reflected this, along with growing concerns about the economy and the extreme weakness of the currency. Corporate profit margins continue to expand, however; a weak yen boosts the earnings of Japan’s many export-focused companies.

Valuations and asset views
Besides equities, we invest in bonds, alternatives and currencies on behalf of our clients. Here’s how we view each of the major asset classes at present. As ever, we pay particular attention to valuations.

• Although the US and Japan now look very fully valued, equity valuations generally appear fair in the rest of the world.

• We see our weighting to sovereign bonds as a potential portfolio hedge should we see a negative economic growth shock. Our preference is now for UK gilts over global sovereign bonds.

• We remain constructive in our outlook for future returns from inflation-protected sovereign bonds, given all major central banks are likely to begin cutting interest rates with inflation still above 2%.

• Alternatives are a useful source of diversification in the event of higher-than-expected inflation, which could challenge traditional assets.

• In currency markets, we do not have strong conviction given the divergent growth backdrop, the disinflation regime and the associated impact on future interest-rate differentials.

Summary
We are multi-asset investors who take a long-term view on the world’s markets. Given fuller valuations, we have grown more cautious on the US and Japan in the equity markets. Although we continue to favour UK gilts in the bond markets, we see attractions in inflation-linked securities and corporate credit, especially high yield. We remain alert to opportunities across the full span of markets and are committed to global diversification across our portfolios.

All data sourced from Bloomberg L.P. (31/07/2024)