Economic growth remains supportive of equity markets.

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 outlook on global markets and economies. Here, we set out the key themes that we believe are driving markets.

• Economic growth remains supportive of equity markets, however, there is a difference in trends. US economic growth is slowing as consumer demand cools from elevated levels, whilst there are tentative signs of improving economic growth in the rest of the world.
• In equity markets, valuations in the US and Japan continue to reflect optimism. An AI secular theme almost entirely drives the former. In the UK, valuations have moved from cheap closer to their long-term average. Following the unexpected French snap election, European valuations have declined.
• Earnings revisions remain positive and profit margins remain robust. Corporate revenue growth has exceeded management expectations, enabling margin expansion and (perhaps) enabling employment retention to be higher than in other cycles.
• Inflation is trending lower but remains above the Central banks’ target level of 2% and closer to 3% in the US and Europe. Headline inflation is now low enough to reassure central banks that further policy tightening is a low-probability outcome. US inflation (headline CPI) has moderated to 3.3% in May from 3.4%, meanwhile, UK inflation has fallen to 2% in June. Services inflation is high, although the very gradual disinflation trend is encouraging.
• Reflation remains the base case, with service costs elevated. In this environment, we expect real GDP to average 2%, with core CPI in a 2–4% range. This scenario can be positive for multi-asset portfolios.

Around the world

In this section, we set out our views on the World’s main equity markets. True Potential remains positive about the outlook for global growth beyond the US and continue to prefer equities to bonds. In this, we are encouraged by the global purchasing managers’ index (PMI), which remains at an expansionary level (above 50) and has shown the strongest output gains for almost two years, with further acceleration in June. True Potential remains alert to the risks of inflation ticking higher and note that equity valuations are looking increasingly full, especially in the US and Japan.

United States

After further share-price gains in June, US stocks look richly valued, with the S&P 500 index now in the 90th percentile of its historical valuation range. Importantly, the same is true for the S&P 500 Equal Weight index – so these lofty valuations aren’t confined to the ‘Magnificent Seven’ (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) and other index heavyweights.

The economic data in the US showed some modest cooling in June, which suggests the post-Covid tailwinds have ended. The evidence suggests that US household consumption is moderating. Leading economic indicators still pointed to a firm growth environment. The initial composite PMI showed that economic output was stronger than expected in June and at its highest level for 26 months.

The US Core Consumer Price Index (CPI), stripping out food and energy prices, fell in May to 3.4%, down from 3.6% in April. But the core CPI has now been above 3% for 11 months. This supports our reflationary view, in which we expect real GDP to average 2%, with core CPI in a 2–4% range. Over the next 12 months, we expect core CPI to remain in the lower half of that range. Markets have acknowledged this development, revising the number of rate cuts expected for 2024 (from six at the end of 2023 to two at present) and pushing out the timing of the first cut to September. Given the uncertainty over the timing of cuts, 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, thus pushing inflation higher.

Rest of the world

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

In Europe, economic data is still positive. European Headline CPI has fallen over the past year to 2.6%, which offered the European Central Bank room to cut its benchmark interest rate in June – the first cut for more than eight years. The market currently expects two further cuts in 2024.

In the UK, the Labour Party won a landslide victory on 4th July. After falling over the past year, the UK CPI is now at 2% – within the Bank of England’s target range for the first time in four years. Accordingly, the Bank of England is expected to begin cutting rates later this year. Most market participants expect two cuts in 2024, with the first cut to come in August. The UK has continued to surpass economic consensus estimates in June, however, the trend does appear to be rolling over.

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. The equity market continues to exhibit volatility and a lack of direction.

European and Emerging Market equity valuations are close to fair. In True Potential’s view, we have become incrementally more cautious of Japan with economic activity disappointing and evidence of negative earnings revisions. Valuations are above fair value given the strong returns over the last 18 months. Valuations in the US are rich.

Besides equities, we invest in bonds, alternatives and currencies on behalf of our clients.

• 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 on the return outcomes from Global High Yield corporate bonds given the attractive yields on offer and our positive view on nominal global growth.
• Alternatives are a useful source of diversification in the event of higher-than-expected inflation, which could challenge the returns from traditional assets.
• In currency markets, we remain neutral on sterling. This is because we still see room for the UK’s stickier inflation components (compared with the US and Europe) to impact interest-rate differentials in the future.

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 US and Japanese equity markets. We continue to favour UK gilts, 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. (03/07/2024)