Key highlights:
- Global growth remains resilient and the outlook is improving.
- Inflation remains a mixed picture. While pressures have eased this year, longer-term inflation risks continue to build.
- The Federal Reserve, Bank of England and European Central Bank are likely to remain patient, maintaining broadly supportive monetary conditions.
- Risk premiums are rising on sovereign bonds but credit remains attractive. We favour shorter-term, quality credit and are also finding value in emerging markets.
- The equity bull market is intact, although periods of volatility are likely and leadership is beginning to shift.
- While there are concerns that enthusiasm around AI may have run ahead of reality, we believe the trend has further to run and could deliver significant benefits for economic growth and productivity.
- The dollar is likely to continue to depreciate over the long term and sterling is also at risk.
- Gold is offering an attractive entry point and remains in a long-term bull market, as are industrial commodities.
- Geopolitics, the ‘changing world’ and ‘fracturing global economy’ will be powerful influences on the global economy, financial markets, capital flows and policy makers for years to come.
- Investors should be mindful of risks including higher inflation, rising bond yields, AI-related disappointment and new geopolitical shocks.
- The macro background is changeable and provides both risks and opportunities.
Global growth remains resilient
The global economic and market backdrop remains supportive, and in many respects the outlook has improved over recent weeks. Energy prices have fallen significantly, oil and gas flows through the Strait of Hormuz have resumed and government bond yields have retreated. Lower energy costs should help support economic growth by easing inflation pressures, strengthening consumer spending and supporting corporate profitability.
Importantly, the global economy entered the Iran conflict from a position of strength. While stronger growth may create some longer-term inflation pressures, central banks are unlikely to rush into policy changes and should remain broadly supportive of economic growth in the months ahead.
This remains a supportive backdrop for risk assets and equities, in particular.
Despite two wars, their energy shocks and trade tensions, the global economy has continued to grow since the pandemic, demonstrating remarkable resilience. This is thanks to a number of supportive factors including a resilient US economy, an AI-related investment boom, expansionary fiscal policies and modestly accommodative monetary policies in all of the major economies. Recent economic data points to strengthening activity with a broad pick-up in global trade and manufacturing and US consumer confidence, with the three major economies (US, China and Europe) all firming.
Assuming the war is over and the Strait of Hormuz re-opens as expected, lower energy prices and improving business and consumer confidence will also boost activity. Indeed, it is possible that we experience a global growth boom over the next year or so, with nominal growth in the US and G7 economies particularly strong. One of the long-term consequences of the fracturing world, as demonstrated by the Iran war, is the likelihood of higher government spending on areas such as defence, energy security and infrastructure for many years to come. Hence, fiscal policy will need to be expansionary moving forward and central banks will be forced to keep monetary policy relatively loose given the rising levels of global debt.
Inflation pressures are building
Inflation is likely to be a bigger issue for investors and policy makers as longer-term pressures are clearly building. The strong growth outlook as described above is clearly a contributory factor to rising inflation expectations but there are a number of other factors at play. For example, many businesses continue to enjoy strong profitability and have largely been able to pass higher costs on to customers without too much difficulty.
Also, after a long period of China exporting deflation through price cutting and a depreciating currency, this has reversed and Chinese export prices are rising at the same time as the yuan is appreciating. Although the AI-related capex boom underway in the US is boosting productivity and might be disinflationary longer term, it is clear that the prices of tech hardware and software are rising. In addition, the resultant spend on infrastructure and data centres is pushing up the cost of labour and other input costs for the construction and related sectors.
Over the next few months, inflation could surprise on the downside thanks largely to lower energy and commodity prices post the opening of the Strait of Hormuz. In the US specifically, easing wage pressures, a weaker property market and a stronger dollar are also helpful. Central banks will likely remain patient as they assess the longer-term threat to inflation, recognising that monetary policy cannot solve every inflation challenge, particularly those caused by supply shortages or geopolitical events. The only effective remedy is time, which allows production and demand to adjust and supply disruptions to dissipate.
Interest rate expectations have shifted materially over recent months, mainly due to the war, and markets are currently anticipating one interest rate rise in the US, UK and Europe over the next 12 months. We think it more likely that rates will remain at current levels for the next few months and that the Federal Reserve (“Fed”), under the new leadership of Chair Warsh, might even cut rates later in the year as inflation eases and the Fed adjusts its monetary policy approach. However, further out, central banks will face a more challenging period if inflation proves to be more volatile and starts to consistently move higher, as expected.
Equities remain well supported
Equity markets have been resilient and strong over the past year or so and this is largely due to the strength of the global economy, excitement around AI, and impressive earnings growth. Indeed, stocks are benefiting from rising margins and strong earnings expansion across most sectors and markets with analysts revising up their forecasts for the rest of this year and next. The sources of this surge in profitability are an outsized demand for computing power as AI technology proliferates, the ability of corporations to capture an increasing share of productivity gains, reduced leverage and resilient consumer spending.
This is a positive tailwind for equities and, if economic activity accelerates, as expected, it should further boost earnings and alleviate any valuation concerns. Some areas of the market, particularly those linked to AI, appear expensive. However, many global markets still offer attractive valuations and opportunities for long-term investors; the broader US market remains reasonable from a valuation perspective whilst many non-US markets also offer good value. Valuations will be a significant factor in long-term equity performance but can stay overvalued or undervalued for prolonged periods of time in a favourable macro environment, especially where earnings are the key driver of returns.
Other positive tailwinds for stocks include the fact that global liquidity is abundant and investor sentiment remains reasonably cautious, so there is plenty of scope for investors to increase their exposure to equities as sentiment improves. There is some concern that the pending queue of mega-cap IPOs and fund raisings, including SpaceX and Anthropic, will be negative for the market. Whilst there is some merit to this, the total monies raised should easily be digestible given the elevated liquidity levels and the fact that US companies annually return to shareholders, through share buybacks and dividends, a multiple of this amount. In addition, market issuance in the US has generally been subdued over recent years with a resultant fall in market capitalisation.
Whilst tech has led the recent rally in equities, we appear to be in the early stages of a rotation of capital away from expensive growth stocks and out of the US into non-US markets and sectors, which are likely to benefit from the accelerating growth story and cheaper valuations, such as cyclicals, value and small cap stocks. This was one of the key features of equity markets last year and the trend appears to have resumed post the war.
A selective outlook for bonds, gold and currencies
The outlook for bonds is less straightforward than it is for equities. Sovereign bond yields have generally risen in recent years due to several reasons, including higher inflation, central banks embarking on quantitative tightening and investors demanding a higher risk premium given the likely increase in global debt, looser fiscal policies, the fracturing world and rising geopolitical risks. Yields have fallen back over the past month or so in line with falling energy prices and an easing of concerns around short-term inflation and central bank policy.
Given the macro environment and in particular, the likelihood of accelerating growth, higher inflation and even bigger fiscal deficits, sovereign bond yields will probably continue to move higher over the next few years, especially at the longer end of the maturity curve. Credit markets, on the other hand, have performed well and look attractive, despite the fact that spreads over equivalent sovereign bonds have fallen to very low levels. In view of the strong fundamental outlook for corporate balance sheets and profitability, it is not out of the question that investors perceive credit markets to be a more attractive and lower-risk investment than government bonds for a while. Select emerging market debt also looks positive, and our fixed income strategy is to focus on quality credit and short-duration issues as well as special situations.
We believe that gold remains in a long-term bull market and the recent correction may present an attractive opportunity for investors looking to increase exposure. Higher energy prices, rising bond yields and the threat of increasing inflation have been problematic for gold since the Iran war commenced and heavy selling by momentum and leveraged investors have driven prices materially lower. The new Fed chair and the current hawkish tones emanating from the Fed Board have also been a headwind. However, gold now looks to have stabilised, and the technical positioning of the market has improved, as have valuations. Meanwhile, the structural bullish forces, which include central bank buying and retail investors looking to hedge away growing risks of currency debasement, remain in place. Commodities generally look attractive against the background of improving global growth and the fracturing world.
The US dollar has strengthened recently, supported by economic resilience and geopolitical uncertainty. We think it is likely that the dollar bear market resumes in the near future as global investors continue to allocate capital away from the US due to the threat of higher inflation, a bigger fiscal deficit, rising debt levels and the weaponisation of the dollar. If the Fed proves to be more dovish than expected, which is likely, then this will add to the downside risks. The Chinese yuan, other Asian currencies and the yen are probably the long-term winners from dollar weakness and the macro backdrop. If the weaker dollar trend does re-emerge, then this will add to the global growth and reflationary impulse and is especially positive for emerging markets and commodities.
Risks, opportunities and portfolio positioning
The key risks for this bullish outlook are the threat of higher inflation, disappointment around AI and geopolitics. Equity bull markets usually end when central banks are forced to tighten policy aggressively or when the economy heads towards recession. Both of these look unlikely at this juncture, but the Fed could raise rates prematurely or seek to reduce the balance sheet too quickly and bring about a liquidity crisis. Alternatively, bond investors could force yields materially higher if they demand bigger risk premiums or if they perceive the central banks to be soft on inflation.
The debate continues around an AI bubble and how big a threat this presents. In my view, the AI infrastructure buildout has much further to run as companies race to integrate AI into their operations. Scepticism about AI is bullish, not bearish, as many clients remain worried about the sustainability of current capital spending whereas markets tend to peak when nobody questions the prevailing narrative.
Regarding geopolitics, we are certainly in a new world of elevated uncertainty and risk, but it would likely take a major escalation in the current climate or a significant new shock to have a major detrimental impact on markets or the economy.
In conclusion, we remain optimistic on the global macro and investment outlook. The equity bull market remains intact but an extended pause, correction or shakeout is possible after a strong run and given that some technical measures and valuations look a little stretched. However, it is just as likely that the market leadership changes and the rally broadens out into non-US markets and other sectors as explained above. The positive backdrop should ensure that any corrections or periods of risk-off are modest and temporary, at least until a meaningful economic or political roadblock develops, such as much higher bond yields or slowing economic growth.
In the meantime, and similarly to last year, it makes sense to increase exposure to non-US markets and more cyclical and value sectors to take advantage of the evolving macro environment. Although US equities, including tech stocks, also look attractive and it would be a risky strategy to move significantly underweight the US. We have gradually been making the appropriate changes to our portfolios over recent months and will continue to do so as we see things evolve, with a keen eye on the potential risks as always.
