Investment Outlook July 2024

Investment Outlook
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07/2024

“Sell in May” doesn’t always pay.‍

Following the famous old stock market dictum, “Sell in May and go away,” would have been costly for equities investors this year. Those who took an early vacation missed out on some respectable gains. Contrary to typical seasonality, global stock markets have risen by almost 7 percent since the beginning of May. Granted, a brief correction in April means that equities are up around 2.6 percent for the quarter, in US dollar terms.

The US and Chinese equities markets were among those leading the charge in Q2 as they outperformed the global market; the Japanese and European markets lagged behind. Looking at the big picture, we retain the view we expressed in the previous issue of MFO Investment Outlook: We think neither extreme optimism nor outright pessimism is currently warranted. The backdrop for risk asset markets continues to be mixed, with positive cyclical developments in various economic fundamentals counterbalanced by looming uncertainties and structural challenges.

On the positive side, the general stabilization in global business climate indicators so far this year, particularly in manufacturing and external trade, continued in Q2. For the seventh month in a row, global business activity measured by the JPMorgan Global Composite PMI accelerated in May. In addition, the US economy’s remarkable resilience persisted, as mirrored in the surprisingly strong earnings season for many listed companies. The April dip in US business activity turned out to be short-lived and was followed by a strong uptick in May. What’s more, the Eurozone economy also started to perk up after its mild recession during the winter, inching back into the growth zone thanks to accelerating export demand, which partially compensated for domestic weakness. In the coming months, we think the Eurozone economies should benefit from looser financing conditions as the European Central Bank marked a shift in its policy stance and posted its first interest rate cut in June. In so doing, it joins the Swiss National Bank, which kicked off this policy pivot with a 25-basis-point rate cut in March, followed by another one in June.

However, the list of looming uncertainties and risks has not grown any shorter. Geopolitical tensions remain at their highest levels in decades, not only challenging regional and global security, but increasingly affecting global trade as well, as polarization is on the rise between the world’s three major trading blocs – the US, China and Europe. Industrial policies that subsidize domestic industries and punish imports through tariffs are now back in fashion, despite their well-known shortcomings that ultimately weaken economies and hobble trade. Whatever its flaws, global trade has been a driver of economic growth, poverty reduction and economic convergence between the world’s more and less developed regions in recent decades. However, this issue pales in comparison to the grave implications of potential further escalations in several conflict regions.  

In addition, although inflation is broadly in retreat, uncertainty also shadows the Federal Reserve’s likely imminent switch to a looser policy stance, particularly regarding the timing and the degree of this shift. The Fed has to achieve a fine balance between fighting inflation, which has proven sticky, while not acting too slowly, given the long lag between policy changes and their transmission to the real economy, all the while maintaining financial stability. This daunting task is not made any easier by America’s enormous and persistent sovereign debt levels. The US government’s debt-to-GDP ratio has climbed near to all-time high levels, even surpassing the peak after WWII, while the federal budget has notoriously posted deficits for over two decades.  

With all this in mind, we reiterate our cautiously optimistic view of risk assets. We remain fully invested in equities and abstain from tactical deviations to one direction or the other. In addition, given attractive yields, we have moved to increase the credit quality in our fixed income portfolio while shifting the allocation close to the strategic level. We maintain a minimal underweight on fixed income, though, because of potential fresh volatility flare-ups in sovereign bond yields given the prevailing economic and policy uncertainties and the eventual changes in the markets’ assessment of sovereign risk. We also keep a slight overweight in hedge fund strategies, which could profit from fresh market dispersions and volatility spikes. And we retain our allocation to gold. While we think its recent rally has likely run its course, we think gold remains a useful portfolio diversifier and safe-haven asset.

1.1 North America

  • At the beginning of 2024, GDP data indicated that economic growth had slowed year-over-year from 3.4 to 1.3 percent thanks to lower government expenditures, reduced private consumption and a negative contribution from net exports and inventories, while residential investment growth accelerated.  
  • At the same time, economic indicators signaled an increase in business activity in Q2, especially in services, as the S&P Services PMI and the ISM Services PMI surveys rose throughout the quarter. The S&P and the ISM PMIs for manufacturers sent mixed signals, however. The S&P index moved further into the growth zone while the ISM’s findings implied falling manufacturing activity in April and May.
  • Similarly, the Aruoba-Diebold-Scotti Business Conditions Index, which broadly tracks economic activity but at a higher frequency, implied that US business conditions remained in line with average levels at the end of June.
  • At the same time, despite robust domestic demand, labor market data implied that the hot labor market continued to normalize during the quarter, with the unemployment rate picking up slightly from 3.8 percent at the end of Q1 to 4.0 percent in May. Nevertheless, although the gap is shrinking, employees continue to benefit from positive net demand for labor, as vacancies still exceed the number of job seekers. These favorable conditions are mirrored in the growth of real wages, up by 0.8 percent year-over-year in May. Together with fading headwinds from high inflation, this rosy employment picture continues to support consumption.
  • All in all, the US economy continues to display remarkable resilience. While economic activity may be past its peak, the relevant indicators currently imply that GDP growth in 2024 should slow gradually towards the trend rate.  
  • At the same time, and consistent with strong demand, services price inflation has proven sticky, feeding overall consumer price inflation. The headline CPI rate is at 3.3 percent and the core rate at 3.4 percent year-over-year, clearly above the Fed’s 2-percent target, even after falling a bit more than expected in May. Therefore, the Fed unsurprisingly kept the policy rate unchanged at its June meeting while delivering a rather hawkish-sounding message, projecting just one interest rate cut for the year, after penciling in three cuts at its previous meeting in March.

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US growth remains above trend

Source: LSEG, MFO

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CPI inflation remains elevated

Source: LSEG, MFO

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1.2. Europe

  • As signaled earlier by business activity indicators, the Eurozone economy managed to return to growth in Q1, expanding by 0.3 percent over the quarter and 1 percent year-over-year. This rebound was primarily driven by faster growth in exports and a decline in imports, which counterbalanced softer domestic demand due to falling capital expenditures.
  • In the coming months, the Eurozone's export-oriented economy should continue to benefit from an improved export climate and the stabilization of the global manufacturing sector. Global export orders have slightly accelerated according to the new-export-orders sub-index of the JPMorgan Global Manufacturing PMI, with the sub-index rising above the critical 50-point mark in April after spending 25 consecutive months in contractionary territory.  
  • In addition, improving consumer confidence and, by European standards, healthy labor market conditions – with a vacancy rate near historical highs and an unemployment rate near historical lows – also support the outlook for consumption.  
  • At the same time, Eurozone economies should benefit from looser monetary conditions after the ECB cut its policy rates in June, following almost two years of tightening monetary conditions. The ECB apparently believes that inflation should return to levels consistent with price stability over the coming three years. Since the transmission of higher key interest rates has worked in recent quarters and, unlike in the US, has had a clear dampening effect on economic activity, we would expect monetary easing will also produce palpable results and support economic activity.
  • As is the case in the Eurozone, the Swiss economy is also looking at stabilizing conditions and an improving export and manufacturing outlook. GDP growth in Q1 accelerated, beating expectations as it expanded by 0.5 percent over the quarter and by 0.8 percent year-over-year on the back of rising capital expenditures and accelerating household and government spending.
  • In the coming quarters, the Swiss economy looks set to benefit from looser monetary policy conditions following the SNB’s policy turnaround in March and its second rate cut in June, as well as the stabilizing economic conditions of its trading partners in Europe and Asia.

‍Export climate improves

Source: LSEG, MFO

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Not yet out of the woods but improving

Source: LSEG, MFO

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1.3. Asia and Emerging Markets

  • Our assessment of the global economic picture for EM economies hasn’t changed substantially since the previous issue of MFO Investment Outlook. Business activity continues to expand faster in the emerging economies as a group than in their developed market peers. EM economies are benefitting from cyclical improvements in global export demand and the stabilization of business activity in the manufacturing sector.
  • In addition, EMs tend to profit from favorable domestic funding conditions, while the heavyweight Asian exporters – China, Japan and India – enjoy tailwinds from the extremely depressed external values of their currencies. But these cyclical silver linings pale against the current backdrop of structural challenges and heightened geopolitical tensions.
  • As we have pointed out previously, the era of hyperglobalization in goods trade has evidently come to an end. Global trade is no longer based on multilateral rules but, increasingly, is formed by bilateral trade sanctions and retaliatory measures. Trade is further distorted by subsidies for critical industries, leading to welfare losses for both consumers and producers. The formation of geopolitical blocs is ongoing, not only focused on security issues but also on trade, capital flows, supply chains and industrial policy generally.
  • The constellation of the world’s three largest trading partners is in flux. China now not only sees its trade relations with the US under pressure after the US hastily imposed punitive tariffs on Chinese imports. The EU’s strategy to “de-risk” its supply chains has also become a growing cause for concern, a worry that was apparently justified, as the EU Commission announced provisional tariffs on Chinese electric cars in June in response to what it deems to be unfair competition from China’s government-subsidized electric car makers.
  • Consequently, trade as an engine for economic development, poverty reduction, and economic convergence is losing steam, while the capacity of the global economy to absorb shocks is being weakened, which we think will likely lead to stronger swings in business cycles.
  • At the same time, China is struggling with severe structural issues of its real economy, and also with a loss of confidence among investors, which is reflected in the evolution of its stock market. The MSCI China Index has been flat over the past ten years, which, after inflation, amounts to a loss. This anemic performance is likely to undermine the confidence of foreign investors, adding to the woes of globalized trade, and further stifling international capital flows.

China’s rates lower than peers’

Source: LSEG, MFO

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Chinese equites’ “lost decade”

Source: LSEG, MFO

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2. Financial Markets

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Source: LSEG, MFO

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Source: LSEG, MF

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2.1. Equities

  • Equities struggled at the beginning of the second quarter, with the bulk of losses coming in mid-April when Fed Chair Powell signaled that, given the recent inflation data, interest rates cuts were on hold. In addition, tensions in the Middle East fanned risk aversion in the market.  
  • However, the market’s mood picked up with the kick-off of the earnings season in the latter half of April. A full 78 percent of S&P 500 companies exceeded Q1 earnings-per-share estimates. That’s slightly above the long-term average. Earnings growth tracked near 7 percent in Q1 and would have been up double digits were it not for a big loss by Bristol Myers Squibb.  
  • That said, from another perspective, the earnings season could be seen to paint a very different picture. The mega-cap tech stocks drove all the earnings growth in the first quarter, led by Nvidia, whose earnings rose by a staggering 468 percent. If the top five tech names (Nvidia, Amazon, Meta, Google and Microsoft) were excluded, the remaining S&P 500 stocks would have seen a 1-percent year-over-year drop in earnings.
  • Given their earnings strength, the Magnificent 7 stocks again outperformed the market by a wide margin, with a return of nearly 17 percent, while global equities as measured by the MSCI World Index were up a more pedestrian 2.6 percent during the quarter. This also led to further outperformance for growth stocks. The MSCI World Growth Index ended the quarter up 6.4 percent while the MSCI World Value Index was down 1.2 percent in Q2.
  • The value of the Magnificent 7 stocks has increased sixfold over the past five years, so investors might well wonder whether these stocks are in a bubble. Looking at the fundamentals, this doesn’t seem to be the case, because earnings have also risen nearly six times since 2019. While these stocks trade at elevated multiples compared to the market, this is mostly related to their superior financial metrics. In fact, if we look at the multiple premium vs the broader market over the past few years, these stocks are currently trading below the historical average.
  • In addition, companies seem less worried about growth and inflation. The transcripts of the S&P 500 companies’ Q1 earnings calls show that the words “recession” and “inflation” were mentioned fewer times than in all the calls since Q4 2021.  
  • Hence, while stocks aren’t cheap, we don’t think they’re in bubble territory, assuming the economy holds up. In addition, market technicals continue to be supportive. We therefore maintain our neutral positioning in equities.

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Growth stocks widen their YTD lead

Source: LSEG, MFO

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Inflation and recession worries fade

Source: LSEG, MFO

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2.2 Fixed Income

  • In April, yields in western bond markets continued to rise thanks to persistent US inflation data, as inflation exceeded expectations for the third month in a row. In addition, the US Federal Reserve sounded a somewhat more hawkish tone. Consequently, bond yields rose rather quickly, which persuaded the Fed to calm the markets by announcing it planned to reduce the monthly pace of its balance sheet reduction from USD 60 to 25 billion per month, starting in June.  
  • The European Central Bank, on the other hand, met market expectations and cut its key interest rate by 0.25 percent in June, for the first time in the current policy cycle. However, as real wage growth has continued to surpass expectations in both Europe and in the US, causing worries about stickiness in underlying inflation, uncertainty around the timing of policy rate cuts by the two central banks prevails for now. The market currently prices in two interest rate cuts each by the ECB and the Fed by the end of the year.  
  • Credit risk premiums fell to new annual lows during the quarter, as measured by the iTraxx Europe and Crossover indices, but began to rise slightly from June, reaching 0.6 percent for investment grade and 3.2 percent for high yield at the end of the quarter. At the same time the three major rating agencies, S&P, Fitch and Moody's, assigned more downgrades than upgrades in Q2, in North America, Europe and Asia-ex Japan, and the ratio of down- to upgrades even rose compared to the previous quarter in Western Europe and Asia-ex Japan. This downtrend in credit quality does not justify the current high credit valuations, in our view. On a positive note, however, most issuers have been able to postpone their refinancing for several years and will therefore not have to rely on the capital market in the near future. However, if interest rates continue to be high for much longer, this would lead to significantly more defaults. Substantial declines in yields, on the other hand, would justify the current credit risk premiums, as companies will be able to refinance more favorably in the future than they can today.
  • Due to the elevated uncertainty – stretching beyond mere credit risk – we feel comfortable with our current high-quality fixed income allocation. Our overall allocation remains unchanged, close to, but slightly below, the strategic allocation.

 S&P, Moody’s Fitch downgrades per upgrade

Source: LSEG, MFO

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Credit spreads near historical lows

Source: LSEG, MFO

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2.3 Alternative Investments

Hedge funds, private markets and commodities

  • During the second quarter, hedge funds’ performance was flat, according to the HFRX Global Hedge Fund Index. While hedge funds protected capital well when risk assets sold off in April, they also did not meaningfully participate in the subsequent risk asset rally when looking at the index. Alpha on the long side remains challenging given the narrow market, and the short side was also more difficult than in Q1, with meme stocks resurfacing. Global macro funds continue to wait for a spike in volatility and largely maintain their positioning for steeper yield curves in developed markets, particularly in the US.  
  • Gold set a record high in the second quarter, with the yellow metal topping USD 2400 per ounce in May. It continues to trade with relatively low correlation to interest rates and the US dollar, highlighting that there are other factors at play, such as non-G7 countries diversifying away from the US dollar.

Currencies

  • The Swiss franc started Q2 by extending its strong depreciation trend against major currencies and then sharply appreciated from the end of May onward, presumably on the expectation of a narrowing interest-rate differential versus the Eurozone. In total, the franc gained 1.1 percent against the euro, and 0.3 percent against the US dollar over the quarter. Hence, at the end of Q2, CHF was down only 3.6 percent since its peak at the end of 2023, after having temporarily depreciated by up to 6.5 percent on a broad trade-weighted basis. Despite its temporary steep downtrend, Swiss import prices remained below 2023’s level throughout H1, while a significant overvaluation in purchasing-power-parity terms was also avoided.
  • Despite the Bank of Japan's long-awaited pivot from negative policy rates in Q2, the yen continued its downward trend against the US dollar, weakening a further 6.4 percent following a 7.3 percent decline in Q1. The Chinese renminbi slightly depreciated against USD, too, maintaining its significant undervaluation. An eventual dovish shift in monetary policy by the US Federal Reserve lingers as a potential trigger for unwinding these valuation discrepancies, although its effect on currency dynamics remains uncertain amid evolving global economic dynamics and heightened geopolitical tensions.

Gold climbs to another record high

Source: LSEG, MFO

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The yen remains a bargain

Source: LSEG, MFO

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3. Investment Views

  • Broad-based economic stabilization and the smooth deceleration of US economic activity towards its long-term trend continued in Q2. In addition, positive earnings surprises from US stocks make the market appear less extravagantly priced – albeit with significant earnings dispersion. In combination with positive market momentum and improved sentiment, this continues to persuade us to stay fully invested at our neutral strategic exposure.
  • We also have kept our fixed income allocation unchanged from the previous quarter, after having gradually increased the exposure from a maximum underweight close to the strategic allocation. We now keep a minimal underweight only, and we have increased the credit quality of our fixed income portfolio to its highest level in years.
  • The increase in our overall fixed income allocation followed the general rise in bond yields, which finally made the asset class attractive again after years of low, no, or even negative yields, helping it to regain its diversifying role in a multi-asset portfolio. After all, this feature presupposes that the yields to maturity might fall in the event of an economic or market downturn, which requires them to be high enough. The increase in credit quality followed a compression in credit spreads and worsening credit market fundamentals, mainly in the form of rising credit rating downgrades.
  • Finally, mirroring the slight fixed income underweight, we have kept our slight overweight in hedge fund strategies and gold, as they both should help to preserve assets in difficult market phases, while hedge funds further contribute to diversification thanks to their broad opportunity set. However, in the case of gold, we think the rally may have run its course for now, absent any fresh shocks that would revive a flight to safety, since the real gold price is close to its historical high and, hence, appears rather expensive right now.

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Overview

Source: MFO

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Nadja Bleuler

Chief Economist, Partner
Über MFO
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