In our H2 market outlook (“Normalisation ahead”), we highlighted 5 key themes: 1) The normalisation of global economic growth; 2) Labour market normalisation; 3) Central banks kicking off easing cycle; 4) The normalisation of the equity market leadership and 5) A pick-up in volatility.

Throughout the summer, several of these stories have taken centre stage. We see tangible signs of a slowdown in the global economy, such as the positive momentum from the beginning of the year in Europe and China fading away, and the US economy gradually cooling down, although the risk of recession remains quite low. Still in the US, recent indicators show that the labour market is cooling off but remains supportive of robust consumption growth.

With regards to central banks, the expected global rate cut cycle has started in Europe and will soon begin in the US. Rarely in recent history has a central banker (bank?) been as clear as during the last Jackson Hole Symposium: The Fed’s pivot is coming, i.e. the Federal Reserve will start to adjust its monetary policy as soon as September FOMC meeting.

The summer was also characterised by 2 market developments. First, a brief come-back of volatility. As mentioned in our August Asset Allocation Insight, global equities endured a technical correction in early August led by the unwinding of the yen carry trade and growth fears. While the spectacular spike in the VIX index (S&P 500 implied volatility) was very brief, it was a harsh reminder that market positioning is quite extended and that a market accident can take place at any time. The other market development has been the early signs of a market style and sector rotation. Indeed, the 2023 and H1 2024 market darlings – the US mega-caps tech stocks – are struggling to regain their all-time highs. Meanwhile, the equal weighted S&P 500 hits all-time highs. The trend thus remains positive while the participation is broadening, which is a positive development.

As usual, the central bankers’ symposium which took place at Jackson Hole (Wyoming) was eagerly awaited by market participants. Here’s a summary of the Fed’s Chairman Jay Powell:

1. "The time has come for Fed policy to adjust"
2. Fed "will do everything" to support a strong labour market
3. Fed does not welcome further weakening of the labour market
4. Confidence has grown that inflation is heading to 2%
5. Balance of risks to Fed mandates has changed
6. Inflation has declined significantly toward the goal

Therefore, it seems that the Fed’s pivot is just around the corner with the first rate cut to take place at next FOMC meeting.

While markets are now expecting 8 rate cuts over the next 12 months, we remain prudent with regards to how aggressively the Fed will loosen its monetary policy.

GLOBAL GROWTH

Global economic growth remains positive but at a moderate level (close to 3%). While positive, it is now at risk of slowing down due to high interest rates and geopolitical uncertainties.

The positive momentum of the beginning of the year in Europe and China is dwindling, and the US economy is gradually cooling down. Global manufacturing activity is still under pressure while services hold well across most regions. The risk of recession is low and all key economic areas are in moderate expansion in 2024, including Europe and China.

In the United States, the labour market is cooling off but remains supportive of robust consumption growth. The US labour market has been normalising and can no longer be described as tight, easing pressures on wages. However, it is still supportive for domestic consumption and keeps the US economy growing.

In the Eurozone, economic growth has settled into a soft but positive rate as service sector activity is supported by domestic demand. Manufacturing sector activity remains under strong pressure from weak external demand and high interest rates. Germany is particularly impacted by the weakness in manufacturing activity, while service-oriented economies fare better.

Switzerland’s economic activity continues to gradually recover but remains soft.

In Japan, the flap of a butterfly wing in Tokyo can cause a storm on global financial markets. The Bank of Japan has finally started the normalisation of its monetary policy with a rate hike from 0.10% to 0.25%. More rate hikes could come in the months ahead, as the BoJ is far behind the curve and economic activity has recovered from the 2023 soft patch.

China is muddling through moderate growth without significant monetary or fiscal policy support. Weak growth (around 5%), as depicted by the latest data is the price to pay for getting rid of past excesses. The real estate market’s slump continues, and the authorities have no interest in engineering a short-term economic recovery. China has its eyes on the long term and prepares for the future challenges, such as Western tariffs and a stronger domestic demand.

In other developing markets, India continues to run hot, and Brazil’s prospects are improving.

GLOBAL INFLATION

Inflation is slowing down across the board and now tends to surprise to the downside in Developed and Emerging economies. The disinflationary trend remains in place as excess demand and labour market imbalances normalise (especially in the US). With more confirmation of inflationary pressure easing, central banks will be able to adjust interest rates lower as their monetary policy is currently on the restrictive side.

Our asset allocation preferences are based on 5 indicators, including 4 macro and fundamental indicators (leading) and 1 market dynamics (coincident). The weight of the evidence suggests a neutral allocation to equities. Below we review the positive and negative factors for each of them.

Indicators review summary - our five pillars

The Macro cycle remains positive for equity markets, with recession risk being low, inflation coming down, and the central banks normalising their monetary policy.

Liquidity remains neutral as the effects of ongoing quantitative tightening are offsetting the expected loosening of rates from the Fed and other central banks.

We remain neutral on earnings growth as the momentum is positive, despite slowing down, while the margin cycle is positive for the US, although negative for EU and JP.

However, our equity valuations indicator has now moved to negative territory, as seen in the Equity section.

Regions, sectors, and styles

We remain neutral on equities on the backdrop of a resilient albeit still slowing growth environment and elevated valuation. From a regional perspective, we continue to favour US and European equities, as China continues to battle a weak internal demand and Japan economic momentum remains soft. From a sector/style perspective, we lean toward large/quality capitalisation, with a reasonable valuation as some rotation is going on with investors expecting the easing cycle to start soon by the Fed. On the other hand, we don’t see yet conditions to increase exposure to smaller capitalisations and cyclicals, which would be early signs of a reacceleration of economic growth.

Earnings

The second-quarter earnings season is now behind us and was rather reassuring, with AI/technology and the high-end consumer in the US remaining resilient. Overall, guidance provided by corporations has confirmed the outlook for 2024 earnings, with negative revisions for cyclicals and smaller caps offset by positive revisions for mega caps.

Looking ahead, we speculate that the debate will centre around: a) the pace of the earnings growth slowdown for large-cap tech, b) the sustainability of AI investment, and c) the realism of the sharp earnings acceleration.

Regarding the deceleration of earnings growth for large cap tech, it is coming from a high base (+37% YoY in 2024) to still an attractive growth of >20% for 2025 that is above the market average.

On AI, more and more investors are questioning the future return on investment from the massive investments done by large technology companies. While the concern is valid, companies like Alphabet and Meta are already benefitting from AI-driven optimisations, and most recognise the need to keep investing to avoid falling behind competitors. Nvidia’s second-quarter results makes us believe the investment cycle will likely continue into 2025. The next important milestone will be the capital expenditure (capex) guidance that large-cap tech companies, expected at the beginning of next year.

Overview

As we navigate through August, we maintain a neutral position in fixed income within our portfolios, guided by a mix of reassuring inflation data, a cooling job market, and the anticipation of upcoming Federal Reserve rate cuts. While these positive signals provide some optimism, several factors warrant caution. Ongoing supply pressures to finance the high fiscal deficit, the persistently inverted yield curve, and continued interest rate volatility suggest it's too early to adopt more bullish stance. Additionally, with a soft landing still as our base case scenario, the potential for significant long-term interest rate declines remains limited. In this context, we continue to favour the short and intermediate portions of the yield curve over long-duration bonds. We remain cautious on high yield, holding a neutral position on Investment Grade credit, while expressing more reservation toward high yield given stretched valuations—especially compared to Investment Grade credit—at this stage of the cycle. Moreover, with potential volatility on the horizon in H2 2024, we are also cautious with regards to USD-denominated Emerging Market debt, although EM local debt could present opportunities if the US dollar continues to weaken.

Government Bonds

Our outlook for government bonds with maturities under 10 years remains optimistic, as we anticipate favourable conditions for yield improvements by year-end. This perspective is supported by several key factors:

• Reassuring Inflation Data and Economic Stability: The US economy is showing signs of normalisation, with the job market cooling and inflation rates gradually declining, albeit with occasional volatility.
• Monetary Policies: Federal Reserve Chair Powell’s recent statement—"the time has come"—has paved the way for a possible rate cut at the upcoming FOMC meeting in September. Additionally, easing quantitative tightening and enhancing liquidity in the Treasury bond market (buyback program), are expected to further stimulate demand.
• Bonds as a Diversifier: Bonds are once again proving their worth as effective diversifiers in balanced portfolios, with their correlation to equities turning negative.
• Historical Trends: Historically, bonds have performed well ahead of the first rate cut, typically 2 to 4 months in advance. With the first rate cut likely in September, we are in a favourable period.

However, we remain cautious about longer-term bonds due to the inverted yield curve, negative term premiums, and ongoing rate volatility. Additional concerns include the growing US fiscal deficit and increased Treasury issuances.

Chart: Bond-Equity Correlation Turns Negative in August for the First Time in a Year!

Source: Syz CIO office, Bloomberg

In Europe, we maintain a neutral stance as the European Central Bank (ECB) initiates monetary policy normalisation, beginning with its first rate cut in June. We anticipate additional rate cuts in September and December, which could support a bull steepening of European rates. The market has largely priced in the French election outcomes as a contained, idiosyncratic risk. Indeed, we haven’t seen any contagion to other European issuers; for instance, the yield spread between 10-year Italian and German bonds returning to pre-election levels of 130bps. However, the bond market still perceives some risk, as the 10-year French real yield is near its highest level this cycle. While European wages remain a concern, the latest wage report shows promising progress, and ECB members are confident of further normalisation soon. Our outlook on UK government bonds is also neutral but close to turning positive.

We decided to adjust our view on the USD to Neutral (from Positive)

• Following the recent US economic data on inflation and employment, and the speech of Jerome Powell at Jackson Hole, we now expect the US dollar to remain broadly stable against other major currencies in the coming months. We no longer expect a stronger US dollar.
• The clear easing in inflationary pressures in the US, along with the normalisation of the labour market, now give sufficient confidence to the Fed for starting to lower its key rate. This will start in September and will likely be followed by more rate cuts in the following meetings of 2024 (November 7th and December 18th) and into 2025. Depending on labour market and inflation data, the Fed could even implement 50bp rate cuts to bring the real cash rate rapidly closer to a neutral stance.
• Up until now, the dynamism of the US economy compared to other large economic areas suggested that USD rates could have remained higher than other G7 currency rates for longer, with the rate differential possibly even widening as the ECB, the BoE or the SNB were already cutting their rates. This would have supported the US dollar.

We remain positive on gold, which continues to exhibit low volatility with other asset classes and should be a beneficiary of any tail risk event. We note that a significant gap remains between gold and real yields. Why? Because: 1) With debt sustainability having become an ever-increasing issue, the market anticipates that real interest rates cannot stay at this level for too long; 2) Investors buy gold as insurance against adverse circumstances, such as inflation, recession, etc. 3) There is heavy demand stemming from central banks, especially in emerging markets.

We are keeping a positive stance on commodities as a portfolio diversifier and protection against inflation upside, which is not our core scenario. Commodity prices are moving higher, driven by resilient US growth, geopolitical uncertainty, segmentation of global trade and AI demand for energy.

• As highlighted in our August 2024 Asset Allocation Insight, our view was that the early August market correction was driven by technical factors rather than macro and fundamentals. The unwinding of the yen carry trade was an accident waiting to happen (see our June 2022 FOCUS note “Has Japan’s central bank created a monster?”). The heavy net long positioning by CTAs, the traditional low liquidity of August and the high valuation ratios of some crowded trades (e.g. Mag 7) created the perfect “summer cocktail” for pullbacks of major global equity indices and a spectacular spike of the VIX.
• As explained in the August 2024 Asset Allocation Insight FAQ, there was no reason to panic as macro and fundamental conditions remain favourable to equity markets. Still, history shows that stock markets remain bumpy in the 4 to 6 weeks which follow a spike in the VIX.
  
  

TAA Balanced moves

We started the year with an allocation to equities which was close to our Strategic Asset Allocation (SAA). Due to market effects, the allocation has been rising progressively to OVERWEIGHT throughout the first half of the year and we didn’t sell into strength.

However, during our July Tactical Asset Allocation Committee, we decided to rebalance portfolios towards a neutral allocation to equities, which means that we effectively reduced our exposure to equities in our clients’ portfolios. We did so by rebalancing our US equity exposure towards SAA neutral point (e.g. this implied a 2% reduction in balanced accounts). Regarding Fixed Income, we also made some minor rebalancing moves within portfolios. For instance, in a balanced account we reduced the underweight of High Yield bonds, while staying slightly underweight vs our SAA across all 4 currencies (+1%). The two changes mentioned above resulted in a cash increase, typically by around +1% in balanced accounts.

As mentioned earlier, our stance on equities remains neutral but we expect market volatility to stay elevated for a while. We also note that the correlation between equities and bonds is turning negative, which improves the diversification characteristics of government bonds.

As such, the committee agreed to continue the move further toward neutral on the fixed income side, by moving the long end government bonds back to neutral while holding our equity allocation at neutral.

TACTICAL ASSET ALLOCATION (TAA) – 27.8.2024