.png)
Nvidia, the artificial intelligence industry leader, was the star of the first half of the year as it briefly joined the $3 trillion dollar club in terms of market capitalisation. As of now, just three stocks - Microsoft, Apple and NVIDIA - now account for 20% of the index, and their outsized gains have helped the S&P 500 to enjoy double-digit returns since the start of the year.
However, unlike last year’s very narrow gains, more sectors, asset classes and regions are participating in the upside.
We also note that the NYSE A-D Line keeps reaching new highs (see chart below – source: J-C Parets). The US equity bull market is not just 7 stocks. It's not just Tech either. And it's definitely not just large caps. Yes, some correction and rotation can take place from time to time. But it remains a bull market until proven otherwise. It's just a bull market... And it has been for over 2 years now.
This is a positive sign for the strength and length of the bull market. We continue to see value in diversification. So far, the benefits of AI have gone to companies developing it and providing its hardware and infrastructure. The next phase could benefit companies applying AI for productivity gains. We recommend balancing equity portfolios between growth stocks and cyclical and value-style investments.
The “equity rotation” has been accelerating recently with the come-back of the equity markets “laggards” (small-caps, value style) at the expense of Tech / growth sectors. As shown on the chart below (source: Bianco research), we just witnessed the biggest outperformance of small-cap stocks over large-cap stocks, over a 5-day period, in history (data starts in 1978).
What are the triggers for the current “size / style rotation”?
While many analysts do see it as a “Trump trade”, we tend to disagree. Since the weaker US CPI print, the market has been pricing in a dovish “Powell trade”: the dollar has been weakening and US long term bond yields are going down. The style/size rotation which has been taking place is a reflection of this.
If the market was putting on a "Trump trade", we think the exact opposite should be happening: the dollar should be strengthening and US yields should be rising (more on this in the appendix at the end of this note).
Small-caps have been the main casualties of the monetary policy tightening (as shown on the chart below – source: Goldman), a large portion of Russell 2000 debt load is floating. It thus makes a lot of sense that small caps were the most hit by monetary policy tightening / higher interest rates. Now the Street is anticipating rate cuts, small-caps underperformance might be coming to an end...
For US small caps, rates are just as important as growth since 2022. And as we know, March of 2022 was when the hiking cycle began...
Earnings dynamics are also playing a role in this size rotation (see below chart from JPM). Indeed, 2025 and 2026 look much better for US small caps earnings, relative to large caps.
On our side, we don’t necessarily play the rotation through small caps only. Indeed, we believe the change of leadership will also benefit the “Magnificent others”. These are firms that have sound balance sheets, consistent earning streams, and significant growth potential, but have not yet been rewarded by investors.
Companies like these can be found across sectors and industries, including value segments and non-US markets.
Market volatility has remained subdued so far in 2024. But the outlook for the remainder of the year is less certain. For instance, elections tend to be associated with a perceived risk of greater public sector instability and often trigger a pick-up in volatility (see chart below – source: BofA).
EQUITIES
We remain overall neutral on equities on the backdrop of a muted macro environment, relatively elevated valuation, low volatility, and high concentration as, since the beginning of the year, the US market has been boosted by the mega capitalization stocks.
Lately, however, volatility is returning with significant rotation amongst sectors and styles triggered by the looming interest rate cut by the Fed, as well as the higher odds of a Trump election in November. The outlook of lower interest rates is causing some rotation into more value and smaller size companies as they are the most sensitive to interest expenses and economic activity. In addition, the rhetoric from the Trump camp is echoing in favor of more domestic oriented businesses vs the technology/semiconductor sector as he believes the production should come back to the US.
As shown below, small caps (Russell 2000) sharply outperformed the Mag 7 over the past couple of weeks.
In that context, we remain neutral equities with a tilt towards the US for its economic resilience and Europe for its slow but continuing recovery. On the other hand, we remain underexposed China as the housing market continues to pressure consumption and Japan as the external demand doesn’t offset a weak domestic consumption.
Earnings
Q2 earnings season is on and has started on a good footing with the banks and TSMC that reassured investors on the strength of the semiconductor cycle. However, these good results in the semiconductor space were offset by the negative news flow out of the US stating that more export restriction should be applied for China.
US equities are expected to continue to grow earnings at the fastest pace and with an acceleration from 11.3% to >14% EPS growth in 2025. The Mag 7 are still large contributors as the consensus expects this group to grow EPS by more than 20% in 2025, but the main acceleration is expected from the rest of the market with the S&P 500 Equal Weight to more than double the pace of EPS growth next year despite recent negative revisions.
This phenomenon is not visible in Europe, where EPS growth is quite similar across the size spectrum, but the earnings acceleration is also visible from a mid-single digit EPS growth this year to more than 10% next year.
Switzerland and Japan estimate revisions benefitted from a weaker currency.
The Mag 7 stocks remain large EPS growth contributors albeit the expected EPS growth rate is slowing from 34% this year to 21% next year. Tesla is the only exception due to a sharp EPS contraction in 2024 that is expected to normalize in 2025.
Valuation
Valuation is contrasted across regions with higher than historical multiples in the US and Europe, reflecting the acceleration in earnings growth in 2025. This is also the reason of our neutral stance as expectations are relatively high in both earnings and valuation.
However, valuation is cheaper as we go down the size spectrum, both in the US and Europe.
FIXED INCOME
Our fixed income strategy remains close to neutral but with a slightly negative tilt overall. We hold a cautious stance, influenced by mixed market signals. While we are wary of long-duration bonds and certain credit sectors, we see potential opportunities in short and intermediate government bonds. Our position on Investment Grade (IG) credit is neutral, while we are more reserved about High Yield (HY) and USD-denominated Emerging Market (EM) debt.
Government Bonds
We have a cautiously optimistic outlook on government bonds with maturities under 10 years, expecting favorable conditions for yield improvements by the end of the year. This view is supported by several key factors:
- Economic Stability: The US economy is showing signs of normalization, with inflation rates gradually declining despite occasional volatility.
- Monetary and Fiscal Policies: Efforts by the Federal Reserve and US Treasury, such as easing quantitative tightening and enhancing liquidity in the Treasury bond market through a buyback program, are expected to stimulate demand.
- Valuation and Market Dynamics: Real rates above 2% make bonds attractive compared to equities. The market anticipates a gradual normalization process for monetary policy, with more than two years expected to reach the terminal rate.
- 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 projected for Q3/Q4 2024, we may be approaching such a favorable 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: Is a Fed Rate Cut on the Horizon Before the Elections?
Source: Syz CIO office, Bloomberg
In Europe, our stance is neutral as the European Central Bank (ECB) begins monetary policy normalization, starting with the first rate cut in June. We expect further 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 risk, with the yield spread between 10-year Italian and German bonds returning to pre-election levels of 130bps. While European wages are a concern, ECB members are confident they will normalize soon. Our outlook on UK government bonds is also neutral. The political shift following Labour's victory has not significantly impacted the gilt market, with memories of the 2022 crisis under Liz Truss prompting caution towards expansive fiscal policies. The 10-year UK Gilt yield has fallen by 7bps to 4.12%, reflecting increased investor confidence in the new government's fiscal prudence. Additionally, there is growing anticipation for an earlier start to monetary policy normalization by the Bank of England, possibly by August or September.
Chart: Market Perception of French Election Risks
Source: Syz CIO office, Bloomberg
Corporate Bonds
Our stance on investment-grade bonds remains neutral. Credit spreads have tightened significantly to their lowest levels since 2021, reducing the safety margin to just 15% of the total yield. Current market conditions are "priced to perfection," necessitating close monitoring. For the first time since 2022, there are more BBB-rated bonds with a negative outlook than those with a positive outlook. Despite these factors, the solid macroeconomic backdrop and concerns over US Treasury sustainability suggest that it might be premature to reduce credit exposure. In the high-yield sector, we see selective opportunities in short-term corporate high-yield bonds due to their favorable risk/reward profile, though we acknowledge that overall valuations in high yield are stretched, especially if volatility increases in the second half of 2024.
Chart: Breakdown of Yield in Different Fixed Income Segments
Source: Syz CIO Office, Bloomberg.
Emerging Markets
Our outlook on hard-currency EM debt is slightly negative, although we identify some attractive opportunities in bonds with up to 4-year maturities and yields above 6.5%. The strengthening US dollar and rising US real interest rates pose significant challenges, overshadowing the recent relative outperformance of this segment. Market sentiment towards EM debt has worsened, reflected by persistent negative capital flows and increased short interest in USD-denominated EM debt. Valuations are notably stretched, with EM corporate spreads at their narrowest since 2007.
Chart: Evolution of Emerging Market Corporate Spreads (bps)
Source: Syz CIO Office, Bloomberg
FOREX (view against USD)
EUR/USD (negative): Rates and macro dynamics are less negative for the EUR, but macro developments importantly also support the USD --> our rating is NEGATIVE.
CHF/USD (negative): Fundamentals no longer warrant additional CHF appreciation, and the real rate differential pleads for a firmer USD vs Swiss franc at least in the short run. In the short-term, the USD might benefit from the real interest rate differential (nominal rate - inflation rate) that has recently become more supportive for the greenback: inflation in the US is slowing while short-term nominal rates remain high, leading to rising real USD rates. As real CHF rates remain broadly stable, a higher real rate differential supports the US dollar --> our rating is NEGATIVE.
JPY/USD (from neutral to negative): It is highly likely that Japanese authorities will intervene as the JPY has been testing the 160 level against dollar. Nevertheless, there is no guarantee that intervention will prove effective. The BoJ is "trapped”: Japan is experiencing increasing inflation expectations alongside a continuous devaluation of the yen, exhibiting an almost perfectly negative correlation. This reflects the dilemma of an economy burdened by excessive debt, necessitating continuous accommodative monetary policies in the face of structural inflationary pressures. If Japan wants to slow its FX devaluation, they could raise rates. However, that would greatly increase their deficit, which the BOJ would have to monetize, and thus accelerate money supply growth.
We have decided to downgrade the view on the JPY from NEUTRAL to negative vs USD and all major currencies. While we are aware that the JPY has already lost significant ground vs most currencies, we take note of some recent economic developments that have lowered the chances of a BoJ catchup in rate hikes and of a resulting rebound in the currency.
ALTERNATIVES
We remain positive on gold, which continues to exhibit lower volatility than 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? 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 (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.
We maintain a neutral view on Hedge Funds. We like well-established Global Macro funds that have a multi-portfolio managers approach. We cautiously like Relative Value funds but are wary of liquidity conditions. We like having a core position in a diversified systematic strategy with a long-term commitment. We prefer staying away from Equity long/short and directional funds as their beta is too high. We do not like Event Driven funds as we believe the merger & arbitrage landscape will be very challenging in 2024.
