The US equity market is 4.7% off its recent highs (as of July 26), but remains 19% higher than 12 months ago.
Periodic equity corrections are inevitable, and it is possible the current pullback extends. With the Fed appearing set to cut rates in September, however, and seemingly no recession on the horizon, the global equity uptrend should resume. We still expect US/global equities to be higher by year end.
Macro Backdrop Remains in Line with Soft Landing
The US macro backdrop is unfolding as anticipated in our baseline scenario, characterized by softening growth and a gradual loosening of the labour market, alongside a building moderation of inflation.
Overall, aggregate GDP growth for the world economy should be around 3-3.25% for the remainder of the year, which is close to average levels. However, dispersion among the major economies will be smaller than before.
While the US looks set to slow, European growth is on track for moderate improvement, albeit off a low base. A degree of re-syncing within the world economy means that monetary policy among major central banks should move in the same direction towards coordinated easing. This is a further positive for global risk assets.
The Chinese economy will likely continue to limp along, with economic growth well below historical levels but still in positive territory. Disappointment around recent Chinese (GDP) growth has been followed by disappointment over a lack of subsequent fresh stimulus from the Third Plenum. This has prompted selling in commodities, the A$ and global cyclicals. We don’t see China’s current subdued growth rate as a genuine threat to the global economy. Trump’s protectionist policies (if elected) pose a potentially greater risk to China (and the world), but the exact shape remains uncertain.
Still Early Days for US Earnings Season
It’s too early to get a clear read on the US reporting season. Our base case is to expect moderate (high single-digit) earnings growth over the coming year. Top lines should be reasonable, aided by ongoing strength in tech spending (the US market is overweight tech versus the broader economy), while profit margins should hold up as unit labour costs remain tame. The recent US equity correction is seemingly in part due to disappointment around earnings announcements, but this is more a function of how high the bar has been set after the market’s stellar (tech-driven) run than anything overly sinister in results so far. The next two weeks will provide a clearer read on how the US corporate sector is tracking from an earnings perspective.
US Recession Still Looks Unlikely
Relative to the consensus view, we believe that the risks for both US growth and inflation are tilted at least moderately to the downside. This could create some additional volatility, but the Fed easing cycle needs to be considered as an offset to any growth jitters.
Importantly, we do not expect the Fed’s current policy stance to cause the severe economic and financial stress that usually triggers a bear market in risk assets. Signs of economic and financial stress remain relatively contained.
US recessions are almost always led by financial crises, and these crises are usually triggered by Fed monetary tightening. The 2023 regional banking crisis could have become a systemic shock, but the Fed effectively clamped down on it by promptly opening an easily accessible liquidity window. Regional banks are seemingly on the mend, with the deposit base growing again and net interest margins rising. With the Fed looking set to ease, bonds having already rallied and credit spreads remaining tight, the odds of the economy being struck by another systemic event are relatively low, in our view.
An Everything Else Rally?
The soft-landing scenario is already seemingly well reflected in the US equity market, although the concentrated nature of the rally suggests there is plenty of scope for the market advance to broaden. Rising expectations for a dovish shift by the Fed and a relatively soft landing for the economy should lend support to lagging segments of the market that have been weighed down by the Fed’s tightening cycle, as well as the unbridled build-up of excitement over AI. Underperforming quality growth stocks outside of the Magnificent 7, as well as small caps and other “value” areas of the market, all stand to benefit from this broadening out of the market advance. This rotational shift may mean that the S&P 500 struggles to make decisive headway in the second half of the year, but we would see a broader but slower advance as a fundamentally healthy development.
TRUMP 2.0 - Inflation or Deflation Risk?
Apart from a sharper-than-expected economic slowdown, a looming risk to our constructive thesis is policy uncertainty related to a second Trump presidency, should he win the November presidential election.
The extension of Trump’s 2017 tax cuts and the prospect of additional deregulation will likely support equities into and immediately after the US election. However, the enactment of his draconian tariff policy may well undo the positives, if it actually comes to pass. Trump’s proposed 60% tariff rate on Chinese imports may also just be a bargaining tactic, but a sharp rise in import duties on Chinese goods is certainly possible. Apart from the election result itself, there is still a large degree of uncertainty surrounding the timing and ultimate magnitude of such an impost. From that perspective, the market will be reluctant to act until the situation becomes clearer, but this does pose a key risk over the medium-term.
Fed Pivot Should Support Both Stocks and Bonds
We keep global equities at a neutral allocation. US valuation is still relatively full, but in the absence of economic or financial stress, pullbacks are likely to remain shallow and forthcoming monetary easing should reinvigorate market breadth. However, US tech may spend some time working off overbought conditions, which will drag on index performance.
The potential for further growth moderation, coupled with dissipating inflationary pressures, should drive at least a moderate decline. We maintain an overweight to fixed interest (and an overweight floating rate credit). Overweighting long bonds also offers investors an effective hedge against a significant downside growth surprise, relative to our base case scenario.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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