While the global political environment looks ever more uncertain, equity markets are at all-time highs and volatility recently hit a post-Covid low. How do we explain this? In our view, the answer lies in expectations of growth and inflation. Since last October, confidence in a soft landing has been rising, with inflation and interest rates having peaked. Despite the fact that the scale of expected rate cuts has diminished considerably since then, this matters less for equities than bonds. The latest positive earnings season, relative to expectations and a pattern of rising earnings' sentiment across developed markets have been of further support.

In general, if the economy and profits are growing and the cost of capital is moderating, it is likely that equities will rise. We are now at a juncture that valuations are now arguably full, and sentiment is near but not quite euphoric. This leaves equities from here more vulnerable to disappointments, whether it be economic growth, weak labour markets or sticky inflation. Given these risks, we view diversification as paramount, not only at an asset class level, using alternatives, but also within asset classes.

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In the decade post the Global Financial Crisis, the zero interest rate environment meant that diversification generally did not boost returns and Sharpe ratios. Investors would have done better putting all their money in the US, or for that matter US technology, than spreading risk across markets and sectors. However, as the cost of capital normalises, diversification is likely to improve the Sharpe ratios of portfolios in our view.

One of the key economic data points that has evolved in recent weeks is the normalisation of the labour force. The job-workers gap has fallen back to 2019 levels, essentially suggesting that we are close to a more balanced labour market. Consensus expectations remain for a softening of the global economy through the second half of the calendar year. This suggests that any further softening in labour demand, could now result in rising unemployment as opposed to falling job openings. Whilst many market participants may consider ‘bad news to be good news’ in a market setting, as the ever present ‘Powell Put’ supports the market, we caution against being complacent.

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Current economic settings suggest we are late cycle. Whilst from an asset allocation perspective we remain fully invested in terms of our strategic asset allocation to equities, we do believe that investors should consider typical late cycle factor and style tilts such as overweight quality and defensive growth sectors. Additionally, we remain overweight mega cap technology.

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One of the key market narratives is the impact of central bank divergence given the European Central Bank (ECB), the Bank of China (BoC) and the Bank of England (BoE) have either begun cutting or are expected to cut in the near term. Sweden’s Riksbank and the Swiss National Bank (SNB), along with the ECB, have already started cutting rates, as have many emerging markets. The main channel through which policy rate divergence could impact the economic outlook is the foreign exchange channel, as lower capital flows and currency demand in countries where yields are lower may lead to currency depreciation. This depreciation would lead imported goods prices to rise in local currency terms, thereby posing upside risk to inflation that could constrain dovish policy divergence.

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In a year where over half the world’s population goes to the polls, we expect some volatility from unexpected results with the focus being on the legislative outcome and the resultant fiscal discipline. This volatility is particularly evident for Eurozone equities driven by surprise French legislative elections and renewed fears of populism and European Union exits. Whilst markets are now calming, the market is concerned over the French far-right majority government that would unwind Macron’sUnited Advisory Quarterly Newsletter – July 2024 12 market-friendly reforms. Additionally, should Marine Le Pen’s party defy expectations and achieve a parliamentary majority, it would be unlikely to push for ‘Frexit’ and would instead focus on curbing immigration.

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In the US the fiscal outcome will largely be determined by the Congressional results. To change federal tax or spending requires legislation. Under a Republican sweep, expect lower taxes and higher spending whilst a Democratic sweep will likely have higher spending and higher taxes narrowing the fiscal deficit. A split government where the party in the Whitehouse is not the same as the party controlling each of the Houses of Congress, probably implies a more muted outcome. Despite this the President can adjust tariff policy outside of Congress. The lessons from the 2018 tariffs policy can meaningfully impact growth and inflation expectations.

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The scenarios we laid out in our 2024 Outlook remain unchanged. This quarter we increased the probability to the US Soft Landing scenario versus the March quarter, with a corresponding decrease in the No Landing scenario through to the end of the year.

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