Transcript

We see the recession fears driving recent stock market volatility as overdone. Yet, we could see more flare-ups ahead of the U.S. presidential election and diversify our exposure within U.S. equities.

1) Earnings growth broadening

U.S. corporate earnings have proven resilient even as volatility has spiked. All sectors beat market expectations for Q2 earnings. Analysts are forecasting broad-based earnings growth over the next 12 months.

We expect tech’s leadership on earnings to persist. Yet, a narrowing gap in growth between U.S. tech companies and the rest of the market suggests U.S. equity returns can broaden.

2) A resilient economy

We view extreme market reactions to weaker economic data as overdone.

Growth is moderating, as widely expected. The unemployment rate has ticked up. But that’s not because demand for workers has fallen. Rather, higher immigration is expanding the labor supply.

We get selective in AI as investors question big spending on the AI buildout by top tech companies.

We turn to energy and utilities companies providing key inputs for the AI buildout, as well as real estate and materials names tied to the infrastructure build.

We also go underweight short-term U.S. Treasuries as markets price in many more Federal Reserve rate cuts than we expect.

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U.S. recession fears and other factors have jolted markets. We could see more volatility flare-ups ahead of the U.S. presidential election. We move from a U.S. tech focus within our equity overweight, leaning further into a wider set of winners from the artificial intelligence (AI) buildout. We don’t see the Federal Reserve cutting policy rates as sharply as markets expect and go underweight U.S. short-dated Treasuries. We prefer medium-term Treasuries and quality credit.

Earnings broadening out

Past performance is not a reliable indicator of current or future results.
Notes: The chart shows the change in aggregate analyst earnings forecasts for U.S. sectors.

We see multiple factors driving market volatility: resurgent recession fears due to some softer economic data, pre-U.S. election jitters and profit-taking as investors make room for new stock issues. Yet, U.S. corporate earnings have proved resilient. All sectors beat expectations for Q2 earnings, driving broad improvement in profit margins. Overall S&P 500 earnings growth was 13% in Q2, beating the 10% consensus expectation, LSEG data shows. Analysts are forecasting broad-based earnings growth over the next 12 months – especially for sectors tied to the AI theme. See the chart. We see a narrowing gap in earnings growth between U.S. tech companies and the rest of the market – even if tech still leads the way – suggesting U.S. equity returns can broaden. We favor high-quality companies delivering consistent earnings growth and free cash flow in case volatility persists.

We still favor the AI theme yet fine-tune our exposure. In the first phase of AI now underway, investors are questioning the magnitude of AI capital spending by major tech companies and whether AI adoption can pick up. While we eye signposts to change our view, we think patience is needed as the AI buildout still has far to go. Yet, we believe the sentiment shift against these companies could weigh on valuations. So we turn to first-phase beneficiaries in energy and utilities providing key AI inputs – and real estate and resource companies tied to the buildout. Outside the U.S., we trim our overweight to Japanese equities. The drag on corporate earnings from a stronger yen and some mixed policy signals from the Bank of Japan following hotter-than-expected inflation make us less positive. But we expect corporate reforms to keep improving shareholder returns.

U.S. economy holding up

U.S. earnings growth broadening beyond early AI winners is a sign the economy is more resilient than markets are pricing. Growth is moderating, as expected. Yet, we view extreme market reactions to softening economic data as overdone. Activity is holding up versus what some sentiment data would imply. The unemployment rate has ticked up due to higher labor supply stemming from an unexpected rise in immigration, not lower demand. In the medium term, we see a shrinking labor force, large U.S. fiscal deficits and mega forces, or structural shifts, like geopolitical fragmentation all underpinning sticky inflation.

Even as inflation is falling toward the Fed’s target in the near term, higher inflation over the medium term will limit how far the Fed can cut rates, we think. Growth jitters and cooling inflation have driven 10-year yields to 15-month lows as investors have priced in more than 100 basis points of cuts by year-end and about 240 basis points of cuts over the next 12 months – implying a Fed response to a recession. That would take policy rates below our view of the neutral interest rate – the rate at which policy neither stimulates nor holds back growth. We go underweight short-dated U.S. Treasuries, looking for income elsewhere in developed markets such as short-dated euro area bonds and credit.

Our bottom line

We expand from a U.S. tech focus, leaning into a wider set of winners from the AI buildout. We trim our Japanese equity overweight. We go underweight U.S. short-dated Treasuries, preferring medium-term maturities and quality credit.

Market backdrop

U.S. stocks tumbled as recession fears and other factors shook markets. The S&P 500 suffered its largest weekly drop in 18 months. Two- and 10-year U.S. Treasury yields slid to around 3.70% as markets priced in sharp Fed rate cuts in the next 12 months. We think these recession fears are overblown, as last week’s U.S. jobs data confirmed. Job growth is slowing but is far from the layoffs that typically signal recession. Wage gains don’t suggest inflation will cool to the Fed’s 2% target, in our view.

In the U.S., August CPI data is the main release this week. Services inflation has fallen in recent months as wage inflation has eased some, thanks to a surge in immigration. Whether that labor supply shock persists will influence how much the Fed can cut interest rates, but we think market pricing of cuts is overdone, with wage inflation still too high to be consistent with overall inflation returning to 2%. We, like markets, expect the ECB to cut rates this week.