Equities look more attractive

Markets continue to face uncertainty around the Strait of Hormuz and the durability of the AI trend. Nevertheless, there are sufficient mitigating circumstances and positive trends to support a positive outlook for the global economy, which remains resilient.

Firstly, reduced oil demand from Asia, alternative shipping routes and reports that some oil shipments continue to move through the strait provide investors with confidence that the global economy can handle the closure of the strait. Secondly, AI investments continue to be an important driver of economic growth in the US and are expected to surpass USD 1,000 billion next year. The benefits of that growth also appear to extend beyond hyperscalers and the IT sector. Finally, we expect economic growth to continue across all major regions for next year, while the Federal Reserve (Fed) is unlikely to raise interest rates in the foreseeable future. Together, these factors offer investors a favourable backdrop.

The outlook for equities has become increasingly favourable as the summer has progressed. The macroeconomic backdrop has remained strong, and this earnings season has reinforced confidence in the AI theme. Importantly, we are now seeing the first evidence of AI monetisation, as companies increasingly demonstrate that AI and cloud investments will contribute to higher profits. Although the earnings growth expectations were already high, companies exceeded forecasts and also provided strong forward guidance.

Additionally, we see a bullish broadening of the market where the uptrend is not just in mega-cap stocks but also extending to the rest of the market. Therefore, we are increasing our equity position from neutral to overweight.

Our decision to move to overweight in emerging markets also means we are reducing our position in developed markets from neutral to underweight. Within developed markets, we keep our preference for North America over Europe as North America provides the most attractive combination of earnings momentum, broader AI participation and supportive macro indicators.

We are also increasing our position in the IT sector from neutral to overweight. The earnings outlook for the sector was already good, but is improving even more, and the recent correction in semiconductor stocks has improved valuations. At the same time, demand for compute power and semiconductors continues to exceed supply. The sector could also benefit from a rebound in software stocks which have underperformed the market so far this year. Valuations of software stocks are supportive, while software companies are likely to be among the largest beneficiaries of AI deployments.

Finally, we are decreasing our position in consumer staples from neutral to underweight. Earnings growth in the sector is one of the weakest across the market, and it faces potential headwinds such as rising agricultural prices.

In summary, we are raising our equity allocation from neutral to overweight. Regionally, we now favour emerging markets over developed markets. At the sector level, we are overweight IT and industrials, while underweight consumer staples and real estate.

Bond investors have faced rising yields in recent months due to several factors. Sticky inflation, high budget deficits, and debt issuance linked to AI investment are increasing bond supply while dampening demand. Higher yields not only increase borrowing costs for both governments and companies, at certain levels they also become a headwind for equities. For now, we don’t believe this is the case, but this is why the recent developments are important to monitor.

The US Treasury Department conducted a joint Japanese yen intervention and announced purchases of long-dated US Treasuries to counter rising yields. While such measures could help ease pressure on borrowing costs, both the intervention and the buybacks were relatively small and is lacking the ‘firepower’ to materially change market sentiment.

Nevertheless, we believe that the global economy is sufficiently resilient to absorb the recent yield increases. Real rates, the nominal rate whereby inflation is deducted, are still at low levels both in Europe and the US. We also expect inflation to gradually decrease and yields to decline. We continue to believe that high-quality corporate bonds are more attractive than government bonds in the current environment, as they offer a high level of creditworthiness alongside more attractive yields.

A strong earnings season and continued macroeconomic resilience support a more optimistic outlook for equities. Meanwhile, the strength of the AI theme provides additional support for emerging markets and the IT sector. Therefore, we raise our position in equities, emerging markets, and the IT sector to overweight from neutral while lowering our positions in developed markets and consumer staples from neutral to underweight. In fixed income, we continue to prefer high-quality corporate bonds. We also maintain our allocation to gold, which continues to provide portfolio diversification, while benefiting from structural tailwinds.

Richard de Groot
Chair Global Investment Committee