Monthly Investment Letter: Catching up

Investors returning from summer vacations might not notice much change in financial markets over the past month. Compared to when I wrote my last Monthly Letter, global equity markets are roughly unchanged, 10-year US Treasury yields are down by around 35 basis points, and the US dollar has depreciated by around 2% against the euro.

Yet August saw both the largest one-day points fall in Japanese market history and the VIX volatility index spike to its highest level since the onset of the pandemic. This month has also seen a change in the polling around the US election. All of this raises questions about whether we are at the start of a bigger shift in the trajectory for markets, economies, politics, and interest rates.

In this letter, I’ll focus on three topics:

1. What’s changed over the past month and what it means for the outlook;
2. what the recent volatility teaches us about investing and how to navigate such turbulence in the future;
3. and how to bring both together into a robust investment strategy for the current environment.

Although weaker US economic data was a trigger for the recent volatility, we do not believe the US economy is entering a recession. Nevertheless, we do expect the Federal Reserve to respond by cutting interest rates. We now expect the Fed to cut interest rates at each of its three remaining meetings in 2024, with the potential for a 50-basis-point reduction if warranted by a weakening of the labor market or consumer spending. We also believe momentum in the US presidential race has now shifted toward Vice President Kamala Harris.

We are making some changes to our asset class preferences this month. After a strong recent performance from quality bonds, we close our preference for fixed income and for high grade (government) bonds within the asset class. We continue to recommend that investors shift excess cash into quality fixed income—including investment grade corporate bonds—to prepare portfolios for lower interest rates. Diversified fixed income strategies can also help enhance portfolio yield.

In equities, we recommend focusing on quality companies. Those with strong balance sheets, competitive advantages, and exposure to structurally growing revenue streams should be well positioned to navigate economic uncertainties. In the months ahead, potential cyclical and geopolitical headwinds could contribute to volatility in the technology sector, and may present an opportunity for investors to build up long-term exposure to artificial intelligence (AI) at more favorable prices.

Elsewhere, we see upside for gold prices and the Swiss franc, both of which can also improve portfolio diversification and insulate against risks. Meanwhile, we move the US dollar to Least Preferred and upgrade the euro, the British pound, and the Australian dollar to Most Preferred.

Market swings in the past month have shown how quickly the focus can shift away from fundamentals. Investors who diversify, have a long-term perspective, and a clear idea of what they plan to buy and sell have a better chance of navigating and taking advantage of such periods of volatility in the future.

What’s changed and what does it mean for the outlook?

Over the past month, we have revised our projections for the US election outcome and for Fed policy rates.

The probability of a Harris win is rising

President Joe Biden’s decision to withdraw his bid for a second term in office and endorse Vice President Kamala Harris as the Democratic nominee have transformed the US electoral race. Although “hypothetical” polls prior to Biden’s withdrawal appeared to show little advantage to a change in candidate, national polls now give Harris a three-point1 advantage over former President Donald Trump. Harris has also improved on Biden’s position in some of the critical swing states.

While we continue to caution against reading too much into the polling data at this stage, we have adjusted our probabilities to reflect the recent momentum shift. We now assign a 40% probability to a Harris win with a divided Congress (Republican Senate, Democratic House), and a 15% probability to a “blue sweep” in which Democrats win the presidency and control both the House and Senate (both up 5 percentage points versus our previous projections). We see a 35% probability of a “red sweep” and a 10% probability of a Trump win with a divided Congress (both down 5 percentage points).

The recent shifts in the race reinforce why investors should avoid making outsized portfolio moves in anticipation of specific election outcomes. But investors looking for ways to insulate portfolios from election-related volatility can consider adding exposure to gold and the Swiss franc—both seen as so-called “safe-haven” assets by the market.

1 FiveThirtyEight.com , as of 21 August.

We have also identified some of the most potentially election-sensitive stocks, including within the US consumer discretionary and renewables sectors, as well as currencies like the Chinese yuan, where we recommend that investors manage any overexposure.

The Fed looks more likely to cut interest rates

The outlook for Fed rate cuts has also shifted in recent weeks, with data showing the Fed now has both the imperative and the leeway to cut interest rates.

US unemployment rose to 4.3% in July, up from 3.7% just six months ago, suggesting the Fed may need to act to support employment. Meanwhile, US consumer price inflation slowed to 2.9% year over year in July, its lowest since early 2021, which should improve the Fed’s confidence that inflation is on a sustainable path back to its 2.0% target.

We now expect the Fed to cut interest rates at each of its three remaining meetings in 2024, with the potential for a 50-basis-point rate cut if warranted by a weakening of the labor market or consumer spending. Indeed, in the minutes for the July FOMC meeting, “several” participants noted that the recent inflation and labor market data had “provided a plausible case for reducing the target range 25 basis points” already at the July meeting. That suggests a low bar for the Fed to act aggressively on additional signs of economic weakness.

As returns on cash are eroded around the world, investors will need to act to invest excess cash and money market holdings. We see diversified fixed income strategies and equity income strategies—including dividends and volatility-selling strategies— as increasingly attractive alternatives to cash.

It is important to note that while our outlook for the Fed has changed, we have not made any major revisions to our economic growth projections. Although payrolls growth was weak, other data—including jobless claims, retail sales, corporate profit margins, and services sentiment—suggest that recession risks are still low. Our base case is for a soft landing for the US economy, with growth bottoming slightly below the 2% trend rate and inflation moderating further. Our base-case scenario is for the S&P 500 to end the year around 5,900 and reach 6,200 by June 2025.

Lessons from volatility about investing

The rise of quantitative trading has added complexity to market dynamics. Quant strategies, which rely on algorithms and statistical models, can amplify market movements and appear to have played a significant role in recent market volatility. According to our estimates, systematic quant funds likely contributed to nearly USD 300-400 billion of the trading equity selling volume in early August.

The quants are likely to be here to stay, and similar episodes can be expected in the future. So how should investors respond?

First, keep a long-term perspective and don’t overreact to price action alone.

• Quant trading can lead to outsized market moves based on individual data points, which can then push individual investors to doubt their assumptions and panic. With the VIX index hitting its highest level since the pandemic after the July US payrolls report, it was easy to feel like a US recession was due. Yet the subsequent broader set of data supported the narrative of a soft-landing scenario. This led to a rally that erased the S&P 500’s early-August losses and the VIX falling back to around 16—below its long-term average. Investors who stayed the course were rewarded.
• Resisting the temptation to try and time the market has historically been a successful strategy. Outside of bear markets—which occur on average about once every seven years—market selloffs tend to be so short-lived that the chances of successful market timing are low. Based on our analysis of data going back to 1960, we estimate that USD 100 invested in the S&P 500 would have grown to USD 59,900 (as of the end of July 2024) by staying invested—versus USD 607 with a “market timing” strategy of selling when the index reached a new all-time high and then waiting for a 10% correction to re-enter the market.

Second, be diversified.

• Market volatility can be worsened for individual investors if they hold concentrated positions in individual securities or markets. On 5 August, Japanese equities fell 12%. Meanwhile, a 50:50 portfolio invested between the MSCI ACWI (in local currency) and 10-year US Treasuries would have shed just 1.6%.
• Historical data supports the long-term benefits of diversification. According to the UBS Global Investment Returns Yearbook, a portfolio where equity investments were split across 21 countries would have experienced 40% less volatility than an average single-country stock investment. Our analysis also shows that a balanced portfolio of equities and bonds has only delivered a negative return over a five-year horizon on 3% of occasions, and never over a 10-year horizon.

Third, keep updated “shopping” and “disposal” lists.

• Such lists can help investors stay disciplined during turbulent times (and avoid panic-selling assets they would prefer to keep), and help investors take advantage of periods of volatility to make strategic trades at more favorable prices.
• A “shopping” list should include asset classes or markets where investors are currently underinvested relative to strategic benchmarks. For many individual investors, this could include alternative assets such as hedge funds and private markets; AI beneficiaries and high-quality stocks with strong long-term fundamentals; or international markets such as Japan or India, where many individual investors lack sufficient exposure.

Conversely, a sale list could include assets with low longer-term return potential or concentrated positions in individual securities or markets. For many, this could include excess cash allocations, concentrated positions in large individual stocks, or “home biased” exposure to a single equity market.

Employing structured strategies can further enable investors to act in a disciplined way as and when volatility arrives.

Investment ideas

Following the decline in bond yields in recent months, we neutralize our preference for fixed income, and now see equally attractive risk-return prospects for bonds and stocks. This is a good environment to deploy capital into balanced portfolios, in our view, as we expect positive total returns across major asset classes over the next six to 12 months.

Fixed income

We shift our view on fixed income from Most Preferred to Neutral. Within the asset class, we also move high grade (government) bonds from Most Preferred to Neutral.

Following the 90-basis-point fall in the 10-year US Treasury yield since April, we see more limited scope for capital gains over our forecast horizon if a soft-landing scenario continues to play out. We expect the 10-year Treasury yield to end the year around 3.85% in our base case, though we note that in an adverse economic scenario, it would likely decline sharply.

We maintain our preference for investment grade corporate credit, where we believe yields remain attractive. We still recommend that investors shift excess cash into quality fixed income given the potential for cash rates to fall quickly as the global rate-cutting cycle advances.

Investors can also consider diversified fixed income strategies—including selective exposure to higher-yielding parts of the asset class—as a way of further enhancing portfolio income.

Equities

We expect S&P 500 companies to grow earnings by 11% this year and 8% in 2025. With US economic and earnings growth solid, inflation cooling, and the Fed likely to cut rates, we expect the S&P 500 to rise to 5,900 by December 2024 and 6,200 by June 2025. Historically, in the absence of a recession, the index has gained 17% on average in the 12 months following the first Fed rate cut of a cycle.

While we see the overall environment as constructive for equities, uncertainty about the economic and political outlook is likely to linger. We therefore recommend focusing on quality companies, as we believe their strong competitive positions, resilient earnings streams, and exposure to structural growth drivers leave them well placed, particularly if economic growth concerns mount. We see opportunities in companies exposed to the energy transition, where we see potential for sustained earnings growth in the coming years, and in select quality stocks in Japan and Europe.

Second-quarter earnings from big tech companies showed that the sector’s fundamentals remain solid, and we still expect sustained earnings growth of 15-20% over the next six quarters. AI spending looks resilient, and monetization is still picking up. Leading tech companies’ capex guidance for 2024 rose to USD 211 billion after second-quarter results from USD 202 billion after first-quarter results.

That said, potential cyclical and geopolitical headwinds could contribute to volatility in the technology sector in the months ahead. To prepare, we believe investors with low existing AI exposure should create a plan to build up long-term exposure to the theme at more favorable prices. Structured strategies—for example, put writing or reverse convertibles on key names—can offer a way of phasing into markets at lower entry levels, subject to investors’ ability and willingness to bear the particular risks of options. Meanwhile, investors with high existing technology exposure can consider capital preservation strategies as a means of hedging against volatility.

At a country level, we have moved UK equities to Neutral from Most Preferred after the market’s strong relative performance. We have also moved China to Neutral from Most Preferred in our Asia-Pacific equity strategy given its weakening economy and increasing geopolitical risks.

Currencies

We move the US dollar to Least Preferred. We expect the trend toward a weaker dollar to continue over the medium term as US growth moderates, inflation cools further, and the Fed cuts rates. The currency’s high valuation and the US fiscal and current-account deficits reinforce the longer-term case for a weaker greenback. We therefore recommend that investors reduce their USD holdings. Investors for whom the dollar is not their base currency should consider hedging their existing USD exposure.

The Swiss franc remains among our Most Preferred currencies. The Swiss National Bank is likely near the end of its rate-cutting cycle, and we believe the franc’s defensive qualities are appealing in a portfolio context amid political uncertainty in the US and parts of Europe.

Furthermore, we move the euro, the British pound, and the Australian dollar to Most Preferred, as we expect all of them to regain ground against the US dollar over our forecast horizon. The Bank of England is likely to cut interest rates less aggressively than the Fed, in our view, and the Reserve Bank of Australia might not cut at all until next year. Meanwhile, we expect the euro to benefit from a strong recovery in the Eurozone’s trade balance, which suffered during the energy crisis. In Asia-Pacific currencies, we move the Chinese yuan to Least Preferred going into the US elections, as a hedge against the risk of increasing US tariffs.

Commodities

We see gold as an effective way of hedging portfolios against concerns about geopolitical polarization, a weaker US dollar, or the persistent US fiscal deficit. We expect lower US rates, solid central bank buying, and recovering exchange-traded fund (ETF) demand to push the gold price to USD 2,700/oz by mid-2025 (from around USD 2,510/oz at present).

On a broader basis, after the recent pullback in commodity indexes, we expect at least 10% total returns over the next six to 12 months, while uncertainty about Chinese demand and global growth cast a shadow over base metals in the near term.

We expect Brent crude prices to move back toward USD 87/bbl by the end of the year. Oil demand growth remains robust thanks to US and Indian consumption, while OPEC+ is likely to be hesitant to add supply. Risk-tolerant investors can consider selling Brent’s downside price risks.

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