Market Insights - July 3, 2023

US companies will release their Q2 earnings figures in the coming weeks. In the previous quarter, S&P 500 companies largely beat the overly pessimistic consensus forecasts, but that could be harder to achieve this time around. The market is extremely bullish as we head into this earnings season, which could lead to more disappointments.

The Swiss National Bank’s most recent rate hike had little impact on long-term interest rates. In fact, the yield curve has flattened in recent months. As the Saron short term rate rises, long-term mortgage lending has become more competitive.

Germany’s IFO leading indicator, which measures manufacturing sentiment, continued to decline in June and was down by more than expected. This is another sign that manufacturing is struggling to keep up with the services sector.

A new cycle is in sight

Inflation is dropping back to more normal levels in many countries. Commodity and producer prices have declined sharply, suggesting that disinflation will continue to work its way through to consumer prices in the coming months.

This reassuring trend should enable the major central banks – starting with the US Federal Reserve (Fed) – to soon put an end to the aggressive monetary policy tightening that has taken place over the past year. Interest rates are likely to remain stable for now, as the major central banks will be reluctant to lower rates while the jobs market remains tight. These labour market tensions have been caused primarily by structural factors, such as the retirement of large numbers of baby-boomers, who have not been fully replaced by younger workers. A transition is already under way and is set to pick up pace between now and the mid-2030s. But the current near-full employment has prevented the global economy from slowing as much as it otherwise would have in recent months. Stable employment and rising wages are boosting consumer spending, with services doing particularly well. The resilience in the services sector has helped to shore up economic growth, while the manufacturing sector is having a tough time in all countries.

Barring a major deterioration in the geopolitical climate, we’re likely to soon see the start of a new economic cycle, after the cyclical trough at the start of the year. The resilient economy and expected end to monetary tightening will be a boon for equities in the months ahead. Overall, stock market valuations are attractive by historical standards, especially since corporate margins have been pushed up by the inflationary environment over the past year. While it’s true that investors have become much more bullish recently, which could lead to a brief consolidation, we nevertheless remain overweight on equities. The only exception is the Japanese market, which has risen sharply in recent months, prompting us to reduce our exposure.

Bonds are also attractive, with yields at a 10-year high. Their valuations have improved considerably recently, so we’re increasing our exposure to European bonds and reducing our exposure to dollar-denominated paper. That approach makes sense when it comes to hedging against the risk of a dollar decline – something that has become particularly expensive, especially for portfolios denominated in Swiss francs and euros.

Japan – a moment of overheating

The Nikkei is up 27% so far this year. Not only has it surpassed its post-pandemic peak of September 2021, but it also ended Q2 with six consecutive months of gains – something that hasn’t happened in the past 25 years.

The Nikkei’s rally is due in part to a search for safe-haven assets in a particularly uncertain global climate. As concerns grow about the scope of China’s recovery, Japan stands out as one of the few Asian markets shielded from geopolitical pressure and possessing a stable monetary policy.

Leading semiconductor equipment manufacturers are getting a boost from the buzz surrounding artificial intelligence, and consumer-oriented sectors stand to benefit from China’s reopening – but with fewer geopolitical headwinds.

But we shouldn’t forget about the monetary policy risk in Japan. The BoJ sits well apart from its peers in the developed world. For now, it shows no sign of changing course – even though inflation is above its 2% target – but it could put an end to its yield curve control policy at any point this year.

Japanese stocks are currently trading at valuations above their historical averages, partly because of the expected structural reforms to corporate governance. But we believe the investor enthusiasm over the past three months is overblown. And because the market’s upside potential is more limited in the near term, we suggest tactically reducing exposure to Japan until the overheating subsides.