Shannon Saccocia of Neuberger notes that while equities sit at record highs, credit spreads are tight and volatility low, markets face the paradox of strength against a backdrop of economic and geopolitical risks.
In recent weeks US and global equities have routinely hit record highs, credit spreads continue to trade at historic tights, and the VIX index of volatility is near its lows for the year so far.
Few would have taken the bet six months ago that risk assets would be performing this way after markets plummeted at the beginning of April; even fewer would have done so had they had full visibility of the macroeconomic weak spots and current levels of fiscal and tariff impact uncertainty and geopolitical risk.
What this points to is the paradox seemingly playing out between a challenged economy and roaring risk markets; a conflict that, as we enter the final quarter of the year, looks unlikely to fade anytime soon.
Reasons to be cautious
We do not have to look hard to see where some of the weak spots and risks are in the economic picture.
There has been a clear deterioration in most of the US employment and inflation data in the last several weeks, so much so that the Federal Reserve has re-engaged its rate-cutting cycle with the market pricing in 120 basis points of cuts in the next 12 months. Last week saw core PCE inflation for July come in at 2.9% (annualised)—still well above the Fed’s 2% inflation target—and this week attention will focus on nonfarm payrolls and the unemployment data, two areas that have been a cause of some concern.
Together with this, the independence of the Fed is in focus and uncertainty persists around the economic impact of tariffs as well as on fiscal policy and sustainability.
Concerns around these macro issues are similarly elevated among other major economies, particularly France, the UK and Japan, all of which have also seen related volatility at the long-end of their yield curves due to worries over their fiscal challenges. Growth in these economies is also sluggish.
To add to the mix, geopolitical risk remains at historic highs, with fresh spikes this month from Russia violating Polish, Estonian and Romanian airspace, and Israel carrying out a strike in Qatar against Hamas’ leadership.
Although these acts have not had a sustained negative market impact, such as higher oil prices or a sharp fall in equities, the risk of broader escalation remains high.
Importantly, these fears are not abstract. Most notably, gold prices recently hit an all-time high in real terms, exceeding the ‘safe-haven’ asset’s previous inflation-adjusted peak from 1980.
Optimism amid the pessimism
Remarkably, despite this pessimistic background, risk markets have ripped higher.
There are several reasons that may help explain why.
First, the continued resilience of the US economy has been impressive, and while there are clear signs of weakness in employment and threats of higher inflation, these signs and others are not strong or numerous enough to indicate a recession, which would provoke an aggressive risk-off move in markets. Growth has, of course, moderated, but markets have rationalised the primary causes and effects and seem to have concluded that the US economy, once again supported by monetary easing, is in decent shape and poised to slowly re-accelerate.
This optimistic view appears, for now, to override any developing concerns around the independence of the Fed and the US’ fiscal challenges.
Second, in the event of a serious downturn, major central banks have more space to step in and cut rates than they have had in more than a decade, which is surely giving markets some comfort. Such action is more credible today because rates are higher than where they have been, and with inflation broadly slowing and back under control, there is more scope for deeper cuts should they be needed.
Third, the continued power and earnings growth of the mega-cap US technology companies – ultimately the ‘Magnificent 7’ – and parallel improvement in earnings across a broader universe of companies, industries and geographies has been a surprise to the upside. Coming into the year there was some expectation US mega-cap tech company earnings would decelerate. Clearly this has not happened, and the broadening-out story has gained momentum, buttressing US and international equity markets.
Importantly, monetary easing and a weak US dollar have also been key factors supporting, if not catalysing, global equities. US and non-US fixed income have benefited from this too.
Fourth, corporate credit quality across investment grade and sub-investment grade markets is generally robust despite relatively high rates, particularly in the US, and persistence of economic and policy uncertainty. The current historically tight credit spread levels reflect this dynamic and the healthy depth of demand from investors, drawn in by the attractive all-in yields of corporate and high-yield bonds. Providing additional support to this is that corporate default rates globally remain relatively low.
Finally, while geopolitical risk remains elevated and may reasonably be expected to spike again in the near-term, markets seem inured to it and are only unnerved by a full-scale war or other humanitarian disaster that affects economic forecasts or asset prices, particularly currencies and oil.
What this means for investors
Without doubt, we are in an unusual environment right now; one that feels as complex as it is unpredictable. As such, investors should rightly be cautious about where to go from here.
However, while conscious of the economic weaknesses and the risks, we remain optimistic in our outlook for growth and risk assets over the medium termr.
In equities, in particular, optimism is clearly being priced in. But we do not believe there is an irrational exuberance and overextension in allocations, not least because absolute yields in fixed income remain attractive.
What is important, especially now, is that investors ensure portfolios are as diversified as they can be across multiple asset classes, providing a balance of exposures across public and private markets that blend attractive sources of risk-adjusted returns with sufficient downside protection.
Multi-asset investing works through the cycles. It is during times like these that it comes to the fore.
