News

Laurent Denize – Global Co-CIO ODDO BHF

After a straight-line upward movement for most asset classes in Q1, Q2 has been more mixed. Entering H2, the big picture remains broadly supportive. However, beneath the surface, financial markets appear vulnerable to multiple threats, from stalling activity momentum and toppish technicals to faltering Tech leadership and election uncertainty. The impending earnings season is unlikely to provide much relief. Is this the calm before the storm? While this is clearly not our base case, we see conditions in place for financial markets to take a summer break.

Economies show signs of softness

In the United States, recent trends indicate fading momentum in growth expectations, with the US economic surprise indicator moving into negative territory. Meanwhile, the US unemployment rate has risen to 4.1%, breaking through its 36-month moving average for the first time since the COVID crisis. Historically, when this has occurred, a quick spike in the unemployment rate has followed.
In Europe, the significant fall in June PMIs (45.8 for PMI Manufacturing), the decline in Germany's IFO business climate index, and the downturn in the European Commission Business and Consumer Survey suggest that the nascent recovery remains fragile. Political uncertainty in France is not helping matters. 

Moreover, the effects of restrictions on shipping in the Red Sea and Panama Canal are being felt globally. World trade is under immense strain amid rising freight costs and potential increases in supply chain disruptions. The impact on global GDP growth will not be negligible.

Bad news is good news… for now
Despite the softening economic backdrop ("bad news"), prices in financial markets have been rising overall. This seemingly counterintuitive behaviour stems from the fact that a weakening economy heightens the prospects for rate cuts by central banks ("good news"). As long as the Fed keeps the door open to a first cut in September, markets may give it the benefit of the doubt and view bad data positively. However, disappointment may follow if at least two rate cuts do not occur before the end of 2024. This scenario is our central forecast with normalising corporate pricing, decelerating wages, and range-bound energy prices.

The story is quite different for the ECB, as economic growth remains lacklustre in the Eurozone and inflation continues edging towards 2%. To that extent, bad news is indeed good news.

Political risk acts as a headwind

In the super-election year of 2024, when almost half the world's population will go to the polls, election uncertainty is weighing on the economic outlook and amplifying the likelihood of a more rangy rather than trendy market in H2. The upcoming US election will surely bring market-moving headlines. Our conviction is that a Trump victory poses a risk for Europe but would likely benefit US equities (Small Caps, domestic Cyclicals, Banks, Tech, Healthcare, Energy). Conversely, European and Chinese equities may be seen as the losers in such a scenario, particularly export-oriented sectors like Automotive and Semiconductors. Another macro question related to US politics is how labour supply might be constrained if there's a slowdown in the flow of migrant workers.

Technicals are toppish for risky assets

Overall, the current state of market sentiment means that a lot of good news will be needed to sustain momentum, while any bad news could lead to more significant and widespread declines. A recent JP Morgan survey shows that only 17% of global investors are likely to increase their equity exposure, compared with 34% three months ago – one of the lowest figures in two years. 

Specifically in the US, the S&P 500 index has not fallen by 2% or more in over a year, the longest such period since 2017. With the five largest companies representing 27% of the index, questions are being raised as to whether this rally should "take a breather", especially since the top 10 companies posted double-digit performance (14%) over the past three months, while the remaining 490 were, on average, slightly in the red. This "fatigue" is particularly visible in Tech, where concentration and investor positioning are both extreme, suggesting the market needs a break.

Earnings season is a much-needed catalyst for the market, but EPS expectations look too high

Positive EPS momentum has helped European and US equities cope with higher-for-longer rates this year. However, EPS revisions have likely peaked as the PMI rebound is stalling and macro surprises have recently turned negative. The risk of further downward EPS revisions has also increased significantly for both Europe (+5% for 2024e and +10% for 2025e) and the US (+11% for 2024e and +15% for 2025e), driven by a slowing economy, worsening business climate (elections, tariffs, fiscal policies…), and the pressure on profit margins. Some recent profit warnings (Airbus, Dassault Systèmes, Volkswagen, BP, Indivior…) point in that direction. 

With valuations no longer exceptionally cheap (particularly in the US with a P/E 12-month forward at 21.4x), we do not expect any salvation from multiples expansion.

Positioning in a “time to breathe” mode

Equities: We remain neutral on Equities with a structural preference for the US vs. Europe. Our primary focus remains on quality and growth. After a strong outperformance in Q1, Cyclicals have overall underperformed Defensives in Q2. This rotation in favour of Defensives has been fueled by recent earnings trends. Given their relative valuation, we continue to prefer Defensives which, in our view, have more room for outperformance than Cyclicals. 

As regards sectors, our preference is for Healthcare, and Artificial Intelligence favouring Software over Semiconductors.  We also recommend a strategic position in Eurozone Small & Mid-Caps: liquidity remains paramount for this asset class, and the recent ECB rate cut is moving in the right direction. Additionally, valuations are lagging and appear very attractive. However, we continue to avoid France-exposed stocks, viewed as dead money. 

Rates: For Europe, we maintain a strategically long duration position amid lacklustre economic growth indicators and expectations of continued disinflation. We prefer Core Sovereigns but stay away from France, as we expect the French OAT Bund spread to widen in the medium term. For the US, we are neutral duration. The soaring odds of a Trump presidency leads to a rising term premium, implying much higher long yields. This also prompts us to be even more cautious on the longer part of the curve. 

Credit: We remain constructive on credit risk as credit markets continue to provide attractive carry with low volatility. In Europe, we favour a dual approach, with Long Duration in Investment Grade and Short Duration in High Yield to benefit from the carry. The quality segment in High Yield appears to be expensive. We also remain very cautious about the over-indebted Real Estate sector. We are negative on US High Yield.

Take a break but stay alert 

Overall, when we consider the global outlook, the environment is a rather supportive one for risky assets. However, there are plenty of concerning developments below the surface leading to downside risks in the “higher for longer” scenario. While we should enjoy the well-deserved break and the calm on the surface while it lasts, we also need to stay alert in case any tail scenarios materialise during the summer.

Disclaimer

This document has been prepared by ODDO BHF for information purposes only. It does not create any obligations on the part of ODDO BHF. The opinions expressed in this document correspond to the market expectations of ODDO BHF at the time of publication. They may change according to market conditions and ODDO BHF cannot be held contractually responsible for them. Any references to single stocks have been included for illustrative purposes only. Before investing in any asset class, it is strongly recommended that potential investors make detailed enquiries about the risks to which these asset classes are exposed, in particular the risk of capital loss. 

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