From Headwind to Tailwind

Global stock markets reached new highs in October, while the default probabilities for U.S. corporate bonds hit record lows. This positive momentum is being driven by expectations of lower interest rates and rising corporate profits.

Investors have plenty to celebrate this year. In the aftermath of the pandemic, inflation acted as a significant headwind for stocks and bonds. However, as inflation has been trending down recently and the central banks started to ease monetary policy, it is now turning into a crucial tailwind. Although the Consumer Price Index (CPI) for September came in slightly above expectations at 2.4%, it remains below the levels typically seen during previous interest rate-cutting cycles. Furthermore, when looking at the past 25 years, inflation has now returned below the average for that period.

This cooling of consumer prices creates room for a more accommodative monetary policy, while also fostering improved corporate fundamentals. Particularly within the S&P 500, net margins have been recovering since their low point at the end of 2022, with many analysts forecasting positive margin growth through 2025.

The bond markets are also sending positive signals. Declining interest rates are providing smaller companies with greater opportunities to strengthen their balance sheets. As a result, credit spreads for high-quality U.S. corporate bonds have fallen to their lowest levels since 2005.

The current record highs in the stock market and record lows in credit spreads reflect that many positive developments, especially due to falling interest rates, have already been priced in. This is also evident in analysts' expectations for the coming quarters. While the current earnings reports still show a transitional phase in terms of growth, double-digit earnings growth is anticipated from the fourth quarter of 2024 through 2025.

However, in our view, an important point is often overlooked: the risk of resurgent inflation has not been fully eliminated. Factors such as economic stimulus packages (e.g., in China), geopolitical tensions (Middle East), and the upcoming U.S. elections could reignite inflation. A good indicator of this is the price of gold, which has risen by more than 30% in USD this year, outperforming stock markets. We continue to believe that gold remains a crucial component of any portfolio in this market environment.

In Europe, the Purchasing Managers' Indexes (PMIs) are not aligned with market performance, especially in the industrial sector, where a downward trend is evident. As a result, we have implemented a regional underweighting for Europe. In contrast, we have raised our outlook for emerging markets to neutral. This decision is supported by attractive valuations, the U.S. interest rate cycle, and stimulus measures in China. Overall, we remain neutral on equities, even though recent market enthusiasm has pushed the risk index to its highest level in three years.

In the bond space, we continue to advocate for a cautious approach to credit risks, as we believe that the compensation for taking on additional risks is currently not sufficiently high.