The global economy continues to withstand protectionist trade policies and recurring flare-ups in the energy crisis whose impact has been substantially lessened by the world’s declining reliance on oil.
Monetary policy has largely remained supportive, though several central banks have started to tighten. Fiscal policy is still expansionary, but its positive momentum in the US is waning as the tax refunds from the One Big Beautiful Bill work their way through, while Europe increases spending on infrastructure and defence.
Business conditions reflect a reasonably solid growth outlook. Purchase mangers index data point to continued strength in the services sector alongside gains in manufacturing activity which is being supported by AI-related investment and reshoring efforts aimed at securing critical resources domestically.
Productivity growth should lift, particularly in the US as new technologies become embedded in company operations. However, this effect may still be several years away from becoming widely observable.
Consumption, by contrast, is slowing as job creation and wage growth peak and cost pressures weigh on discretionary spending, especially among lower-income households. Of particular concern, hiring intentions in the US NFIB Small Business Survey are quite weak, reflecting elevated uncertainty, softer sales expectations, and inflation concerns. Housing construction’s contribution remains constrained by higher mortgage rates and affordability challenges. Europe and Japan are experiencing cost pressures more acutely due to their greater dependence on imported energy.
CHART 1: US SMALL BUSINESS PLANS DETERIORATING
Source: NFIB
The US/Iran conflict looks likely to flare up intermittently, though both sides have incentives to reach a more lasting resolution eventually. Spikes in oil prices weigh on potential GDP growth, but they should not trigger a recession, and slow inflation’s gradual descent toward central bank targets. Longer-term inflation expectations remain contained. Over time, energy markets adjust as pipelines and shipping routes are redirected.
Pressure on the Fed to tighten should ease by year-end
Core US inflation, now 2.8%, is likely to fall nearer to the 2% target over the next year despite higher energy prices in coming months. Softening consumer conditions will make it harder for companies to pass on higher costs. Falling household savings rates indicates that spending is running ahead of income which leaves households with less dry powder without increasing debt.
Wages inflation is moderating, showing that companies are not desperate to hire people. Unemployment is likely to rise above 4.5% from 4.2% as job creation slows. Rent inflation is only 3% annually and there is little impetus for an immediate rise given anaemic house price inflation.
Australian inflation is also likely to follow a softening path, but constraints on productivity mean it may take until the end of next year before it falls to the top of the Reserve Bank’s 2-3% target band. Trimmed mean inflation was 3.5% at last reading. Rents and wages growth are moderating only slowly. In the shorter term there are still the full effects of higher diesel and transport costs on food inflation to work through.
Most central banks will hike or hold rates this year. The European Central Bank lifted cash rates to 2.25% in June and could well raise again to tame the war-induced inflation bump even though demand is softening. The Reserve Bank of Australia is showing impatience with stubborn inflation and could raise for a fourth time later this year.
Markets are also expecting a hike in the US this year, but a shift to accommodation is more likely given the slowing labour market and the drift lower in underlying inflation.
Surprise decisions are likely to be characteristic of revised US Federal Reserve methods under new Fed chair Kevin Warsh. Ben Bernanke brought in “forward guidance” as a tool to help reflate conditions in the aftermath of the global financial crisis. Now the market will have less idea of what to expect. Policy shifts could be more impactful.
Investment strategy
Global equities are supported by strong US earnings and likely softening in economic growth and energy prices which will ease price pressures. Importantly, longer-term inflation expectations remain rangebound, as a material rise would push long duration bond yields higher causing a more significant selloff in equities and credit.
The outlook is becoming more challenging. Markets continue to be driven by momentum where investors follow prices and themes rather than fundamentals, adding to troubles related to narrow leadership, crowded positioning and exposure to sharp reversals.
Stretched valuations, increasingly interconnected economic exposures and elevated concentration risk are reflected in the largest ten companies representing as much as 36% of the US S&P 500 and 49% of S&P/ASX 200. Together with increased use of leverage, single stock volatility is much higher than usual, reminding us of the importance of a patient focus on long-term fundamentals.
US earnings momentum is likely to slow as consumer conditions toughen and the positive fiscal pulse from tax refunds passes. Concerns around AI regulation could increase as midterms approach.
Prospects for the AI buildout are well supported with capex possibly averaging USD 1 trillion per annum over the next five years. But evidence of froth abounds while uncertainty is high over the quantum, timing and placement of eventual investment returns.
We look to reduce exposures to overall market risk, enhance diversification and allow cash to build as those wonderful dividend payments roll in. No more than a neutral equity exposure can be justified. For regional allocations, we preference ex-US and seek diversity beyond the AI theme which reigns over asset classes and regions.
We see a rare chance to buy exceptional companies at attractive valuations as markets are overly fixated on near-term challenges while underappreciating the long-term compounding power of competitively advantaged businesses. Several high-quality stocks have been caught up in concerns over AI disruption and short-term economic challenges. We focus on areas where AI resilience and adaptation are most evident and avoid areas where disruption risks are higher.
We are increasing weights to defensive and higher-yielding global equities, as reduced capital gain potential means yield should play a larger role across the portfolio.
Global value-type stocks are also relatively attractive. Cyclicals are likely to outperform as energy and interest costs ease later this year. US manufacturing new orders are rising strongly now the three-year destocking phase is complete which will help US industrials and European exporters.
CHART 2: US NEW ORDERS LIFTING
Source: St Louis Fed, Assureinvest
