What would change our view on equities?

By Lilian Chovin, Head of Asset Allocation

• Slowing but positive economic growth, resilient corporate earnings and artificial intelligence-related investment remain supportive of equities.
• While we are still therefore overweight equities, we continually assess possible developments that could lead us to re-think our positioning.
• Such developments include a deeper economic slowdown, renewed inflationary pressures and a moderation in artificial intelligence-related investment.

The global economy continues to expand, though momentum is moderating. Our growth indicator has moved into a slowdown phase – activity is expected to keep growing, but at a slower pace.

Crucially, this does not indicate a recession. Growth cycle phases describe changes in economic momentum rather than whether the economy is growing or shrinking in absolute terms. A slowdown phase could develop into a contraction, but neither necessarily implies outright economic decline.

The fact is that the broader backdrop remains supportive of equity returns. Economic activity is expanding, corporate earnings remain resilient and artificial intelligence (AI)-related investment continues to support business spending and profits. Inflation conditions also remain relatively benign, although expectations at the start of the year of interest rate cuts from central banks have all but disappeared.

We have therefore moderated, rather than reversed, our equity position. We remain overweight equities, but have reduced our exposure slightly and adopted a higher allocation to bonds.

At the same time, a core part of our investment process involves identifying potential turning points before they become consensus concerns. There are three developments we are watching closely: a broad, weakening deterioration in growth and earnings, renewed inflation accompanied by restrictive policy, and a material weakening in the AI investment cycle. 

The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short-term needs. This article should not be taken as advice.

Scenario one: growth becomes more challenging

History shows that the current positive but moderating economic momentum could still support equities, particularly if corporate earnings maintain resilience.

So far, recent softer economic activity has been most apparent in areas particularly sensitive to interest rates, such as housing and consumer sentiment. Bond yields have been rising since the start of the year, and this has been weighing on those sectors.

But we monitor indicators including consumer spending, employment, business activity and earnings expectations to assess whether that weakness is spreading more broadly. For now, our analysis suggests it remains contained.

A more broad-based reduction in momentum across these areas could move our indicator into a contraction phase of the growth cycle. This would signal falling economic momentum, but as mentioned, it would not necessarily mean recession.

We would become more cautious if weaker momentum began to undermine demand and corporate earnings. That combination, rather than where we are in the growth cycle, would provide a stronger signal to reduce equity risk.

Scenario two: persistent inflation and restrictive policy

Inflation has fallen substantially from its post-pandemic highs. However, energy market volatility and resilient economic activity could make further progress harder to achieve.

The key risk is not a modest rise in inflation by itself, but persistently high inflation keeping central banks’ monetary policy restrictive and interest rates higher – as growth momentum weakens. Persistent inflation could even, in some regions, increase the risk of interest rate rises.

This could challenge equities through several channels. Higher borrowing costs could affect households and companies, tighter financial conditions could temper activity, and higher bond yields could make fixed income relatively more attractive.

If these pressures were to come together and soften corporate earnings, it could prompt us to adopt a more cautious stance. 

Scenario three: a twist in the AI tale

AI investment has become an important source of business spending and market leadership, and a powerful support for earnings growth.

Spending on data centres, semiconductors, cloud capacity and power infrastructure supports technology companies directly and has wider effects across the economy.

The relevant concern for investors is not routine volatility in AI-related shares. It is whether investment continues to translate into the earnings and productivity gains investors expect. A moderation in AI-related spending could become more important if it affected corporate earnings, investor sentiment and economic growth at the same time.