The US market led the advance among developed markets with a 3.2% return for the S&P 500, building on an 8.7% gain in the second quarter. Notably, the equal-weighted version of the index—which dilutes the impact of the top tech stocks that have dominated the 2023 rally—did better than the main index, returning 3.5% over the month.
The gains reflected renewed optimism that the Federal Reserve and European Central Bank are nearing the end of their tightening cycles. The combination of slowing US inflation and resilient growth—including strong-than expected second quarter GDP and the best consumer sentiment reading in nearly two years—raised hopes that a soft landing is possible.
Meanwhile, the second-quarter earnings season got off to a solid start. With just over half of the S&P 500 having reported by the end of July, around 74% of companies announced results exceeding the consensus forecast only slightly shy of the 77% five-year average. In aggregate, earnings were beating by 6.4%, below the 8.4% five-year average.
But plenty of good news is already being assumed by equity investors, limiting further upside, and we remain most preferred on fixed income. Against this backdrop, we advise investors to:
Lock in quality bond yields. Many investors have held more cash than usual in anticipation of higher interest rates. But policy rates are now approaching a peak. Reinvestment risk for investors holding excess cash or fixed deposits will likely rise. We recommend that investors re-evaluate their cash holdings, ensure they are sufficiently invested and diversified for the long term, and act soon to lock in attractive yields before markets start to price lower rates in the future.
Yields have risen in recent months as the US economy has proved more resilient than expected. We think this provides a good opportunity for investors to put their excess cash to work by locking in attractive yields as the Fed nears the end of its hiking cycle and before markets turn their attention to rate cuts. The more defensive, higher-quality segments of fixed income look most appealing to us, given the all-in yields on offer and the potential for capital appreciation as investors shift their focus from inflation risks to growth risks. We expect high grade (government), investment grade, and sustainable debt to deliver good returns over the balance of the year, and we prefer five- to 10-year maturities.
Seek yield generation for equities and look for laggards. Quality dividend-paying stocks can be a good source of income and can enhance potential equity returns at a time when the risk-reward outlook for broad indexes appears muted over a tactical horizon. The MSCI World High Dividend Yield index and its sustainable equivalent are offering a yield of around 3.85%, close to the 3.97% currently offered by the 10-year US Treasury. Quality dividend equities tend to be found in more defensive parts of the market, and history suggests dividend payments should prove relatively stable even in the event of an economic downturn. Companies in this category also often have strong pricing power, enabling them to protect margins in periods of high inflation. By region, we think this style has the most potential in Switzerland and in Asia.
Stock market gains have recently been concentrated in a few areas, and with valuations among some of the best performers now looking stretched, we expect the gap between the leaders and the laggards to close. Investors should protect their holdings through capital-preservation strategies and rebalance into the laggards, like emerging markets, defensives, and value. This process was evident in July, with the equal weighted S&P 500 index slightly outperforming the main index, while China and emerging market stocks did even better than developed markets.
Diversify with alternatives: We recommend balancing traditional portfolios with an allocation to alternatives. Hedge funds should enable investors to navigate, as well as take advantage of, dislocations in markets in a period of economic uncertainty. Meanwhile, we believe private markets offer a variety of opportunities to earn income and grow wealth over time, including in private equity, private credit, and real estate.
So, while the macroeconomic and policy outlook brightened over the course of the month, we continue to recommend a selective approach to equities, focusing on parts of the market that have so far lagged the 2023 rally. With so much good news priced into equities, we are most preferred on fixed income.
Main contributors - Solita Marcelli, Mark Haefele, Christopher Swann, Vincent Heaney
Original report - What to do after a risk-on July, 1 August 2023.