Stalled US-Iran talks should not derail solid fundamentals

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The price of Brent remained volatile on Thursday, after the US said it had shot down four Iranian drones that had been fired at a commercial ship and announced further sanctions aimed at preventing Iran from charging vessels for transit through the Strait of Hormuz. The news underlined the fragility of the ceasefire and the challenges of finalizing a deal to end the conflict, which is now in its 13th week. The swing between optimism and caution continued to impact markets, with Brent rallying as much as 3.9% to USD 97.99 a barrel on Thursday, after falling 5.3% on Wednesday to a one-month low of USD 94.29 a barrel. 10-year US Treasury yields rose 5 basis points to 4.53%, their first increase in six sessions, while 2-year yields rose 4 basis points to 4.07%, reflecting renewed concerns over accelerating inflation.

But while recent developments have underlined our base case that the road to an eventual diplomatic resolution will be a bumpy one, amid the flurry of conflicting headlines we advise investors not to lose sight of economic and earnings fundamentals, which remain solid.

The first-quarter earnings season has underlined the strength of corporate fundamentals in the US, the Eurozone, and Asia. US first-quarter results have been robust, with underlying earnings growing 19%, the fastest pace in four years. Around 80% of companies have beaten sales and earnings per share estimates, above historical averages, while the median earnings beat has also been better than the longer-term average since 2015. We now expect S&P 500 earnings per share to grow 20% this year, supported by continued economic growth and AI adoption. In Asia, we expect MSCI Asia ex-Japan profits to rise by 62% this year, while in Europe, the breadth of companies beating earnings expectations has exceeded the breadth of revenue beats for a fifth consecutive quarter. This reinforces our view that the market backdrop is not one of deteriorating fundamentals, and that earnings support can help equities move higher over the medium term.

Underlying inflation, though too high to justify imminent Fed rate cuts, remains anchored and should enable the Fed to cut rates later this year. Core inflation has been slower to come down than we expected, causing us to push back our expectations for the resumption of Federal Reserve easing to the December meeting, followed by another cut in March 2027. We have seen upward pressure from AI-related software pricing, for example, which has remained hot near 5% month over month and 14% year over year, based on recent data. But we believe there is a high bar for Fed rate hikes, despite more hawkish recent market pricing. Trend wage growth is below 3.5%, and inflation expectations are still anchored. We could get further support for this view from the April personal consumption expenditures index, the Fed’s favorite measure of inflation, which is due to be released today. As the mood in the Fed likely becomes more dovish through the year, we expect yields to come down, though we advise investors to focus on the shorter end of the curve given risks to the long end from rising government debt burdens.

Government debt burdens are a risk to be monitored rather than a cause for imminent concern, in our view. We expect excessive deficits to be a source of anxiety for investors in the coming years. The US general government deficit is approaching 8% of GDP, the debt trajectory is already steep, and simulations suggest the net cost of debt could rise to nearly 19% of general government revenues by 2031, compared with 14% in IMF projections. This creates a risk that higher debt costs increase issuance needs, pushing yields higher and further raising borrowing costs. But over the rest of this year, our base case remains that yields will decline as inflation concerns ease, and the Fed moves toward rate cuts later in the year. This is why we would not interpret the latest rise in yields as a reason to abandon risk assets, but rather as a reason to remain disciplined on duration and portfolio construction. Investors should balance equity exposure with portfolio diversifiers, such as gold, which we believe can help protect against debt concerns.

So, we continue to view equities as Attractive. We expect equity markets to move higher over the medium term, supported by resilient economic activity, solid earnings growth, and the prospect of easier Fed policy later this year. Our base case is for the S&P 500 to climb to 7,900 by the end of the year, compared to 7,520 at present. Against this positive backdrop, however, we advise investors to consider concentration risks, with the surge in top US tech stocks leaving many portfolios in need of rebalancing. We favor equity exposure across regions and themes, and focus on fixed income exposure toward the shorter end of the curve.