Equity markets have continued to confound investors this year, delivering first-half returns that many would have welcomed over the full year, amid an energy shock that few could have foreseen.
So, after entering the year with a constructive outlook for equities, the question now is whether the underlying drivers of the rally remain intact, or whether recent strength has simply pulled forward returns in a way that leaves markets more vulnerable over the second half.
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The hurdle for further gains is undoubtedly higher. Positioning has rebuilt from the March sell-off and the macro backdrop remains complicated. Even so, evidence points to durable support for the rally.
Increasingly, market strength is being underpinned by improving earnings expectations rather than multiple expansion. That matters as positive earnings revisions have historically provided a more durable foundation for equity performance than sentiment or liquidity alone.
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Risks remain though. Yields are elevated, policy uncertainty is high and market concentration demands attention. But equities have absorbed higher yields and geopolitical disruption while earnings expectations have continued to improve. In our view, that supports staying invested and, where appropriate, selectively adding to risk.
Importantly, markets no longer appear euphoric. That may seem counterintuitive given the extraordinary run-up in parts of the market, particularly across Asian and semiconductor stocks. According to Citi, though, retail trading participation in the Magnificent Seven stocks recently fell to a four-year low, and investor sentiment surveys (considered contrarian indicators) now point to a more cautious outlook.
There is also useful historical context. Despite persistent negative headlines, the S&P 500 delivered a 14.9% return over Q2 - its twelfth-strongest quarter since 1950. On each previous occasion that the index delivered a quarterly gain of this magnitude or more, returns over the following two quarters were also positive. History does not repeat, but it often rhymes.
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Perhaps because of this, comparisons with the dotcom bubble continue to be raised, particularly as the Magnificent Seven paced the market higher from the March trough. While there are some similarities between today and the dotcom era, there are stark differences too. Not least, today’s leading technology companies have fortress balance sheets, generate substantial cash flow and offer earnings visibility that is superior to most of the market. Indeed, that profile helps explain why investors piled into US big tech during the second quarter.
In a typical risk-off episode such as the US-Iran conflict, safe-haven demand might ordinarily favour gold, US Treasuries and the dollar. Instead, the Magnificent Seven functioned as a form of risk-off exposure within equities, providing quality, liquidity and defensible earnings to investors.
Looking ahead, the Q2 US reporting season will be an important test for equities. Bottom-up EPS estimates posted their largest intra-quarter increase in five years, lifting analyst expectations to their most bullish levels in some time. With markets driven by the rate of change, the key question is whether earnings growth is nearing a peak.
For now, leading indicators remain supportive. Korean exports continue to signal strong global semiconductor demand, with June growth accelerating to 70.4% year-on-year from 53.4% in May - an encouraging read-through for US technology earnings, particularly across the AI supply chain.
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The other factor for equities is yields, which remain caught between improving inflation optics and a Fed inclined to stay restrictive. Even as core and headline inflation remain uncomfortably high, the broader inflation impulse appears to be softening, thanks largely to lower oil prices and a weak consumer backdrop that is limiting firms’ ability to pass through higher input costs. The latter is quickly becoming more evident, with June nonfarm payrolls rising only 57k. Alongside a 74k downward revision to the prior two months, the three-month moving average has moved to 111k from 164k previously.
In our view, the Fed will tolerate exogenous price shocks if they remain contained, but not if they become broad-based and persistent. Lower energy prices improve the near-term inflation picture, but after more than five years of above-target inflation, the Fed is unlikely to ease meaningfully until it has greater confidence that price stability has been restored. This becomes a tricky set-up to manage if employment continues to soften without a requisite fall in inflation.
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Outside the US, positive earnings revisions are also becoming more broad-based. European equities started the year strongly before underperforming on the US-Iran conflict. More recently, though, the outlook has improved. A stabilisation in the oil price has seen sentiment improve on hopes the growth and inflation fallout may be more benign than originally feared. This has come alongside improving earnings revisions that should see the earnings-growth gap between the US and Europe start to narrow into year-end.
After trimming our European equities overweight during the onset of the energy crisis, we returned the position to benchmark this month. Alongside US and Japanese equity overweights, we remain overweight developed markets overall. Japan remains the year’s standout performer, with further upside potential supported by valuations, positive earnings revisions and a more favourable policy backdrop.
Across emerging markets, there is room for further gains through the second half, on the back of solid domestic growth, resilient trade and AI-linked technology exposure. From a fundamental perspective, earnings are moving in the right direction, with profits expected to grow at a double-digit pace and outstrip developed markets in the year ahead. After years of negative revisions, improving breadth adds credibility to the recovery.
Domestically, the Federal Budget weakened an already modest outlook for activity and earnings. The US-Iran memorandum of understanding has lowered inflation risk and the RBA may now be at or near the end of its hiking cycle. Still, this is unlikely to offset subdued earnings momentum and we have increased our underweight to Australian equities again this month.
In fixed income, softer activity, housing-market deleveraging and fiscal constraints also support the case for longer-duration bonds. As such, we recently lengthened duration exposure, funded from bank bills and inflation-linked bonds. Importantly, carry remains meaningful and bonds should retain value even if the path of rate cuts is shallower or more delayed than investors had hoped.
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The outlook for the second half is far from certain, particularly with markets priced for good news. A sharper rebound in oil prices, a more hawkish Fed or an end to the AI capex narrative could all challenge the current risk backdrop. Indeed, with most markets sitting near record highs and given the challenging backdrop through which gains have been delivered, equities are due a more meaningful pullback. Provided such a move isn’t led by runaway inflation, it may even be a healthy outcome, providing a more sustainable base for the rally to continue and an opportunity to add further risk to portfolios.
For now, however, improving earnings breadth, contained yields and less euphoric positioning support a constructive but selective approach - one that argues for remaining invested and adding risk where the earnings case is strongest, while maintaining duration, alternatives and gold to manage through volatility spikes.
We remain in a volatile and less predictable investment regime - one where portfolio outcomes are unlikely to be shaped by simply being “risk on” or “risk off”, and more by where risk is added, where it is trimmed and how quickly portfolios respond as the opportunity set changes.
Invest for the long term, adjust exposures as risks evolve, and stay anchored to a broader strategic framework.