Major equity markets are again trading near all-time highs, despite a volatile July that saw the major US indices finish the month broadly flat.
The month was shaped by three unresolved questions - whether the Fed may need to tighten again, whether the US-Iran conflict can move toward a durable ceasefire, and whether the AI investment cycle can begin to deliver sufficient returns.
Fed uncertainty continues to shape yields and valuations; the US-Iran conflict has driven sharp moves in oil and commodities; and in AI, the debate has shifted from whether investment will continue to where future profits will accrue.
For now, the answers remain incomplete, but the fundamental backdrop has become more constructive. Equities are being supported by a stronger earnings cycle, improving breadth and a macro environment that looks more like a mid-cycle slowdown than a recession threat.
On the policy front, oil has been the key channel through which geopolitics has fed into inflation expectations. Early in July, escalating US-Iran tensions briefly pushed Brent crude above US$100 a barrel, lifting energy prices and broader commodities. Hopes of an interim peace deal and a possible reopening of the Strait of Hormuz later saw Brent fall below US$80, easing one immediate inflation risk and giving central banks some breathing room. But that relief remains fragile. Persian Gulf exports are still constrained, alternative routes face rising risks, global product inventories continue to decline and uncertainty surrounding the Strait of Hormuz continues to drive sentiment.
More recently, the July labour market report showed nonfarm payrolls fell 23k, well below consensus expectations for an 80k rise. While a negative payroll print would usually strengthen expectations for Fed easing, the signal is more ambiguous. The labour market appears to be in a low-hire, low-fire mode, with participation drifting lower because of population-control revisions, ageing demographics and constrained labour supply. Outside the pandemic, the participation rate is now at its lowest level in 50 years.
The employment data has lowered market expectations for a September rate hike but likely skews the Fed’s near-term reaction function further toward inflation.
At the June FOMC meeting, Fed Chair Warsh emphasised that the Fed is not reliant on any single data point; the focus remains on trends. Core inflation is tracking at 2.6% on a six-month annualised basis and 2.3% on a three-month annualised basis. However, inflation has been above trend for five years and risks becoming entrenched. In our view, upcoming policy meetings remain live should inflation surprise to the upside.
While the Fed held rates steady at its July FOMC meeting, 30-year Treasury yields jumped after the post-meeting press conference as Warsh’s lack of forward guidance and rationale for the decision failed to assuage market concerns about the Fed’s lack of explicit plans to combat sticky inflation.
Warsh has long been a critic of the Fed’s expanded communication. Analysis from Payden and Rygel suggests that while Warsh uses a similar number of words to his predecessors, he focuses more on process than the substance of the economic data. He appears happy for markets to price assets more closely to economic data and, in doing so, provide some of the Fed’s tightening for it. But while a lack of forward guidance is theoretically defensible, there is an element of relinquishing control as the market arbiter and quickly losing credibility in the process. And if every meeting is genuinely live, interest-rate volatility and policy uncertainty are likely to remain elevated, increasing the chance of a policy misstep.
Warsh’s style over substance
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On earnings, the second-quarter US reporting season has been considerably stronger than expected. Blended S&P 500 earnings growth is now tracking above 50% year-on-year, compared with an estimate of 23.1% at the end of June. If sustained, it will mark the strongest quarterly earnings growth in five years.
Encouragingly, all eleven sectors are reporting higher earnings than expected at the start of the quarter. This supports the valuation case, particularly as close to 70% of the market was trading above its 200-day moving average at the end of July.
Still, however impressive, the headline number flatters the breadth and quality of the improvement. Alphabet and Amazon account for around 71% of the increase in index-level dollar earnings since the end of June, while energy has delivered the strongest sector-level earnings growth at 147%, helped by oil prices that were 45% higher year-on-year in Q2. Excluding Alphabet and Amazon, blended earnings growth would fall to 32%. That remains incredibly strong but highlights the influence of a small number of mega-cap companies and favourable sector-specific price effects.
The earnings season left no doubt that AI-related capital expenditure will continue to be a strong market catalyst for the foreseeable future. Indeed, the level of spending saw hyperscaler free cash flow decline to just US$4.8 billion in Q2.
Encouragingly, despite more funding being drawn from debt and equity markets, early signs of a return on the investment are beginning to emerge.
Collectively, the three major cloud platforms - Google, Azure and AWS - grew revenue by 43% while expanding margins, against a sizeable base of US$364 billion in trailing twelve-month revenue. According to BCA, the return on incremental invested capital from a year earlier is almost 30% across the hyperscalers.
Still, the reporting season has not been without incident. While the largest hyperscalers have remained relatively resilient, semiconductor companies and other AI beneficiaries have come under pressure as elevated valuations, export-control uncertainty and signs of China’s technological progress weighed on sentiment. In our view, this is not necessarily unhealthy given the sharp run-up in stock prices for this cohort. Moreover, a market that continues to scrutinise AI investment, capex discipline and future returns is preferable to one where those questions disappear and complacency takes hold.
Outside equities, demand for gold has again begun to emerge following the year-to-date pullback. Central bank demand has become more supportive again, with the PBOC reportedly adding 20 tonnes in July, its largest monthly increase since October 2023, even after prices had fallen nearly 30% from their highs earlier in the year. With geopolitical risks elevated and demand for alternative reserve assets continuing, gold remains a useful hedge against volatility spikes, policy mistakes and geopolitical shocks.
At home, the Australian market still warrants a more cautious assessment. The ASX outperformed in July after a prolonged period of underperformance versus global peers, avoiding the sharp unwind in the AI semiconductor trade, while benefiting from improved risk appetite on hopes of a US-Iran peace deal and support from a sharp scaling back of domestic rate-hike expectations. That mix provided a powerful short-term tailwind, but we would be careful not to extrapolate too far. The domestic market is still far from cheap, earnings growth remains anaemic, and while the RBA now looks more likely to stay on hold, further hikes cannot be ruled out. Australian equities therefore offer a less compelling combination of valuations, earnings momentum and policy support than global equities.
What this means for portfolios
The answers to the month’s three key questions are not yet settled, but the balance of evidence still supports risk assets. Oil has fallen as geopolitical risks have eased, earnings are stronger than expected, and the AI cycle appears to have further to run. We remain overweight growth assets but continue to adjust portfolio hedges with a view to providing strong risk-adjusted returns.
Portfolios have been adjusted so tactical positioning is now set relative to the new Strategic Asset Allocation (SAA). This has resulted in modest changes, including a further reduction in Australian equities, reinforcing the lower home bias introduced through the SAA and our continued cautious view on the domestic market.
Across equities, we have increased our hedge ratio this month to align with the new SAA – specifically through the purchase of hedged Japanese and European equities.
We have also increased exposure to gold. Earlier pressure from higher real-rate expectations and liquidity-driven selling weighed on the metal, but renewed central-bank buying, particularly from China, has improved the backdrop. We have therefore moved to a mild overweight.
With greater confidence that the RBA may be near the end of its hiking cycle, while recognising ongoing policy, valuation and geopolitical risks, we further reduced our duration underweight this month. The purchase of long duration Australian government bonds was funded by a reduction in inflation-linked government bonds.