Equity Market Outlook: Navigating Risks and Opportunities

The equity market outlook can be a complex and daunting topic, but it's essential to navigate the risks and opportunities to make informed investment decisions. Global economic growth is expected to slow down in 2023, according to the International Monetary Fund.

As the world grapples with inflation and rising interest rates, investors need to be cautious and strategic in their approach. The S&P 500 index has historically been resilient in times of economic uncertainty.

Despite these challenges, there are opportunities for growth in emerging markets, particularly in countries with strong economic fundamentals and infrastructure development. The MSCI Emerging Markets index has shown promise in recent years, with a 10-year annualized return of 7.5%.

On a similar theme: Us Equity Market Index

The equity market outlook for 2025 is looking promising, with growth poised to accelerate, especially in the US. The Fed's 50bp cut has narrowed the scope of potential economic outcomes, making it more likely that recession fears will take hold.

Our analysis of cutting periods over the last ~40 years reveals that cycles beginning with a 50bp cut were twice as likely to end in a recession within a year as those starting with a smaller 25bp cut. This suggests that investors should focus on the potential for a recession.

The start of the Fed's cutting cycle has also led to a slight leadership of the soft-landing basket over the first ~35 days, but recession fears eventually took hold. This is a key point to consider when thinking about the equity market outlook.

In the minutes immediately following the decision, our high frequency returns analysis showed strong US beta performance and negative returns to the size factor. This is a sign that markets are reacting to the Fed's move.

The soft-landing basket outperformed in what appeared an immediate right tail “FOMO” reaction, but some of this sentiment reversed into the close following Chair Powell’s commentary suggesting that upcoming rate cuts may be smaller. This is a sign that markets are adjusting to the Fed's message.

The Fed has so far been successful in mitigating recession fears by emphasizing economic strength and the intention to slow the pace of weakening in the labor market. This is a positive sign for the equity market outlook.

A unique perspective: Credit Market Outlook

Labor data including payrolls, unemployment, and jobless claims are stronger on average, but the trend of deterioration has been worse. This suggests that the data is fragile enough to justify the 50bp move.

The rates timing model, which uses a range of alternative data insights to forecast the direction of interest rates, remains positive, signaling conviction in interest rates falling. This supports the Fed’s ability to focus on the growth/employment portion of their mandate without sacrificing inflation progress.

The more recent slight reduction in the long duration position is driven by policy sentiment in broker reports, which suggests that the Fed’s 50bp cut to start the easing cycle will ultimately allay downside growth fears and reduce the need for more aggressive cuts down the road.

Earnings growth for the Mag 7 is expected to decelerate to a (still solid) 20% annual pace, while accelerating for the rest of the market. This shift in earnings composition could drive a more inclusive rally.

The Mag 7 accounted for 63% of S&P 500 returns in 2023, and that share has stepped down to 47% so far this year. This suggests that other sectors are emerging from cyclical headwinds.

Certain sectors, such as industrials, energy, and materials, have been in the doldrums with weak U.S. manufacturing activity for the past two years. But as the cost of capital declines with interest rates, consumers and companies should resume capital-intensive expenditures.

Durable goods subsectors, particularly those tied to housing, should also see a boost. Financials should benefit from increased loan and insurance demand, a more favorable yield curve, normalizing M&A and IPO activity, and prospects for deregulation.

The prospect of deregulation and corporate tax cuts may finally give investors conviction to add to previously unloved areas of the market, like value and mid/small cap stocks.

Here's an interesting read: Baird Equity Capital Markets

As we navigate the equity market, it's essential to balance risks and opportunities. Inflation is easing, and recession risk remains subdued, but volatility is likely to remain elevated in the coming months.

We're seeing a preference for higher duration and more cyclical exposures in portfolios, as positive macroeconomic developments continue to be priced in. This suggests that investors are optimistic about the market's prospects.

To manage risks, we're making efforts to trim our portfolio risks marginally, acknowledging that uncertainty is likely to persist. This approach will help us navigate any potential market fluctuations.

The current economic situation is a complex one, and it's natural to wonder if this cycle will be different from past ones. According to analysis of past cutting cycles, cycles beginning with a 50bp cut were twice as likely to end in a recession within a year as those starting with a smaller 25bp cut.

However, the Fed has so far been successful in mitigating recession fears by emphasizing economic strength and the intention to slow the pace of weakening in the labor market. The labor data, including payrolls, unemployment, and jobless claims, are stronger on average compared to past cycles starting with a 50bp cut.

A recent 50bp cut has sparked concerns about a recession, but our systematic indicators suggest otherwise. The rates timing model remains positive, signaling conviction in interest rates falling based on measures like web-scraped product prices showing continued disinflation in the US.

The probability of recession implied by the model is currently 12%, which is higher than at the beginning of the year but still well below Bloomberg consensus expectations of around 30%. This suggests that the economy remains on relatively strong footing.

Business-to-business activity has continued to accelerate year-over-year across both goods and services, indicating a potential resilience in the economy. Layoff mentions in conference calls haven't significantly increased, further supporting this view.

See what others are reading: Bill Ackman Business Insider

Inflation is continuing to ease, which is a positive trend for investors.

Recession risk has remained subdued despite a slight increase over the summer months.

Volatility and uncertainty are likely to remain more elevated in the coming months, making it essential to trim risks.

We're seeking an edge in alpha generation by identifying areas that can benefit from positive macroeconomic developments.

Risk mitigation is crucial, and we're making efforts to marginally trim risks relative to earlier in the year.

If this caught your attention, see: Equity Market Making

Mid-caps are in a cyclical sweet spot, driven by the strength of the US economy and positive cyclical signs from Europe and China.

The current equity market rally has been more balanced since the beginning of the year, with mid-caps joining the rally and offering catch-up potential.

High financing rates will continue to challenge lower-quality, more-indebted companies, making quality within mid-caps a key focus.

We favour quality within mid-caps, as they are more cyclical and better equipped to handle economic fluctuations.

Swiss mid-caps are among the highest-quality companies in terms of balance sheet and product strength, making them a good investment option.

Explore further: Equity Market Rally