Currencies outlook update: Less room for USD weakening

Recent developments favour the US dollar (USD), including the better economic data, which increases the likelihood of a ‘soft landing’ and a prolonged hold of the Federal Reserve at the peak policy rate. Once recent developments are priced in, improved risk appetite may allow the USD to weaken a little further, but our outlook for EUR/USD at 1.12 suggests that further weakness has clear limits.

The Bank of Japan has not yet abandoned its yield curve control, which would signal preparation for the end of its negative interest rate policy. The first rate hike in Japan will likely come in mid-2024 at the earliest. Therefore, we have scaled back our Bullish short-term outlook and now only hint at some strengthening within 12 months, once the first rate hike comes into focus.

The Swiss franc (CHF) continues to defy its interest rate disadvantage thanks to lower relative Swiss inflation and the Swiss National Bank’s (SNB) sales of foreign exchange assets. However, further upside appears limited. The interest rate disadvantage and risk-friendly environment remain headwinds, and the SNB could return to intervention if the CHF strengthens too much against weakening demand from the eurozone.

The latest cyclical data in Latin America surprised to the upside and points to a reacceleration of economic momentum. This may delay or reduce the extent of the upcoming rate cuts, suggesting that currencies such as the Brazilian real and the Mexican peso remain robust, and their high levels of interest continue to keep the region’s carry trade attractive with limited downside risks.

Developed market equities to move higher into year end

After a stellar performance during the first seven months of 2023, developed market (DM) equities started to correct in August. Importantly, however, we continue to believe that the secular bull market is still alive and that markets will move higher into year-end after the seasonally weak period of August to October.

We see limited contagion risks to DM equities from the current bleak situation in China. The domestic economic backdrop in the US is far more important and continues to be on a solid footing. Moreover, earnings revisions have recently turned positive again, especially in the US, after having stayed in negative territory for 14 months. This usually goes hand-in-hand with positive equity returns over the subsequent 6 to 12 months. Against this backdrop, we recommend using temporary setbacks to increase the equity allocation.

From a regional perspective, we continue to favour US over European equities, with a focus on quality growth names coupled with some defensives plays. For now, we would avoid the ‘China proxies’, i.e. US and European companies with high sales exposure to China, until more decisive policy action is taken.

Emerging market equities subject to higher volatility

Moving from the developed to emerging markets (EM), investor sentiment towards EM equities has taken a turn for the worse recently. As economic data from China continued to deteriorate and policy measures failed to convince the market, stocks in emerging Asia lost more than 8.4% in August. With a year-to-date gain of 13.2%, DM stocks have continued to outperform, while EM stocks have gained just 2.5%. As a result, we remain Neutral on EM equities given the heightened market volatility and macro-economic challenges around China.

Since our mid-year outlook at the end of May, we have made two significant adjustments. First, we no longer recommend short-term trading opportunities in China and expect low equity returns until effective policy action is taken. Second, we are shifting our regional preference from Asia to Latin America.

Asia is being dragged down by current concerns in China and weak end demand in the information technology sector in Taiwan and South Korea. The strong earnings performance in India in Q2 2023 and the defensive investment profile in Southeast Asia justify our Overweight in these countries. However, they only account for around 30% of the Asian market. In contrast, we believe that the easing cycle that has begun in Brazil and Chile (both Overweight) has plenty of room to run, which should support economic and earnings growth.

Speedy evolution in AI brings appealing opportunities

Generative AI (Gen AI) has become the main discussion topic in financial markets and the broader economy since the launch of ChatGPT only a few months ago. During these months, our conviction in the investment thesis has improved meaningfully while the sector continues to evolve at the speed of light.

First, the evolution of Gen AI and its capability to solve increasingly complex problems is advancing fast. New models with trillions of parameters are now being trained, which should expand the use cases. Secondly, the number of companies integrating Gen AI into their offering is increasing daily and spans different industries.

We recommend investors to focus on true AI leaders, with a sustainable competitive advantage. The monetisation potential of AI is what makes it so appealing and gives us confidence in the long-term opportunity. We believe that semiconductor companies are best positioned to benefit in the short term, while the revenue opportunity for cloud server providers and software companies will take longer to fully materialise.

Our Next Generation Cloud Computing & AI index has outperformed the rest of the market, delivering a total return of 55% year to date. While we recognise that the risk/reward relationship has deteriorated, we believe that AI companies can continue to outperform, driven by improvements in fundamentals. We thus remain Constructive on the theme.