Hard to fade

October saw markets contend with credit “cockroaches,” global trade postulation and concerns about the sustainability of the tech capex cycle. Ultimately though, equities finished higher once more. The rally is hard to fade, but investors must be discerning. Our Chief Investment Office explains.

Last month we mentioned that the set-up into year-end appeared more ‘Goldilocks’ than ‘Three Bears’. For now, there is little to change our view.

Indeed, if anything, the backdrop is now more constructive than it was a few weeks ago.

The US Federal Reserve (Fed) delivered another 25-basis point (bps) cut in October, bringing its target range to 3.75-4.00%. Fed Chair Powell cautioned the central bank is not on a preordained path to deliver another cut in December, but an official end date for its quantitiive tightening (QT) program was announced. The move will serve to ease financial conditions and may itself be commensurate to another 25bps cut.

At the same time, US-China trade relations thawed with the announcement of a one-year trade deal that would pause steeper US tariffs and limit China’s export controls on rare earth minerals. Although no formal agreement was reached, the constructive tone was a marked shift from the rhetoric earlier that month that saw US equities register the largest one-day decline since Liberation Day in April.

The announcements followed China’s Fourth Plenum where officials pledged to “form an economic development model driven more by domestic demand and powered by consumption.” Both the US-China trade announcements and talk of consumption-focused stimulus were met with scepticisim, but nonetheless each provided a positive boost to sentiment.  

At home, the RBA held its policy rate steady following the hotter than anticipated Q3 inflation print. While Q3 trimmed mean inflation printed at 1.0% q/q, exceeding both market expectations and the RBA’s own forecasts, we are reluctant to say this is the beginning of any meaningful trend. Indeed, several forward indicators suggest inflation is likely to moderate over the year ahead. Nonetheless, this does provide a tricky set-up for the local equity market, which is already struggling to generate meaningful earnings growth.

The Australian market has meaningfully underperformed global peers over the past 12-months yet remains among the most expensive markets globally. At the same time, estimated earnings growth is the weakest among peers.

We still anticipate the RBA will deliver a final 25bps reduction in February next year, but the most recent inflation data suggests this could be pushed further into next year, meaning consumer stimulus and relief for corporate balance sheets would also be delayed.

Valuations tell a clear story

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Sources: Bloomberg, MSCI, T.Rowe Price.

This construct sits in stark contrast to emerging markets where valuations are cheap and earnings estimates have strengthened with an expectation they will outstrip developed markets over the coming year.

Combined with a softer US dollar, the shift in US-Sino relations and a China pledge to boost aggregate demand, many watchpoints for China and emerging markets now appear more favourable.

With respect to rates markets, any further RBA easing looks largely priced into the short end of the Aussie curve, with the potential for further easing to be removed. The long-end still offers an attractive pick-up in yield versus the short-end and continues to be anchored more to offshore moves in US Treasuries. Accordingly, we may see some flattening of the curve in the near-term.

More broadly, the US Q3 earnings season has generally been positive. With roughly 60% of companies having reported, 10 of the 11 sectors have exceeded expectations and blended earnings growth sits at nearly 14%.

The valuation dynamic and huge capex cycle have seen comparisons made to the turn of the century when the dotcom bubble formed. However, the rebound in earnings from 2020 lows, combined with strong future expectations have seen valuations recede. While investors remain willing to pay a steep multiple for those companies that appear capable of delivering growth, the key distinction to the tech wreck is that today’s biggest technology names are incredibly profitable and among the strongest generators of free cash flow globally.

For now, it looks as though fears surrounding the AI capex cycle have been pushed aside for another quarter at least, with most of the big names pointing to higher spending plans in the year ahead. Nonetheless, investors are becoming more judicious.

Meta’s selloff was a key highlight from the reporting season, with investors questioning the returns on the stated capex plans. While the company generates more than $100 billion a year, its recent decision to issue $30 billion in debt suggests the reliance on free cash flow and existing balance sheet assets to fund this capex cycle cannot continue forever.

The US economy has been fuelled by AI-related spending this year, and a material pullback in spending or loss of faith in the technology would likely deliver a significant shock to the economy and markets.

Still, with a fresh round of stimulus to reach the pocket of US consumers in early 2026 and the potential for additional monetary easing before then, we believe the rally may have scope to broaden. Discernment though is needed for now.

What this means for multi-asset portfolios

This month, we elected to upgrade risk across multi-asset portfolios.

Considering the weaker earnings outlook and steep valuations we have cut our Australian equities exposure taking the position to an outright underweight.

At the same time, we have increased our position in emerging markets equities. This has been done via an increase to broad-cap emerging markets, broad-cap Chinese equities and a discrete allocation to China Tech. The valuation gap and earnings outlook for all three segments relative to US and developed market peers is attractive. The move has taken us to an outright overweight to emerging markets.

Given the increase in risk, we have also lengthened duration. With the long-end of the curve offering an attractive pick-up and an expectation of near-term flattening, we have cut our short duration exposure and increased our position to long-duration bonds. While the additional carry is one reason for the move, the position also acts as a hedge to equity risk in the event of a sharper global slowdown.