Risk off, risk on

Until recently, it has been difficult to argue the case for a near-term market breakout versus a more pronounced sell-off. Over the past month though, several factors have materialised that support an upgrade to portfolio risk. Our Chief Investment Office explains further.

In early April, markets sold off in spectacular fashion as US President Donald Trump announced global trade tariffs on US trading partners. Typically, when markets undergo such an abrupt decline the first consideration is to de-risk portfolios quickly before incrementally adding risk as the problem is unwound. 

On this occasion though, there was no systemic issue or complex problems within the financial system. Rather, all it required was Trump to assuage fears that high tariffs would not be enacted uniformly, with disregard for growth, inflation and financial markets. 

Of course, this was not the only concern for markets at the time. Concurrently, Trump was seeking a passage for his One Big Beautiful Bill Act (OBBBA), equities were looking frothy, valuations were stretched and tensions remained elevated in the Middle East. 

Fast forward three months and equities have not just reclaimed April levels, but pushed meaningfully beyond, reaching new all-time highs. Accordingly, valuations are again looking increasingly rich across much of the developed world. 

So, what cleared the path for equities to continue rising? More importantly, can equities move higher still amid global uncertainty? 

Firstly, the OBBBA has been signed into law. The bill has the potential to create future issues for the US fiscal position. In the near-term though, its passage partially alleviates some growth concerns, clearing the debt ceiling and acting as a sterilisation mechanism to deal with the consumption hit from higher tariff prices.  Indeed, the spectre of higher prices from tariffs, combined with Q1 GDP contraction of -0.5%, had more than a whiff of stagflation for investors. 

Looking ahead, incoming tax cuts and OBBBA-related fiscal spending should assist consumers. Moreover, the advance estimate of US Q2 GDP rose at an annualised pace of 3.0%, suggesting that although domestic economic momentum is easing it remains healthy. Employment remains a watchpoint, deep cracks have yet to appear, but a slowdown is afoot. The latest JOLTS report showed openings fell more than expected to 7.4m, quits declined to 3.1m, while layoffs were roughly unchanged. The quits-layoffs gap has narrowed and is a leading indicator of labour slack.

A softer jobs market is likely to help limit inflation pressures across the services sector, offsetting some of the expected rise in goods prices due to tariffs. At this stage, risks to unemployment levels look more elevated than any reacceleration in inflation as growth slows – favouring a bias toward longer-duration.

Looking to equities, the US Q2 earnings season has started in a positive manner, at least relative to expectations, thanks to negative earnings revisions in the lead-up to the reporting season. Q2 EPS estimates stood at 10.2% pre-Liberation Day, were then subsequently revised down to 5.8%, and are now outperforming that lower bar by posting growth closer to Liberation Day. With 66% of S&P 500 constituents having reported to date, 82% of companies have so far beat EPS estimates – above both the 5-year and 10-year averages of 78% and 75%, respectively.

Earnings revisions made room for positive surprises

info-01

Source: FactSet, Strategas, ANZ CIO

Though a significant share of EPS and revenue growth was expected to come from a narrow part of the market

info-02

Source: LSEG I/B/E/S, Strategas, ANZ CIO

Despite the positive beats, some further context is also necessary. Leading into the reporting season, EPS and revenue growth were expected to be driven by the Communication Services and Technology sectors. So far, this continues to be the case, with Communications and Technology registering earnings growth of 18% and 36% respectively, with Communications one of only three sectors – alongside Financials and Real Estate - to outperform 1 April estimates.

This goes at least some way to explaining why the Magnificent Seven has led the recovery since the April nadir, and why tech-related shares may continue to outperform in the near-term. This also partly informs our overweight to both sectors within our global equites allocation.

Of course, it would be remiss to suggest the market will be one-directional over the remainder of 2025. Rather, we expect volatility to re-emerge over the latter part of the year. Ahead, we expect a significant liquidity drain of roughly $350bn in September as US Treasury replenishes its Treasury General Account now the debt ceiling has been lifted. Moreover, earnings are always an expectations game, and the bar for outperformance will likely become more difficult as we approach Q3. And although 1 August has passed and deals have generally seen tariffs finish lower than Liberation Day – the 12 August deadline with China remains.

In our view though, monetary policy settings and a combination of investor sentiment and positioning should provide a potential cushion for more significant drawdowns. The macro-outlook is hardly inspiring, but with growth remaining reasonable and inflation slowly returning to target, we continue to expect the path for rates to be lower into year-end. Additionally, given the US Federal Reserve (Fed) has, despite Trump’s best efforts, refused to lower its policy rate there is room for policymakers to provide more substantive assistance should markets wobble once more.

Similarly, investor positioning is solid but not yet stretched and sentiment while positive, is not yet extreme. Both potentially help limit the severity of any pullback – at least in the near-term.

What this means for our diversified portfolios

With equities expensive and trade uncertainty elevated, a market pullback remains a risk. However, several factors lead us to believe a more favourable backdrop exists, providing scope for markets to move higher in the near term.

As such, we increased hedged global equities last month, with adjustments to regional preferences, noting the USD remains vulnerable to a medium-term pullback.

With Japanese earnings revisions starting to trend lower and given the political and trade uncertainty, we took profits from our overweight position in Japanese equities, cutting exposure to digest the current mix of factors. Valuations remain attractive, and the structural shift in corporate governance suggests there is room for further upside. We now position at benchmark and look for potential buying opportunities later this year.

Proceeds from this and the previous overweight to cash were invested across broad-cap European and Australian equites, as well as US tech-related shares. European equities are now our preferred region tactically. In Australia, although the earnings outlook remains modest, easier monetary policy over the latter half of 2025 should provide some cushion to stretched valuations. With a more positive near-term disposition toward risk assets, we are comfortable reducing the magnitude of our underweight but remain modestly below benchmark.

The Magnificent Seven have pushed the broader S&P 500 to new highs following the Liberation Day sell-off. Its constituents again account for 22% of the MSCI World Index – the same level seen at the start of 2025. Nonetheless, Q2 EPS and revenue growth has so far been driven by the Communication Services and Technology sectors. We maintain a mild underweight to US equities at the aggregate level but hold an overweight to US tech-related shares – our largest sectoral bias across portfolios.