The risk-on sentiment continued last week, although at a more moderate pace. Major US equity indexes rose by nearly 1% for the week, while the USD index climbed 0.6%, albeit softening towards the end of the week. Looking at the recent outperformance of US assets, mid-caps and the USD, markets are also pricing in a higher probability of Trump winning the US presidential elections, following the dynamics observed in 2016.
Regarding the internal dynamics of the fixed income market, it is worth highlighting the increasing decoupling between rate expectations in the US vs. the rest of the G7 (with the exception of Japan). The 2-year spreads between the US and Europe widened from 157bp to 184bp in October, with an additional 14bp added over the last week, reaching levels similar to previous peaks. In our view, this widening is already pricing in a decoupling between the US vs. Europe and Emerging Markets, particularly China.
Overall, despite increasing uncertainty, recent data indicate the odds of a no-landing versus a soft-landing scenario are rising again. This is particularly relevant for duration, the USD, equities and sectors with medium-term inflation hedging properties. Meanwhile, although inflation dynamics are positive, progress on inflation has slowed significantly. The rise in the US 5Y inflation swap over the past five weeks has been the largest since early March 2023, with underlying and more stable inflation metrics stuck between 2.5% and 3%.
Despite the higher odds of no-landing, medium-term models and earnings still suggest a soft-landing as our central scenario for the coming six to nine months. Our cyclical model still signals a slowdown zone, with variables pointing to a soft-landing scenario. In terms of earnings, consensus expectations have moderated significantly, projecting 4.4% YoY EPS growth in 3Q after 14.4% in the second quarter. Excluding energy, consensus EPS growth for the MSCI USA is 8% in 3Q, aligned with past quarters but clearly below 2Q levels.
Against this backdrop, we expect to see a slowdown in the global economy, with symmetric tail risks in terms of recession and no-landing scenarios. As global inflation pressures remain in check, most central banks are in easing mode, which is bullish for markets and supportive of global stocks and spread products. Even if earnings acceleration in 2024 turns into modest deceleration in 2025, MSCI USA P/E ratios remain high, but the bond market rally has kept relative valuations in check.
Actionable idea: As we approach the election, and with the probability of a Trump victory having slightly increased, we would highlight the implications of market reactions to a Trump or Harris administration. Small and mid-cap stocks are expected to benefit based on a no-recession scenario, lower rates, and increased odds that the market could start pricing in a replay of the 2016 scenario. As happened in 2016, we expect small and mid-cap stocks to get a short-term boost from a potential Trump victory based on (i) lower corporate taxes; and (ii) the potential benefit from import tariffs.