Diversification strategy solves investment dilemma
For all the high valuations and macro risks, investors seem generally optimistic, or at least feel the need to stay in the market
AFTER US President Donald Trump’s threat to raise tariffs on Chinese imports in response to China’s new export restrictions on rare earth metals, the US stock market briefly wobbled before quickly recovering its losses.
This development highlights the dilemma facing investors: On the one hand, multiple valuation indicators suggest the stock market is near a high point, warranting a defensive stance. On the other hand, US economic fundamentals remain strong, with solid corporate earnings suggesting further upward momentum.
Solid fundamentals despite high valuations
The once-feared global recession has not materialised, and the US economy remains resilient. While the US has admittedly not fully absorbed the impact of tariffs and trade restrictions, the overall macroeconomic impact has been limited. Goods imports account for only about 20 per cent of US household consumption, making a price increase of several percentage points manageable, and consumers can often find cheaper alternatives.
Conversely, rising export costs will force Europe and China to reassess their growth models. Looking ahead to the coming quarters, the global economy will likely experience varying degrees of recovery at varying paces.
Investors who sit on a pile of cash face a dilemma. Forward price-to-earnings ratios are above historical averages across many stock markets. However, these elevated valuations are primarily concentrated in large-cap value stocks, while technology stocks remain more reasonably valued.
Moreover, the US stock market continues to benefit from numerous positive factors, including strong corporate earnings, an easing regulatory environment, increasing mergers and acquisitions activity, low energy prices, low unemployment rate, rising wages and the ongoing boom in artificial intelligence.
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In Asia, the Japanese market has performed exceptionally well this year. While corporate profits have been hurt by US tariffs, re-inflation, rising wages, improved consumption and fiscal policy easing have fuelled momentum for the Japanese stock market. Sanae Takaichi, who has become Japan’s first female prime minister, is expected to drive further earnings growth if she launches a new round of fiscal stimulus, leading to a weaker yen.
Emerging market technology stocks have performed strongly in recent months, even outperforming the Nasdaq Composite Index. We remain positive on the outlook for emerging markets, seeing not only strong earnings growth among Asian technology companies but also support from a weaker US dollar, which has historically been a boon for emerging market stocks.
European stock market valuations are not far from their long-term averages, in contrast to markets where valuations are well above average. Market expects an earnings growth of around 13 per cent for the MSCI Europe Index in 2026, exceeding the 9 per cent forecast for the Russell Value Index.
Credit market spreads may widen
Meanwhile, corporate bond spreads have retreated again towards pre-“Liberation Day” levels following the recent widening on worries about bad loans among regional banks in the US. Given the continued uncertainties in the macroeconomic environment, we would not be surprised if spreads widened modestly again in the future.
Therefore, we are more positive about short-term high-yield bonds in the eurozone, where we can find higher yields while mitigating the risk of a widening in spreads.
Market momentum may slow
For all the high valuations and macro risks, investors seem generally optimistic, or at least feel the need to stay in the market. High valuations can stay high for a while. Some investors may be waiting for a significant market correction, hoping to buy the dip. However, the risk of this approach is that the market may not fall as much as expected, and exiting the market risks missing out on the upward trend.
The market’s upward momentum may slow in the future, but given relatively healthy fundamentals, we are looking for sustained gains. Valuations would also decline if prices appreciate at a slower rate than earnings.
Assuming there is no recession, the US Federal Reserve’s rate-cutting cycle should continue to benefit risk assets. We maintain our bullish outlook on US equities, but we are focusing on technology stocks rather than the broader S&P 500. Technology companies are less vulnerable to tariffs and offer greater earnings growth potential.
However, the tech industry is rapidly changing, so diversification is crucial. Even if you cannot predict which companies will be the winners of tomorrow, diversification allows you to participate in the broad uptrend.
We also have adopted a diversified strategy for emerging markets. While China’s technology sector may be affected by US export restrictions in the short term, its strong engineering and research and development capabilities hold significant long-term potential.
Finally, high gold prices – even after the recent correction – reflect market expectations of a shift in US interest rate policy and investors seeking safe havens. Despite some weakness in technical indicators, continued buying by emerging market central banks, coupled with the Fed’s rate cuts, should provide support for gold prices.
The writer is chief market Strategist, BNP Paribas Asset Management
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