One week / one topic: Breakdowns

What happened?

Caught in the relentless barrage of price moves and data releases, a fresh way of looking at things can perhaps provide a modicum of respite – and perhaps some new insights, too?

With that in mind, it is compelling to look at what has worked year-to-date across the US equities spectrum through the lens of factors.

As a reminder, long/short factors are constructed in the attempt to isolate the fundamental characteristics that drive the performance of stocks, with the classic ones being Value, Momentum, Quality, Size and Low volatility.

Sorting through the ever-expanding ‘factor zoo’, two of them stand out in 2025:

• Beta, defined as long stocks with high historical betas, and short positions in stocks with the opposite characteristic

• Earnings quality, defined as long stocks with stable, reliable earnings and lower earnings management, and short positions in stocks with the opposite characteristic.

Put simply, this year – and especially after tariffs day – investors have rewarded riskier and junkier companies at the expense of more conservative and (allegedly) better-managed ones.

To address the understandable confusion, a historical parallel can perhaps help since – as you’d expect – these two factors are normally negative correlated.

In that case, the recent steep drop in correlations really stands out as a symptomatic picture of the current mood.

While a curmudgeonly conservative investor – not me! – might well look at the above and say “See? Investors have lost their mind!”, I actually think this if fairly rational.

After all, the equation ‘Fed cuts + weaker dollar + healthy consumer + solid earnings = bullish equities’ does not look completely off…

Sprinkle on top some political will to ‘run things hot’ and policy interference, plus a healthy dollop of AI capex – to the tune of ~1% of US GDP – and a continued reflationary rally becomes more than plausible.

But what should we do? Turn a blind eye to expensive valuations and take the plunge?

Or perhaps there are better opportunities elsewhere?

Our observations

• Fundamentals: For all the talk about how expensive US equities are, Mag Seven companies – after an impressive 28% earnings growth in H1 – still only sit at average valuation levels compared to the last ten years. Deal with it.

• Price action: As previously observed, EM equities are becoming less correlated to US ones. There are indeed other sandboxes to play in if you really want to.

• Investor beliefs: As much as non-US investors want to reduce their Dollar exposures, there aren’t that many Nvidias around...

So what?

While adopting an ostrich-like stance to the AI theme is simply not going to work (hint: it’s just too big), the narrow focus on this might perhaps lead to overlooked opportunities elsewhere?

As previously observed, (pockets of) EM equities look attractive and indeed we have existing positions across a number of markets.

After listening to a recent senior EM investor panel, I would also summarize the bullish case as resting on the following observations:

• Resilient global growth: tariffs have been in place for a while, but we have not yet seen any catastrophic impact

• Attractive valuations, both compared to US stocks and – in several cases, chiefly in SE Asia – compared to their own history as well

• Policy reforms, especially in Latin America

• Weaker dollar, which might well last for a while as foreign investors continue to increase their hedge ratios

• Shifting geopolitics, with regionalization trends potentially favouring LatAm stocks in particular.

As compelling as this all sounds, we need to nonetheless remain selective as – while valuations can provide a margin of safety in certain pockets, like Brazilian real yields (below) – recent events in Turkey were a timely reminder of what ‘country risk’ means.

Mood music: Tower Of Power – What Is Hip?