The Analyst: cautious optimism is the popular market strategy

Economic data remains mixed, and the recent US government shutdown has made it more difficult to get a full picture of the economy. Inflation has started to rise again, yet stock markets and other risk assets continue to show resilience. Much of this momentum is supported by growing expectations that central banks will intervene if markets begin to struggle.

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The International Monetary Fund’s (IMF) latest World Economic Outlook paints a cautiously optimistic picture. The global economy is showing signs of strain as US trade policies and new tariffs continue to add pressure, but growth expectations have improved modestly. The IMF now forecasts global expansion of 3.2% in 2025, up from 3.0% projected in July, supported by stronger business activity and a weaker US dollar.

“It’s not as bad as we feared,” said IMF chief economist Pierre-Olivier Gourinchas, “but it’s worse than we anticipated a year ago.” Looking further ahead, global growth is expected to moderate slightly to 3.1% in 2026 as higher trade barriers and sticky inflation begin to weigh on economic activity.

On top of this, governments face growing fiscal challenges as public debt continues to rise. The IMF warned that spending cuts or higher revenues may be necessary to restore balance, particularly in Europe, where ageing populations, higher defence budgets, and the push for energy security are straining finances. This combination of long-term spending commitments and slower growth leaves many economies with limited fiscal flexibility should conditions deteriorate further.

Reasons to be cautious

Despite signs of economic strength, many analysts believe that stock markets have limited room for further gains. The S&P 500 continues to trade at about 25 times earnings, a level close to that seen during the dot-com bubble.

Market concentration has also become more extreme. The 10 largest US companies, mostly in the technology sector, are worth more than $24.5 trillion (£18.3 trillion), over five times the value of Europe’s 50 largest firms. The recent $100 billion deal between NVIDIA Corp (NASDAQ:NVDA) and OpenAI illustrates how dependent market performance has become on a few AI giants.

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Meanwhile, long-term government bond yields remain elevated, even as central banks begin lowering short-term rates. This divergence has created challenges for heavily indebted countries such as the UK, France, and Japan.

Gold prices have also continued to climb despite a calmer trade environment, suggesting that investors remain cautious about potential geopolitical or financial shocks.

Reasons to be optimistic

There are, however, several reasons for optimism. The IMF notes that the global economy continues to expand despite higher borrowing costs and policy uncertainty.

The Federal Reserve has already begun to ease rates and is expected to make another cut in October. Historically, when the Fed begins an easing cycle without a recession, equity markets have gained roughly 15% over the following year.

Corporate earnings have also held up well. According to FactSet, profits for companies in the S&P 500 are expected to rise by 8% in the third quarter, marking the ninth consecutive period of year-over-year growth. Since companies typically outperform forecasts, actual growth could exceed 13%, achieving a fourth straight quarter of double-digit earnings expansion.

And smaller US companies are also showing renewed promise. For the first time in years, profit growth expectations for small-cap firms now exceed those of large-cap companies. This shift reflects the benefit of lower interest rates and easing inflation, which tend to support domestically focused businesses. Historically, smaller companies have outperformed larger ones over the long term, but they also tend to be more volatile and sensitive to changes in economic conditions.

What it means for investors

The economic backdrop remains uncertain, but there are clear signs of resilience. Central banks are becoming more supportive, inflation is gradually easing, and corporate profits remain strong.  

For retail investors, the best approach is to stay invested, maintain a cautiously optimistic outlook and keep portfolio well diversified across asset classes, sectors and market cap. Avoid overexposure to certain parts of the market such as AI despite their popularity.

Markets are likely to stay volatile, but with more balanced positioning in portfolios and some patience, investors can benefit from long-term growth opportunities as the global economy continues its gradual recovery.

Market leadership remains narrow, and the so-called Magnificent Seven technology giants now represent about 30% of the S&P 500 index. Investors who hold funds tracking the index may wish to consider alternative structures such as equally weighted funds (e.g. the Invesco S&P 500 Equal Weight ETF Acc GBP (LSE:SPEX)) to reduce concentration risk and achieve broader diversification.

Smaller companies can also play a valuable role in a diversified portfolio. Funds that focus on US small caps, such as the Artemis US Smaller Companies fund, provide access to some of the most innovative and fast-growing businesses in America. This fund would be a suitable option for investors looking to add an adventurous element to their core US exposure and gain access to the growth potential of smaller companies.

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Beyond equities, precious metals such as gold and silver have performed strongly and may continue to serve as useful diversifiers. Investors seeking exposure to industrial materials could explore the abrdn Future Raw Materials ETF USD Acc GBP (LSE:ARAW), which invests in producers of copper, lithium, nickel, and other critical resources driving electrification and renewable energy infrastructure.

As with all thematic strategies, these funds carry higher risks and may be better suited to experienced investors comfortable with greater market volatility.