While policy in emerging markets, and China in particular, is turning incrementally less restrictive, headwinds to profitability and China’s regulatory uncertainty and real estate crisis still add up to a challenging outlook. Aside from some commodity exporters, emerging markets are hampered by higher prices and constrained food and energy supplies. Geopolitical tensions and the eventual realignment of supply chains are added risks.
The hawkish Fed and strong US dollar are weighing on risk appetites broadly, and especially for emerging markets. We will look for evidence of a reversal in the dollar (e.g., other central banks becoming more hawkish relative to the Fed) and a more forceful policy turn in China before revisiting our moderately underweight view on emerging markets.
Given our concerns about Europe and emerging markets, and about global equities overall, our preference for US equities is a relative one. Higher valuations and earnings expectations in the US reflect more optimism about its outlook versus the rest of the world, which we think is justified given a strong labor market, resilient corporate fundamentals, and a high degree of energy independence. Inflation expectations are more contained and there are signs of cooling in goods prices, as well as early signs from a turn in home prices that broader shelter prices will peak in coming months. If we see a global recession, cyclical stocks will underperform — also supporting the US on a relative basis.
Japanese equities could benefit from favorable valuations and a weak currency. Despite acute pressure on the yen and some concerns about upside risks to inflation, the Bank of Japan (BOJ) remains committed to yield-curve control, instead leaning into direct currency intervention to defend the yen. Even if the BOJ were to tweak its yield-curve control approach, the policy mix would still be more supportive than in other regions when combined with likely fiscal expansion. If Japan can create the right kind of demand-driven inflation, especially via wage growth and employment of younger cohorts, it can accelerate nominal economic growth.
Our favored sectors are energy, where supply/demand tailwinds remain strong, and materials. Company fundamentals appear attractive in both sectors thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads. Across sectors, we prefer companies with pricing power, long-term margin stability, and healthy balance sheets, given their potential to fare relatively well amid cost pressures and volatility.