One battle after another: Time to reset expectations?

Figure 1

Turning to fixed income, we have a moderately overweight view on global government bonds. We think the rapid central bank shift from easing to tightening is overdone in some regions, given the potential for high energy prices to drive demand destruction/weaker growth or for a rapid de-escalation in the war, either of which would shift the narrative away from rate hikes and benefit long duration exposure.

Japan is the one market where we maintain a moderate duration underweight. The market is underpricing both inflation and real rate risks in our view. Energy prices are reinforcing increasingly structural inflation pressures amid tight labor markets and a weak yen, while Japanese government bonds (JGBs) have seen far less repricing than peers. With policy hikes delayed and fiscal support turning more proactive, risks are skewed toward higher yields via rising inflation and term premia.

Finally, we raised our view on gold to a slight overweight. We were encouraged by a 20% drop from the recent peak in prices, more neutral technicals, and our confidence in a continued positive secular trend linked to our expectations for a weaker US dollar and a bias among central banks and investors to diversify away from the dollar.

Figure 2

As we’ve seen in prior shocks, markets tend to front-load a repricing of valuations before meaningful earnings downgrades come through. Through the end of March, the decline in the 12-month forward PE on global equities has been similar in magnitude to the adjustment following Liberation Day. While there may be earnings downgrades to come, the price adjustment is close to the average for conflicts historically, but not at the extremes of major energy shocks such as the Ukraine war in 2022 and the Iraq war in 1990. On the sentiment and positioning side, a fair amount of adjustment has taken place, but not a full capitulation.

Again, we are balancing out these competing elements to arrive at our slight equity overweight. Given volatility related to the conflict, we would need to see a further downside adjustment or upside catalysts relating to a resolution of the conflict before we would take a stronger overweight view.

On a regional basis, we have an overweight view on EM against the UK. Overall, AI-demand visibility remains strong through 2027, and as noted, emerging markets in Asia are critical to the AI supply chain. China’s resilience during the conflict has also stood out. The country’s energy stockpiles and diversified energy sources have helped, and there are policy levers available to help smooth any negative effects — even as recent activity data has surprised on the upside.

We have moved to a small overweight view on the US against Eurozone equities. This largely reflects a gap between relative earnings fundamentals and relative price performance, with this gap favoring the US in our view. Relative sentiment captured in investment surveys is also more positive on Europe than on the US and may be due for a reversal. Meanwhile, US mega-cap tech companies have seen a big adjustment in relative valuations, making them attractive again from a PE perspective. Both the UK and Europe ex-UK suffer from a weak earnings outlook, though the UK’s relatively high exposure to the energy sector provides some offset.

Figure 3

We have maintained our long-duration stance based on more attractive carry and two potential states of the world that could lead to lower yields. In one state, persistently high energy prices spill into higher prices for a range of goods and lead to demand destruction and expectations of slower growth. In the other, de-escalation in the conflict reduces inflation expectations and more hawkish central bank reaction functions.

In thinking about possible inflation outcomes, some have drawn comparisons between the current energy supply shock and the 2022 shock driven by the Ukraine war. But we see some important differences that should help contain inflation today. First, governments have less fiscal flexibility to provide stimulus compared to 2022. Second, rates in some regions (US, UK) were already in slightly restrictive territory. Third, the labor market is not as tight as it was in 2022.

As noted, we have an underweight view on JGBs, given that inflation and fiscal risks are meaningful, but both the central bank reaction and inflation/real yields have moved less than in other regions.

As for credit, we remain focused on quality. Spreads widened modestly in March in response to the conflict-induced volatility and percolating private credit concerns. Markets are also responding to increased supply from AI-driven hyperscaler issuance and M&A financing. To take advantage of wider spreads while staying alert to potential spillover risk from the private credit space, we favor European credit including investment-grade and high-yield bonds. Credit fundamentals are healthier in Europe than in the US in terms of debt service and leverage, and the composition is weighted toward asset-heavy sectors rather than software and AI-related leveraged borrowers. Also, while not direct lenders to middle market borrowers, US banks lend to private credit funds and vehicles, a relationship that applies less to European banks.

Commodities: Rethinking our views on oil and gold

Prior to the war, we maintained a modest underweight view on oil, but the hostilities and the surge in oil prices led to a considerable widening of possible outcomes for the asset class with the skew toward the higher end. That heightened uncertainty, combined with exceedingly high costs associated with rolling positions at the front end of the curve, rendered the risk/reward profile of our underweight view untenable and we shifted to a neutral view.

Meanwhile, we used the recent sell-off in gold to introduce a slight overweight view. While there has been some clearing out of long positioning in gold since the war began, leaving it to behave like a risk asset, we believe the fundamental case for the precious metal, including strong long-term demand potential and diversification away from the US dollar, remains intact.

The biggest risk to our long-term bull thesis for gold is the possibility that central banks become net sellers due to capital needs from the war. This keeps us from moving to a larger overweight view, despite the potential we see for large excess returns relative to cash. Importantly, we’d push back against the idea that gold is an inflation hedge, as correlations here are weak or nonexistent. The primary long-term relationships are negative correlations to the US dollar and real yields. We don’t see significant upside emerging in either, but a fundamental reengagement with a bull case in the dollar is an additional risk.

Investment implications

Focus on the long term — Uncertainty about the economic and market impact of energy supply disruptions warrants a reset in short-term expectations. However, taking our longer-term views into account, we still favor a moderate overweight to global equities and opportunistic positioning in other assets that have repriced and are aligned with portfolio objectives.

Earnings are still a tailwind for the US and emerging markets — While higher costs from the rise in energy prices will crimp earnings in some areas, we still see a positive trajectory for US and EM earnings — the US because the AI innovation theme is intact and EM because EM Asia is a lifeline for AI infrastructure in semiconductors and memory.

Consider capturing the spike in yields — Central bank expectations have gone from easing to tightening with the rise in oil prices and potential spillover to other sectors. The move puts global yields at attractive valuations, with the repricing overdone in our view.

Focus on quality in credit — Spreads have widened yet concerns about private credit, AI capex-induced supply, and risk assets, in general, persist. We find European credit to have better fundamentals than the US in terms of debt service and leverage, and it is more insulated from US private credit issues.