Can markets keep climbing the wall of worry?

Global equities continued their march higher in the third quarter. Despite questions about fiscal health and central bank independence, the US dominated the global picture as the US Federal Reserve (Fed) resumed rate cuts and AI spurred eye-popping revenues and earnings. While some might be skeptical about the market’s exuberance, we think the fundamentals can remain supportive for the next 12 months and we maintain our overweight view on global equities relative to bonds. 

Our optimism hasn’t wavered because we continue to see good earnings drive higher returns in the US, particularly among mega-cap stocks. That said, we think allocators should consider moving up in quality in fixed income — from high-quality credit to government bonds and from lower-quality to higher-quality credit. We also think diversification from growth to value is critical in equities. 

To highlight a few of the details, we still favor Japanese equities, given the improving earnings outlook and shareholder-friendly policies, while we have a moderately underweight view on European equities. In fixed income, we continue to see opportunities to take advantage of regional differences in monetary policy and market pricing. Our highest-conviction view within government bonds is a moderately overweight stance on the UK, where fiscal management fears are fully priced in. This contrasts with Europe and the US, where rate cuts may fall short of market expectations. In credit markets, we lowered our view on high-yield bonds to neutral when spreads approached all-time tights, and we raised our view on emerging markets (EM) debt to moderately overweight. Around half of EM debt is investment grade and spreads aren’t as compressed. We’re monitoring credit markets after pockets of weakness surfaced in US consumer finances, but these appear to be isolated cases rather than signs of broader economic or credit risk.

Equities: Positivity persists but valuations give pause

We continue to hold a moderately overweight view on global equities. The global earnings picture is solid and the policy backdrop is supportive. While questions remain regarding US tariffs, much of the uncertainty seems to be behind us. We continue to view AI positively. The massive investments being made are giving the economy a near-term boost and may drive even more meaningful, long-term productivity gains. 

Why aren’t we more positive given these drivers? Valuations have risen, particularly in non-US markets with weaker earnings growth, and uncertainty remains high on several policy fronts in the US and elsewhere, including around issues of fiscal sustainability and central bank independence.

We have moved our view on the US from moderately underweight to moderately overweight. While gains have been limited to a relatively narrow group of mega-cap stocks, we see some signs of a broadening earnings recovery as Fed rate cuts support small caps and value segments. In addition, lower corporate taxes, higher levels of investment, and deregulation may help some of the laggards. While the market is richly valued, we think this is in line with a high return on equity, and earnings are still being delivered. 

We maintain our moderately overweight view on Japanese equities. Corporate governance reforms and restructuring continue to provide a tailwind, and buybacks are at record highs. At the macro level, ongoing reflation should be a positive for Japanese equities. Despite strong nominal GDP, monetary conditions remain loose even with a potential rate hike later in the year . 

We have lowered our view on Europe ex-UK and the UK from neutral to moderately underweight, mainly because of weak earnings prospects. The lack of earnings growth indicates that recent gains in Europe ex-UK have been valuation-driven, which means the region is no longer cheap or unloved. For its part, the UK suffers from an absence of tech exposure and from its domestic economic and policy reliance. 

We maintain our neutral view on EM equities. Lower US rates, a weaker US dollar, and stronger risk appetites all support EM. However, much of the move has been sentiment-driven, with earnings not improving. Even in China, neither macroeconomic nor earnings fundamentals are improving, although optimism on AI and tech innovation seems partly justified. 

Sector-wise, a variety of factors — whether earnings-, technical-, or valuation-driven — are shaping our preferences, rather than any strong overarching theme. We have an overweight view on communications, staples, and utilities; an underweight view on materials, health care, and industrials; and a neutral view on technology and financials. 

Government bonds: Divergence and opportunity 

Globally, central banks are generally moving toward rate cuts, but the magnitude, timing, and market expectations vary substantially. We see opportunities to take advantage of these regional differences within our government bond view. Our highest-conviction regional view is to be moderately overweight UK government bonds. With the UK government facing a fiscal shortfall and new rules requiring a balanced budget by 2029 – 2030, all eyes will be on the budget announcement in late November. The consensus is that it will include tax hikes and spending cuts equivalent to £30 billion or 0.35% of GDP per year, but we think the fiscal hole will be substantially smaller and the process of filling it will be spread over several years through 2028. 

Against our bullish UK view, we are bearish (moderately underweight view) on the US, Europe, and Japan. We think the market has gotten ahead of itself when it comes to Fed rate-cut expectations when inflation is still sticky and recession risks are low. There’s not much more cutting for the European Central Bank to do — it’s already delivered 150 basis points of rate cuts over the past year — and we see some upside growth potential from German fiscal expansion. As for Japan, monetary policy remains accommodative, inflation risks are to the upside, and fiscal policy is likely to loosen following the October election. 

Credit: Time to take profits in high yield?

Tight spreads keep getting tighter, so upside is limited. We see isolated cases of credit stress in US consumer finances emanating from weaker income cohorts like subprime and 24 – 30-year-olds struggling with higher unemployment and the resumption of student loan repayments. Still, we see no clear catalyst for broader spread widening, and the overall backdrop appears positive for risk assets. Given rich valuations, however, the time may have come to move up in credit quality, from high yield to EM sovereign debt. 

We think the macro backdrop for EM is positive, thanks to Fed easing, a weaker US dollar, and loose financial conditions. EM debt’s (EMD’s) composition is about 50% investment grade and 50% high yield, a more defensive allocation relative to equities than high yield. Finally, EMD offers a potential spread pickup relative to both global corporate investment-grade bonds and high yield. In a more stressed US economic environment, EMD spreads would also tend to benefit from their longer duration relative to other spread markets.

Commodities: Focusing on oil and gold prices

We have a moderately underweight view on commodities driven by our view on oil, where we have a small underweight view given the rise in oil prices. With OPEC barrels returning, the demand/supply balance points to a potentially sizable oversupply. 

We have taken off our long-standing overweight view on gold. While the geopolitical environment and the investor/central bank urge to diversify remain favorable for gold, recent momentum has taken the gold price beyond our targets and the technical setup looks somewhat fragile after the strong push higher.

Investment implications

• Consider maintaining a slight pro-risk stance — We are relatively optimistic on global equities and favor a modest increase in exposure. Earnings support higher valuations, especially in the US, while monetary and fiscal policy are stimulative and trade uncertainty has receded. We see little risk of recession and favor equities over bonds.
• Within equities, emphasize earnings growth over valuations — We favor the US and Japan over Europe in developed market equities. AI euphoria in the US seems unlikely to fade. In Japan, we see evidence of improved capital return to shareholders and positive earnings revisions. European companies face a challenging mix of slow economic growth and earnings prospects that lag other regions.
• Within fixed income, look for regional divergences and consider moving up in quality in credit — We have a slight overweight view on duration and credit. Within duration, we have a moderately overweight view on the UK and a moderately underweight view on the US, Japan, and the eurozone. Within credit, we have downgraded our view on high yield to neutral and raised our view on hard-currency EMD to moderately overweight.
• Keep an eye on commodities — We maintain our underweight stance on oil given our view that the oil market is likely to be in surplus this year as OPEC slows production cuts. We continue to lean positively toward gold but currently see a case for taking profits and staying at neutral while waiting for a better reentry point. 
• Remember the risks — A spike in inflation remains the main downside risk to markets. In addition, a much softer US labor market could raise recession risks and geopolitics remain a risk to watch. Upside risks include reasonable US trade deals with Europe, Japan, and China, as well as concrete signs that AI is increasing productivity.

Next: read our Global Economic Outlook