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Despite the steep stock market sell-off already this year, we see three reasons to believe the backdrop will remain negative and warrant a moderate equity underweight for the next 6 – 12 months: 1) the reversal of accommodative monetary and fiscal policy, 2) persistently high inflation, and 3) the risk of lower corporate earnings and multiples. The US equity market, where valuations are still fairly high, might well be feeling “ghosted” by the Federal Reserve, with Chairman Powell having all but said the central bank will not come to the market’s rescue and will be looking for the economy to pass longer-term inflation tests before taking a less hawkish stance. On the other hand, the US entered this challenging period in a strong position, with healthy household and corporate balance sheets, and Japan has the advantage of attractive valuations. Thus, we prefer a moderate underweight to equities, rather than an all-out underweight, and we favor the US and Japan over Europe and emerging markets.
Turning to the bond market, we have raised our view on defensive fixed income from moderately underweight to neutral. We think market worries are shifting from stagflation to weaker growth, yet fed funds futures are signaling more rate hikes than the Fed’s hawkish forecast. Higher yields of around 4.5% in high-quality bonds mark a departure from the return-free rate environment, and we think slower growth and the market’s expectations will limit future spikes in rates. We still have a moderately underweight view on growth fixed income, with no tilts in any of the underlying sectors (as shown in our “Multi-asset views” table). We remain bullish on commodities, though we have taken our view down a notch to moderately overweight, reflecting our belief that the cycle may put a slight damper on demand but structural issues limiting supply in energy and metals will prevail.
We maintain our moderate overweight view on Japan and the US. Japan’s valuations are the most attractive among major developed market regions (Figure 1) and its weak currency is an advantage. In contrast to many peers, Japan should benefit from higher inflation, given its secular backdrop of persistent deflationary pressure. and its market is under-owned by global investors.
With the Bank of Japan steadfast in its defense of yield-curve control even as other central banks tighten, Japan has a more supportive policy mix than other regions. Taking this into account, along with clearer evidence of improving corporate governance and low valuations, we expect Japanese equities to continue their year-to-date outperformance against other regions on a local currency basis.
US stocks have been particularly exposed to the recent sell-off due to a bias to tech and expensive growth stocks, which are higher duration in nature. This repricing may not be over yet, but amid global growth risks, the US market could have an edge, being relatively more defensive in nature versus other regions, especially in an environment of heightened geopolitical uncertainty.
Europe has higher leverage to the global cycle and a more fragile growth backdrop given China’s struggles. We maintain our moderate underweight view on the region, as tighter financial conditions begin to hit purchasing manager indices. The European Central Bank (ECB) has opened the door to a June rate hike and an end to quantitative easing in the third quarter, as inflation concerns remain front and center. The Ukraine war continues to put pressure on the economy as countries pivot away from Russian oil and gas.
While emerging market valuations are low, China faces potentially long-lasting uncertainty with respect to COVID and regulatory policy, which means the risk premium is chunky but the catalyst for a reversal in performance is lacking. Other large emerging markets in Asia face headwinds as well, including global cyclicality (Korea and Taiwan) and expensive energy (India). High energy and food prices are likely to impact many emerging markets and could raise the risk of political crises. Within emerging market equities, we prefer Latin America given the region’s commodities exposure.
We continue to see a case for diversified commodities exposure given structural inflationary pressures stemming from underinvestment in capacity and inventories at multi-decade lows. Still, we have changed our view from overweight to moderately overweight to reflect weaker demand as the balance of risks shifts from stagflation to a growth slowdown.
With slowing growth likely to put downward pressure on prices, we favor industrial commodities with acute supply bottlenecks, such as aluminum, and those hit directly by curbs on Russia, such as oil. The oil market remains tight, though the lockdown-induced slowdown in China and the potential impact on demand have made us somewhat less bullish.
Three factors have made us a bit more optimistic that the 10-year US Treasury rate will find a clearing level at around 3%. First, a lot of monetary policy tightening is already priced in as a result of Powell’s emphatic commitment to “break inflation’s back.” Looking at the futures market, investors had anticipated in early May that the fed funds rate would reach almost 3.5 by the end of 2023, some 250 basis points (bps) higher than its current level (light blue line in Figure 2). Second, growth is slowing already, with higher rates feeding into the real economy via asset prices, home-purchase traffic, and manufacturing, and reflected in tighter financial conditions (dark blue line in Figure 2). And third, even if the Fed “blinks” and backs off tightening, they face credibility risk, in which case the market may tighten for them and thus slow the economy anyway.
Within high-quality rates, we favor US rates and investment-grade corporates relative to European government bonds and we are neutral on Japanese government bonds (JGBs). While the Fed is the most hawkish developed market central bank, we think markets have adequately priced policy. We see more pain in Europe, where the 10-year bund yield is around 1.10%, inflation is very high at 8.1% as of May, and the ECB is getting more hawkish. In Japan, inflation, at around 2.5%, is just above the central bank’s long-awaited target. Even if the bands for 10-year JGBs are widened due to concerns about higher inflation, we think the upside risk for yields is limited.
As of May 31, US corporate bonds were offering a yield of 4.2%, so we believe allocators will covet steady coupons compounding at higher-than-median spreads. In our view, riskier credit is vulnerable to spread widening in a slowing economy.
While recession is not our base case, the probability has risen. Recession is the downside case where tighter fiscal and monetary policy aimed at reversing the inflation impulse has a high potential for policy errors.
Central bank tightening is starting to impact the most rate-sensitive sectors, such as housing, and consumer confidence continues to weaken. Meanwhile, the prolonged period of low rates and excess liquidity has likely led to a misallocation of capital in some areas, which may be exposed as air pockets in liquidity are revealed. These could lead to accidents, or market failures, as in past periods of reduced liquidity.
Another downside risk is an escalation in the Russia/Ukraine conflict that forces Europe into a full phase-out of Russian gas (not just oil). Finally, global uncertainty has begun to weigh on the earnings outlook, with company profit warnings precipitating sharp sell-offs, and earnings expectations have room for further downward adjustment.
A soft-landing scenario with inflation moderating without a hit to growth is not our base case, but it is an upside risk. In the US, there are some indications of a potential peak in inflation, including in goods inflation — e.g., the inventory/sales ratio appears to have bottomed. While services inflation has been strong due to reopening pressures, early signs of a slowdown in the housing market will feed through to shelter inflation.
China is implementing a number of easing policies to counter a contraction in its economy and some senior officials are pushing for more. However, zero-COVID policies could stymie the effective transmission of stimulus measures.
While the fiscal impulse is negative in most regions relative to COVID-era largesse, fiscal policy remains expansionary in the European Union and the UK, due to the long tail of prior programs and to subsidies aimed at mitigating the impact of cost-of-living increases. Further fiscal easing in the second half of the year is an upside risk, particularly in China and Europe, and could partly offset the global growth slowdown.
Tilting toward quality — We expect the global cycle to slow, with liquidity being drained from the financial system, and therefore prefer a moderate underweight to equities and a tilt toward quality as opposed to any particular sector. We think companies with pricing power, long-term margin stability, and healthy balance sheets will be more attractive amid continued supply-chain disruptions, cost pressures, and volatility.
Sticking with fixed income amid higher volatility — From a yield perspective, we think US rates and investment-grade corporates stack up well to equities. At current valuations, high-quality fixed income has the potential to dampen portfolio volatility and provide some protection against further equity sell-offs as the global cycle softens.
Continuing to seek inflation protection — There is no sign that commodities companies are planning to ramp up capital spending and production. Thus, we see a continued supply/demand imbalance that could keep commodities prices elevated structurally and argue for commodities equities, inflation-protected bonds, and some real assets.
Approaching credit allocations judiciously — We think spread widening has further to go in high-yield assets if, as we expect, the economy slows over the next 6 – 12 months. That said, we see select opportunities in convertibles, structured credit, short-duration credit, and housing-related assets.
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