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For much of the year, bad news for the economy was good news for markets. More slack in the US labor market, for instance, was cheered by risk assets as a sign that growth and inflation were moderating and the Fed might achieve a soft landing. Now the other side of this relationship is playing out: A stronger-than-expected economy has pushed the expected terminal interest rate higher for longer, causing stocks to struggle. Meanwhile, still-tight labor markets and rising commodity prices indicate ongoing inflation pressures, at a time when businesses and consumers have yet to fully absorb the impact of higher rates. This could mean a third phase of the narrative, where a weaker economy spells bad news for markets (Figure 1).
Figure 1
What’s our view? While it has taken longer than expected, we think higher rates will hurt the global economy and that a slightly cautious investment stance is still warranted. We’re also tracking a number of risks still unfolding as of this writing, including a potential US government shutdown, the spike in oil prices, and the strong US dollar. That said, we are more sanguine about the resilience of the US economy given several positives we had underestimated: the increase in household net worth from gains in stocks and real estate; low pandemic-era interest rates locked in by consumers and businesses; and plenty of liquidity.
On balance, we still expect risk assets to underperform defensive fixed income, given high valuations for the former and the lagged but looming impact of restrictive monetary policy. However, we have reduced our underweight views on global equities and credit spreads and we are quite close to neutral across our active weights overall. Our highest-conviction views are in Japan: Equities there have finally begun to embrace economic and corporate governance improvements, while slow-drip monetary tightening has left real rates in negative territory and expensive relative to other regions. Among spread sectors, we prefer global investment-grade credit. We remain moderately overweight commodities, with a focus on copper and gold.
We have raised our view on global equities to moderately underweight but maintain a defensive tilt. We think the lower interest-rate sensitivity of consumers and businesses, and the overall strength of the consumer, make a US hard landing less likely. However, we still believe the distribution of risks for the global economy, and even the US, is skewed to the downside. While the effects of tighter policy are playing out with more of a lag than in the past, there will eventually be a monetary overhang, which implies lower equity valuations and downgrades in earnings expectations.
We think the fiscal impulse that has propped up the private sector will in time become a drag on growth in the US and Europe as they consolidate fiscally — although the impact may be less noticeable in Europe, where fiscal stimulus has not been fully deployed on the ground. We also expect higher inflation risk globally as the path to further disinflation becomes more fraught. A worsening growth/inflation mix will chip away at margins. Meanwhile, global equity valuations are still expensive, in absolute terms and relative to cash. We observe more regional divergence, with the US and Japan outperforming Europe cyclically, and valuations similarly disparate.
We maintain our overweight view on Japanese equities. While the market is no longer cheap, positive economic momentum has fed through to higher margins and earnings growth. The Bank of Japan (BOJ) decision to add flexibility to its yield curve control policy in July has not challenged the market’s outperformance, partly because the yen has continued to weaken against the US dollar. In addition, Japanese equities continue to show good market breadth.
We have an underweight view on US and European equities relative to Japan. We upgraded our US market view slightly, taking into account the resilience of the economy and companies’ exposure to AI trends. But US valuations seem priced for perfection, making them vulnerable to a downgrade in growth expectations sparked by the resumption of student loan repayments, auto worker strikes, or any number of other catalysts. Corporate balance sheets still look solid, although we see some signs of weakening in net margins and interest coverage.
European valuations are attractive and we have more conviction that the European Central Bank has reached the end of its hiking path as the economy has cooled. However, weak earnings momentum and downward adjustments in profitability — in what we believe to be a stagflationary base case — leave us downbeat on equity market prospects. We also see cracks emerging in the service sector, a negative sign for the labor market and consumer resilience.
We have downgraded our China view to neutral, as we have been too optimistic on the potential for a cyclical uplift as well as on structural issues holding back sentiment and investors’ willingness to engage. We are tracking a raft of recent policy measures and signs of cyclical green shoots suggesting we may be at peak pessimism, but also note that there are fewer signs of a turnaround in consumer sentiment or the property cycle. The case for emerging markets (EM) ex-China is also finely balanced, with domestic monetary policy easing juxtaposed against a strong US dollar and inflation risks from food and oil.
Regarding sectors, we are positive on financials and negative on materials. We expect financials to be supported by strong corporate fundamentals as well as continued positive sentiment, while we expect the materials sector to struggle given weaker return on equity and higher return volatility.
A number of factors drove government bond yields around 50 bps higher in the second quarter. First, longer-maturity real yields rose as markets embraced the Fed’s mantra of “higher for longer,” which translated into expectations of a higher fed funds rate for a longer period. Second, the term premium — which compensates investors for duration risk — widened to reflect greater long-term inflation uncertainty and rising US public debt (which, among other things, prompted Fitch to downgrade US government debt in August). Finally, the BOJ took the first step toward tightening monetary policy by relaxing its yield curve control and allowing 10-year government bond yields to rise to around 50 bps. While this does not seem particularly dramatic on its own, 0% rates in Japan anchored rates in other regions to some extent.
So, are rates likely to go even higher? We remain moderately overweight duration overall owing to the mixed picture on global growth and attractive valuations in the US. Growing evidence that the US economy is getting pinched by higher rates suggests that the Fed is at a restrictive enough stance to slow the economy. European growth has notched down and looks recessionary. Therefore, we favor US and European duration relative to Japan (Figure 2). The risk is that the US term premium widens further, either in response to the Fed losing credibility in its inflation fight or because markets demand a larger term premium for being a creditor to a highly indebted government.
Figure 2
As noted, the global economy has been surprisingly resilient and inflation has come down quickly, particularly in the US, leaving us with less conviction around the severity of a potential recession and credit downturn. Still, we remain in the late stages of the credit cycle, with compressed valuations, tightening credit conditions, and some weakening in corporate balance sheets and cash levels, albeit from very high levels (Figure 3). Despite the risks being somewhat skewed to the downside, spreads may remain rangebound for some time in the absence of a clear catalyst for widening — an environment in which we expect credit income to dominate returns.
Figure 3
Taking these competing factors into account, we have upgraded our view on credit spreads while remaining marginally negative on the asset class in the near term. There may be opportunities to add on weakness in light of the more positive starting point for yields, which are a strong determinant of long-term returns. We prefer higher-quality credit in this environment, and therefore remain more positive on investment-grade credit relative to high yield.
We have downgraded our view on EM hard currency debt relative to global high-yield corporate bonds, a decision driven by the economic resilience in developed markets compared to emerging markets, as well as our inclination toward a slightly less defensive position in credit.
We maintain our moderately overweight view on commodities, driven by positive views on copper and gold. In the copper market, we expect favorable long-term supply dynamics and robust demand spurred by spending on the global energy transition. While we continue to monitor the challenging macro environment in China and its impact on copper demand, we have observed signs of sustained demand strength, particularly from the housing market.
Gold prices have remained stable in recent quarters, defying the typical correlation with higher real yields, which indicates underlying strength. We think gold is a reasonably priced hedge in the context of increased stagflation risk, as well as the potential for geopolitical shocks. Concurrently, central bank purchases in Asia persist as a source of positive demand.
We remain neutral on oil, which has been rallying in recent months with support from a bullish supply backdrop and an improving demand outlook. With the price near year-to-date highs and continued demand risks from a potential global economic slowdown, we prefer to stay on the sidelines and wait for opportunities to engage with the market.
Upside risks include a “Goldilocks” scenario for the US economy, in which growth remains at or above trend and inflation continues to move toward target, as well as a soft landing where growth is below trend but unemployment doesn’t spike. For Europe and China, positive outcomes would include a reacceleration in growth, with developed market central banks abstaining from further rate hikes or beginning to move toward rate cuts. In addition, further advances in AI or announcements pertaining to the technology could impact mega-cap valuations, with a disproportionate impact on equity markets.
Downside risks include a scenario in which overtightening of monetary policy or renewed financial stress shocks a prospectively weaker US economy into a hard landing. In addition, a bank or property crisis in China could create a negative skew for global growth. Finally, escalating tensions in Ukraine or with respect to US/China relations could have profound negative implications for markets.
Consider sticking with quality equities — While we’ve seen signs of economic resilience, restrictive monetary policy is starting to have the desired effect and we see weaker growth ahead pressuring earnings. Across sectors, we favor companies with robust balance sheets and a greater ability to navigate cyclical pressures. We recognize the potential of AI to impact a range of sectors and companies but wouldn’t chase the rally in tech more broadly from here.
Look at the current and longer-term case for Japanese equities — Japanese equities have outperformed other regions year to date, and we think the market’s unique combination of an improving economy and better corporate governance give it a long runway for further gains. Exporters continue to benefit from a weaker yen.
Seek better relative value in fixed income — With the spike in US and European yields and more pronounced economic slowing in Europe, we see a clearer case for US and European government bonds over Japanese government bonds. We favor high-quality fixed income given that spreads in growth fixed income are not compensating investors for recession risk.
Prepare for more opportunities — A worsening growth/inflation mix would pressure margins and credit fundamentals. We favor gold in the face of stagflationary risk, geopolitical deterioration, or de-dollarization. We also think copper is a potentially good inflation play given its large role in the energy transition but constrained supply. Investors should be alert to opportunities to reload risk if markets reprice.
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Toshiki Izumi, CFA, CMA