Asset Allocation Outlook – May 2024

We maintain a neutral view on US equities. The S&P 500 Index appears expensive when evaluated using traditional valuation metrics, especially if real interest rates remain at their current higher levels. However, when adjusted for declining interest rates and long-term earnings growth potential driven by AI, the index appears closer to fair value.

We have upgraded our view on European equities to neutral. European growth appears to have troughed, with economic activity broadening out from services to manufacturing. In addition, we expect the European Central Bank to begin cutting rates as early as this month (June), which should further boost risk sentiment towards European assets.

We have downgraded our view on Japanese equities to neutral. Japanese equities have experienced significant outperformance relative to global equities in recent quarters. While we view the structural case as largely intact, higher valuations, monetary tightening by the Bank of Japan (BOJ) and a potentially stronger yen present near-term headwinds for relative performance. 

Our outlook for emerging markets (EM) equities remains neutral. Cyclical and structural headwinds persist for Chinese assets. However, earnings are starting to stabilise and valuations remain attractive. Balancing these factors, we see a wide range of potential outcomes for EM equities in this environment and lean towards a neutral stance.

Our US rates outlook is neutral. Recent upside inflation data surprises have driven further market repricing in rates, with markets now pricing in less than two US rate cuts this year, below the Federal Reserve’s own projections of three. We think that the round trip in US 10-year yields since late 2023 presents a more balanced reflection of the outlook for US policy. 

We still have a neutral view on European rates. We believe disinflation across the European Union has further to go and we see significantly less risk associated with fiscal policy and term premia. However, the recent outperformance of European rates prevents us from moving to an overweight view.

We maintain our neutral view given our expectation that the BOJ will remain patient as it looks to normalise policy. Top-line Japanese growth remains weak, and we are seeing slowing inflation. Nevertheless, we still agree with the narrative that Japan should, at some point, phase out extraordinary monetary easing.

We anticipate that spreads will likely remain range-bound, with little room for further tightening. As a result, we believe that the income component (carry) will primarily drive returns this year, with little potential for capital gains, hence our shift to a marginally neutral view.

We have shifted to an overweight view on high-yield relative to investment-grade credit. We expect high-yield debt to benefit from better overall conditions for risky assets. While spreads remain tight, all-in yields provide a significant cushion against spread widening in the absence of a significant rise in default rates, which is not our base case.

We have downgraded our view on EM debt to underweight, primarily due to the expected continuation of low growth in EM economies. We see more limited opportunities for tightening across EM high yield. While the return of weak issuers to the primary market has boosted sentiment, flows have been limited. Continued strength in the US dollar remains an additional headwind for the asset class.

We still have a neutral outlook on gold markets. Gold has meaningfully outperformed real rates over the recent inflationary period, limiting further price upside from here, in our view. A punitive roll yield requires a substantive price appreciation to justify any overweight.