We have moved our view on European equities from underweight to neutral. We see signs that economic momentum has bottomed out and the disinflation trend is more reliable than in the US, giving the ECB a clearer path to cut rates. Earnings have been more lackluster, with earnings revisions the worst among the major regions we monitor. A turn in earnings momentum and/or breadth would give us more confidence to turn positive on this inexpensive market.
We have moderately underweight views on China and EM ex-China. China’s headwinds are more structural, with factors such as internal deleveraging and geopolitical uncertainty limiting the potential for the market to outperform over a 12-month horizon. The policy response remains tepid or reactive as the government is unwilling to deploy the full policy toolbox to stem deflation, all of which has left private sector confidence suppressed.
EM ex-China is a more positive story, with robust macro momentum in India and other parts of Asia and structural reform in South Korea. The AI ramp-up’s impact on semiconductor demand should be positive for the region. We need stronger conviction on the global cyclical expansion and a meaningful decline in the US dollar before we can move away from our underweight view here, which is more tactical than that on China.
At the sector level, we have an overweight view on energy, financials, and consumer discretionary and an underweight view on health care, industrials, and materials. Consumer discretionary is our largest overweight view, with interest rates and macro fundamentals now supportive (e.g., real disposable incomes are rising) and valuations providing a tailwind. The materials sector is our largest underweight view, with sentiment, trend, and valuations all serving as headwinds.
Government bonds: For now, rates have adjusted appropriately
The two main policy events of the first quarter were the Fed and ECB campaigns to adjust expectations from six rate cuts to three and the BOJ’s decision to end its negative interest rate policy. Ten-year yields in the US and Europe rose around 30 bps, much more than in Japan, where expectations exceeded the BOJ’s measured announcement.
Now that these events have unfolded and volatility has dropped, we are happy to sit with a neutral overall duration view until some mispricing appears. One exception is our view that European rates could rally earlier and more than US rates. The premise here is that while European growth may be improving, it is from a near-recessionary base. This is because European growth is bifurcated between the north and south, with the latter being more service-oriented than Germany, the largest European economy. Long the powerhouse of Europe, Germany is now the laggard as it deals with structural challenges from weak manufacturing, high wages, and competition from China. In addition, now that energy prices have come down, inflation is on a clearer downward trajectory. We think the bar for the ECB to cut rates is lower than for the Fed, with US inflation being stickier.
We changed our view on Japanese government bonds from underweight to neutral. The BOJ not only ended negative interest rates, but also its yield curve control and ETF and REIT purchase programs. While these changes were dramatic in direction, the ultimate impact seems mild at this juncture given the leeway the BOJ gave itself to manage the shift to prevent rates from spiking higher. As a result, yields actually fell after the news.
Credit: Confident enough to take a cautious step forward
In a world of easing credit conditions, expected policy rate cuts, lower inflation pressure, and solid growth, we have raised our view on credit spreads to moderately overweight. With yields lower across credit markets, companies have been coming to market to issue new debt and refinance existing debt. This supply has been met by a supportive demand backdrop, as investors seek to lock in yields ahead of rate cuts.
There are signs we are at or near a peak in default rates in high-yield markets, which has historically been associated with flat or tightening spread levels. We are keeping a close eye on distress ratios, which are typically a lead on default rates and have been coming down in recent months (Figure 2). Given spreads are already tight versus history, we don’t think there is much room for further tightening and instead anticipate spreads will remain range-bound this year. In this environment, we expect income to be the primary return driver for credit investors, which motivated our move to a moderate overweight view on credit.
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