The equity rally in July and August seems like a distant memory, with market optimism having been wiped out by higher inflation readings, more central bank tightening, another natural-gas supply shock, continued weakness in China, and corporate earnings warnings. In addition, divergent monetary and fiscal policies — highlighted by the UK’s initially conflicting signals on these fronts — are driving market volatility and dislocations. On balance, we see tighter monetary policy and the risk of lower corporate earnings and multiples weighing on risk assets over the next few months. But in this environment, the risk/return profile of assets can change dramatically, and we are on the lookout for prices being driven down by factors other than fundamentals. Among the signals we will be watching for in order to assess whether it’s time to add risk: Is the market pricing in a severe recession and is the economy sufficiently weak or inflation sufficiently contained to trigger a pause in Fed tightening?

Our regional views have changed somewhat, as higher inflation is being met with asynchronous central bank, cycle, and market reactions. Within our moderately underweight view on global equities, we continue to prefer the US and Japan but are more negative on European equities. The US is supported by consumer spending and balance-sheet health, while a European recession due to the energy supply shock seems inevitable.

Turning to bond markets, we were early in calling a shift in market sentiment from stagflation to weaker growth last quarter but continue to think weaker growth is coming and with it, stabilizing bond yields. Here too we are differentiating more between US and European markets, with the Fed ahead of the ECB in its inflation fight (Figure 1). Within our neutral overall global rates view, we favor being long US rates and short European rates.

Figure 1

We retain our underweight view on growth fixed income, consistent with our quality bias. Spreads do not, in our view, compensate investors for the elevated risk of recession. We are moderately bullish on commodities but now prefer energy over metals, which could remain weak given China’s ailing property market and a weakening global cycle.

Equities: Global challenges weigh most heavily on Europe and emerging markets

We continue to prefer US and Japanese equities over Europe and emerging markets. Geopolitical tensions and the energy crisis remain an overhang in Europe, with the almost complete shutdown of Russian gas making a recession the most likely scenario. Valuations, earnings expectations, and positioning reflect a more pessimistic outlook (Europe is cheapest among developed markets) but could have further to fall to reach recessionary levels.

While EU and UK measures aimed at supporting households, relaxing fiscal rules, and limiting energy prices will help, much more policy tightening is needed in Europe. Entrenched inflationary pressures mean that the European Central Bank (ECB) and the Bank of England (BOE) will need to continue to hike, even into a recession. In the UK, expansionary fiscal policy has exacerbated the twin deficit problem and stoked fears of a balance-of-payments crisis.

European energy supply should remain constrained until at least 2025 – 2026, when meaningful new sources of gas come to market. Over the short to medium term, this is likely to leave European energy prices at multiples of US prices (Figure 2), leading to the risk of energy rationing and a potential loss of relative production and competitiveness. This is reflected in a weaker euro, which has partly offset tighter financial conditions and supported European equity outperformance in local-currency terms, but eventually the burden of adjusting to weaker fundamentals may shift from the currency to equities.

Figure 2

While policy in emerging markets, and China in particular, is turning incrementally less restrictive, headwinds to profitability and China’s regulatory uncertainty and real estate crisis still add up to a challenging outlook. Aside from some commodity exporters, emerging markets are hampered by higher prices and constrained food and energy supplies. Geopolitical tensions and the eventual realignment of supply chains are added risks.

The hawkish Fed and strong US dollar are weighing on risk appetites broadly, and especially for emerging markets. We will look for evidence of a reversal in the dollar (e.g., other central banks becoming more hawkish relative to the Fed) and a more forceful policy turn in China before revisiting our moderately underweight view on emerging markets.

Given our concerns about Europe and emerging markets, and about global equities overall, our preference for US equities is a relative one. Higher valuations and earnings expectations in the US reflect more optimism about its outlook versus the rest of the world, which we think is justified given a strong labor market, resilient corporate fundamentals, and a high degree of energy independence. Inflation expectations are more contained and there are signs of cooling in goods prices, as well as early signs from a turn in home prices that broader shelter prices will peak in coming months. If we see a global recession, cyclical stocks will underperform — also supporting the US on a relative basis.

Japanese equities could benefit from favorable valuations and a weak currency. Despite acute pressure on the yen and some concerns about upside risks to inflation, the Bank of Japan (BOJ) remains committed to yield-curve control, instead leaning into direct currency intervention to defend the yen. Even if the BOJ were to tweak its yield-curve control approach, the policy mix would still be more supportive than in other regions when combined with likely fiscal expansion. If Japan can create the right kind of demand-driven inflation, especially via wage growth and employment of younger cohorts, it can accelerate nominal economic growth.

Our favored sectors are energy, where supply/demand tailwinds remain strong, and materials. Company fundamentals appear attractive in both sectors thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads. Across sectors, we prefer companies with pricing power, long-term margin stability, and healthy balance sheets, given their potential to fare relatively well amid cost pressures and volatility.

Fixed income: More positive at higher yields

We think the bond markets are ahead of the equity markets in terms of being priced for the Fed’s forecast peak fed funds rate (as shown in Figure 1). The Fed’s median forecast of 3% inflation (based on the Personal Consumption Expenditures Price Index) and a fed funds rate of 4.6% in 2023 implies a positive real rate of over 1.5%, which we would consider restrictive in real terms (and that, of course, is the Fed’s policy goal). Yields near 4% on US 10-year Treasuries and the Fed’s clear willingness to sacrifice growth make us confident that valuations of US government bonds are attractive. The key question is whether the Fed’s terminal rate needs to go higher to bring inflation down.

In Europe, we have become more cautious on the rates market. Our macro team has a higher-than-consensus view on European inflation and ECB hikes and is below consensus on GDP, suggesting a more stagflationary environment than in the US. Fiscal spending is high and rising, which could heat up demand even as the ECB is trying to stanch it. 

We lowered our view on investment-grade corporate bonds from moderately overweight to moderately underweight since spreads are not particularly wide given our base case of recessionary conditions. We also think spreads are not wide enough in growth fixed income to compensate for higher defaults in a recession. That said, all-in yields of around 5.5% in investment grade and more than 9% in high yield may be attractive for investors seeking income and as an alternative to equities. We also see select opportunities in short-end credit, given low dollar prices and attractive carry, and in structured credit, where older vintage non-agency residential housing assets may be well insulated from losses given the equity built up in these structures.

Risks

Downside risks to our views include a severe recession in the US that comes about because either the Fed is unsuccessful at re-anchoring inflation or financial conditions tighten excessively. A severe recession is also a downside risk in Europe, where it would mostly likely be precipitated by a prolonged energy crisis and associated cuts in industrial production.

Other downside risks include extreme currency volatility (e.g., markets punishing the currencies of regions with expansive fiscal spending and too loose monetary policy) and more dramatic developments in the Ukraine conflict, including a higher risk of nuclear deployment by Russia. 

Upside risks include a soft-landing scenario, where the Fed tightens policy just enough, and significant policy intervention in China. On a micro level, corporates may be able to maintain pricing power, thus preserving margins and sustaining earnings growth over a 12-month period at higher levels than consensus currently expects. Another upside risk to our equity underweights (whether overall or regional) is that valuations, especially in Europe and emerging markets, have adjusted to more than fully reflect earnings and other risks.

Investment implications

Tilting toward quality — Synchronized central bank tightening is likely to slow the global cycle. We think the focus should be on companies with pricing power, long-term margin stability, and healthy balance sheets, given their potential to fare relatively well amid cost pressures and volatility. Company fundamentals in the energy and materials sectors appear attractive thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads.

Preparing for regional divergence — While many central banks are tightening policy at the same time, we expect individual economies and markets to behave differently. For example, European equities and rates appear vulnerable to drawdowns compared to the US. Currency exposure bears watching, as we could well see more cases of a country’s fiscal and monetary policies working at cross purposes — like the one that sent government bond yields soaring in the UK — which could create market dislocations and investment opportunities.  

Selectively rebuilding defensive fixed income exposure amid higher volatility — High-quality fixed income looks more competitive versus equities from a yield perspective and could offer upside and diversification once a slowing cycle gains traction. 

Seeking inflation protection — While demand destruction is a headwind for commodities, a continued supply/demand imbalance could push oil prices higher, as could output cuts signaled by OPEC. We think TIPS breakevens remain attractive, as do some real assets.

Approaching credit cautiously — Spreads are not particularly attractive given the higher risk of recession. That said, we see opportunities in structured credit, particularly in older-vintage non-agency residential housing, and in short-duration credit.