Do fundamentals support a risk-on tilt?

From a market perspective, we might be close to nirvana. Growth has surprised to the upside, inflation is coming down, earnings have supported rich valuations, and financial conditions are easy. No wonder investors’ risk appetite has roared back. Importantly, central banks are viewed as credible, having worked to tone down the market’s rate-cut expectations. The repercussions of a policy error are well understood by markets in all regions: Ease too soon and risk having to reverse course and tighten more aggressively, reviving the possibility of a recession. Ease too late and risk the cumulative effects of restrictive policy tipping the economy into recession. 

While this environment may seem too good to be true (and only the 1995 – 1996 period resembles it), we are hard-pressed to identify risks that could sustainably derail it over the next six months, though the US election is top of mind. But even if US political turmoil threatens the positive risk environment, central banks seem to have a “free option” to cut rates in response, given that they consider current policy to be restrictive. 

Now more confident in the fundamental and technical picture, we have raised our views on global equities and credit spreads to moderately overweight. Were it not for rich valuations, we might have moved to an even stronger overweight view. Within equities, we favor the US and Japan over Europe and emerging markets. In the US, we are loath to discount AI as a transformative technology given the earnings power demonstrated by the Magnificent Seven. While we have reduced our view on Japan to moderately overweight, we think there could still be another leg to the country’s economic recovery, with recent wage hikes inspiring more consumer spending.

Now that markets are in line with central bank projections of rate cuts this year, we have a neutral view on duration. We see relative value in being long duration in European versus US government bonds; US growth is much stronger than in Europe and the disinflation trend is clearer in Europe. In credit, we have moved to a moderately overweight view from underweight. Valuations are rich, but we think they could stay that way for a while given the positive economic backdrop and strong demand for income. We also see better value in European high yield compared to US high yield. 

Equities: More to like in developed markets, while worries linger in EM

We have increased our view on global equities from neutral to moderately overweight. Economic growth is firming up, with the US leading the way but global laggards also improving. New orders suggest global manufacturing activity is picking up to join already healthy services activity. With global equity valuations relatively high, we would expect earnings expansion and upward revisions of EPS growth to be the main drivers of performance. We would turn more bullish on further evidence the economic expansion and the equity rally are broadening out. 

We have reduced our long-standing overweight view on Japan to a moderately overweight view. We are still positive on the path of structural reforms, which give further runway for a re-rating. Moreover, strong wage hikes driven by union agreements are likely to boost inflation further, especially on the services side. This is a positive for domestic consumption, which has lagged the recovery. It is noteworthy that company profits have been resilient in the face of rising wages so far. However, our outlook on both inflation and short-term rates is above consensus following the recent policy move away from negative interest rates and a cap on Japanese government bond yields. As a result, a stronger Japanese yen is a risk, as EPS is very sensitive to moves in the currency given the export orientation of the market.

We have turned more positive on the US, where both earnings and the economy show resilience and the AI theme seems likely to continue boosting the market’s relative prospects. While valuations of the Magnificent Seven stocks remain higher than the broad market, the companies have delivered on earnings, so their valuations have actually come down in recent months despite strong price gains (Figure 1). Recent dispersion within the Magnificent Seven (with Tesla and Apple underperforming for idiosyncratic reasons) has also left more opportunities for active managers, though we would still like to see increased breadth across the US market. Meanwhile, in an environment of resilient growth, equities have delinked from rate expectations: The market is now expecting only three rate cuts in 2024, down from nearly seven, but equities have shrugged it off. We think this dynamic can continue.

Figure 1

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.

Figure 2

That said, we continue to believe there are risks for credit in 2024, with the market priced for a benign environment. The recent decrease in yields is beneficial for companies looking to refinance, but current yields are higher than the weighted coupons, so some businesses may still struggle with refinancing.

We have a slight preference for European high yield over US high yield. On valuation, Europe is where there is still a bit of premium left and the potential for some tightening in spreads. We are also turning more constructive on the European macro outlook, which, as noted earlier, may give central banks the latitude to cut interest rates sooner than the Fed.

Commodities: Questions arise for gold and oil

Based on our outlook for gold and oil, we have moved from an overweight view on commodities to a neutral view. Gold has been a strong performer in recent months, but we see limited potential for further price appreciation. Central banks and other investors have been building gold allocations this year after weak sentiment in 2023, and more recent gains have been driven by an expectation of lower real yields later in 2024. With heightened geopolitical risks priced in, we think a lot of the positive case has already played out.

One of the main drivers of our positive view on oil in recent quarters has been an expectation of constrained supply from OPEC. While this expectation hasn’t changed, growth in non-OPEC supply from the US and Latin America is weighing on our outlook. We believe geopolitical risk in the Middle East limits the downside risk to oil prices somewhat, but overall, we are less constructive than we have been.

Risks

Downside risks include a scenario in which core inflation reaccelerates or spikes, leading central banks to push back against aggressive rate-cut expectations or even to resume hiking. Another possibility is that the lagged impact of tighter monetary policy causes financial accidents in commercial real estate or other more vulnerable areas, or leads to a recession. We could also see the Middle East conflict broaden, pushing up oil prices and increasing macro uncertainty. Finally, there is the potential for US political turmoil precipitated by the lead up to a fraught election period.

Upside risks include an even more benign environment (versus our base case) in which the loosening in financial conditions lifts growth above trend and disinflation resumes. Other upside possibilities include a scenario in which equity market gains become more broad-based and therefore more durable and a resolution to the conflicts in the Middle East and/or Ukraine.

Investment implications 

Consider increasing equity allocations — The improving global economic environment should support valuations and continued earnings expansion, despite more measured rate-cut expectations. 

Anticipate broadening in the equity rally — We see signs of the rally broadening beyond the Magnificent Seven, which could benefit some market segments that have lagged, such as value and small cap. Regionally, we favor the US and Japan but we have also lifted our view on Europe. From a sector perspective, we favor energy, financials, and consumer discretionary. 

Consider maintaining a neutral duration stance and overweighting credit — Developed market rates are fairly priced in our view. However, we see potential opportunity in some divergence between the ECB and the Fed, with the ECB likely to cut rates sooner. Credit spreads could stay tight for a while given the positive fundamental backdrop, lower anticipated defaults, and strong institutional demand. 

Benign expectations could be disrupted — While we favor a risk-on tilt, we are concerned about volatility later in the year stemming from the stark policy differences between the US presidential candidates and the market implications. Heightened geopolitical tensions could also induce higher volatility.

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