Sahm rules are meant to be broken

Just as it seemed everyone had studied up on the Sahm rule, which indicated the US economy was in recession based on a half percentage point rise in unemployment, the Fed cut rates by 50 basis points (bps) and left a recession looking much less likely. Fed Chair Jerome Powell assured markets that the size of the cut did not suggest concern about the US labor market but instead represented a risk-management measure to ensure the Fed does not fall behind in its full employment mandate and a “strong start” toward pushing policy rates back to neutral. 

Rather than rules of thumb, we’re focused on prospects for growth, inflation, policy and valuations. We’re also well aware of the risks related to the US election, but ultimately, we think monetary policy and prospects for a soft landing will be more important to markets than politics, so we have retained our moderately overweight view on global equities. As of this writing, the US presidential race was very close, raising the specter of lawsuits, allegations, and social unrest. But our base case is a peaceful transfer of power and divided government, which will avoid the most extreme policies espoused by the candidates. If we are correct, election-induced volatility could be an opportunity to add risk. If we are wrong, we will need to reassess the economic implications.

With an additional 150 bps of rate cuts projected by the Fed by year-end 2025, we expect equities to outperform fixed income. After the Fed’s first rate cut in past easing cycles, global equities have performed well when there was no recession (left chart in Figure 1). On the other hand, fixed income has performed slightly better in a recessionary environment (right chart). Within equities, we continue to see gains broadening beyond the mega caps. Our top equity pick is Japan, followed by the US — although we have turned neutral on the US given pricey valuations. After August’s mini crisis, precipitated in part by the Bank of Japan’s (BOJ’s) interest-rate hike, yen carry trades have been flushed out and the BOJ is likely to pursue a measured pace of tightening. 

We are less sanguine about Europe, which has an uninspiring earnings outlook and is exposed to China, which still faces problems in the property market and other challenges. China’s recent stimulus announcements are a positive development, but it will take time to determine whether they go far enough to change the market’s longer-term trajectory. Beyond China, we maintain a neutral view on emerging market (EM) equities, where valuations are relatively inexpensive but a clear inflection in global growth is still needed.

Figure 1

Given the rally of nearly 80 bps in 10-year US Treasuries leading up to the Fed’s rate cut, we see limited upside for duration in defensive assets and have moved to a neutral view. We have retained our moderately overweight view on high yield. We see extreme bifurcation between the spreads of higher- and lower-quality spreads, reflecting distress in CCC bonds. While Fed easing will provide some relief, it won’t change distressed situations overnight. Thus, we think high-yield spreads will be rangebound and returns will be driven by coupon income.

Within commodities, where we have a moderately overweight view, we have increased our stance on gold given continued demand from central banks and lower US real rates, among other factors. We take a contrarian view on oil where we see upside to the current low price amid fading recession risks, overstated worries about oversupply, and the potential to earn carry.

Equities: With fundamentals still favorable, keeping an eye out for entry points

We retain a moderately overweight view on global equities. While markets were more volatile in the last quarter, we remain confident in the fundamental resilience of companies and the global economy. With the low risk of an economic hard landing and inflation largely in control, developed market companies are well positioned to achieve robust earnings growth. Following the recent rate cuts by the Fed and the People’s Bank of China, we expect most central banks to loosen monetary policy over the next 12 months. 

All of these factors should support equity valuations, though there are potential headwinds to consider. In particular, while we think markets can deliver on earnings expectations, negative earnings surprises from the Magnificent Seven are a top risk to equity markets in the near term. That said, we continue to expect an improvement in earnings growth outside of the large-cap tech sector, which will be reflected in price action. We’ve seen early signs of broadening at a stock and sector level, as shown in Figure 2.

Figure 2

The potential for volatility driven by the US election over the next few months keeps us from moving to a stronger overweight view on global equities. We do not have a high-conviction view on the election outcome and prefer to allow ourselves some room to lean further into equities at more favorable entry points.

We are neutral on US equities, mostly out of prudence as the market made new highs following the Fed’s September rate cut and appears expensive based on traditional valuation metrics. However, when adjusted for declining interest rates and long-term earnings growth potential, the US index appears closer to fair value. Earnings are supported by an expansion in margins, with the growth in productivity well outpacing that in unit labor costs and pointing to improving competitiveness.

With valuations of Japanese equities looking more favorable following the August volatility, we are leaning into Japanese equities after a hiatus earlier in the year. We believe much of the volatility was driven by technical dynamics linked to positioning and the carry trade, rather than fundamental weakness. We also believe the structural case for Japanese equities, including an improving macro backdrop, corporate reforms, and increased cash return through buybacks, remains largely intact. There is room for further re-rating here, with our expected returns evenly balanced between valuation expansion and earnings growth components.  

In China, recent stimulus is a step in the right direction for liquidity and sentiment. However, we await more policy detail to determine whether this marks a long-lasting turning point in sentiment and valuations. In the meantime, weak private sector confidence, worsening property market dynamics, and intensifying deflationary risks make us cautious about the outlook.   

We have also turned more negative on European equities relative to other markets. The outlook for earnings is lackluster — with the exception of more domestically oriented sectors such as banks and utilities, the region’s equities remain quite dependent on an inflection in the global cycle.   

Within sectors, we are most positive on financials, followed by consumer discretionary, utilities, and IT. We have an underweight view on materials, staples, and communication services. These relative sector preferences add up to a balanced cyclical view, and our long IT versus short communication services view neutralizes an outright Magnificent Seven bet.

Government bonds: Easing cycle underway 

Central banks around the world are in easing mode and China’s recent cut in the reserve requirement ratio adds to the list. Of course, there are exceptions. The BOJ is normalizing rates higher and variations in growth and inflation are causing some central banks, such as the Bank of England (BOE) and European Central Bank (ECB), to move at a more measured pace. However, we think the Fed’s strong 50 bp cut signals a commitment to sustaining US growth that will support the global economy as well.  

That said, we moved our long duration view to neutral and have no regional relative value views. As in past easing cycles, markets anticipated the first Fed rate cut, with the US 10-year yield declining almost 80 bps prior to the September FOMC meeting. From here, we think the 10-year yield will remain rangebound around 3.25% – 4.25%, with the front end of the yield curve likely to experience more downward pressure than the long end. In fact, the 10-year yield actually rose after the Fed’s announcement. In addition, markets have priced in substantial additional easing (Figure 3). This includes cumulative cuts of around 180 bps by the Fed, 135 bps by the BOE, and 170 bps by the ECB over the next 12 months — all of which are more than the central banks’ own projections.

Figure 3

The focus from here will be on real growth. Higher jobless claims could signal a weaker employment and growth picture. On the other hand, lower inflation and looser financial conditions amid buoyant markets are helping sentiment, leading to tentative signs of improved activity. Ultimately, the Fed will need to guide policy to the unobservable neutral rate — the rate that neither restricts nor accelerates growth — and estimates there are in a wide range. The Fed’s long-term terminal rate gives us a clue. It is at 2.9%, around 200 bps from the current policy rate. That is quite a bit higher than what was considered neutral in the past and might be lower if the cycle weakens more than expected or even higher if inflation turns out to be structurally higher amid deglobalization, a shrinking labor force, increased government spending, and mounting costs related to the energy transition. 

Credit: Still checking enough boxes for a moderately overweight view

With central banks cutting rates, inflation receding, and growth on a good trajectory, the macro backdrop continues to be favorable for credit. Company balance sheets have stabilized and remain healthy, supported by a positive earnings season. We are past the peak in high-yield credit default rates, and more accommodative capital markets have made it easier for companies to refinance and term out liabilities, decreasing the impact of the maturity wall. This supply has been well absorbed by strong demand, as investors lock in an attractive all-in yield.

We anticipate that spreads will remain rangebound in this environment. As a result, we believe income will primarily drive returns over the next year, with limited opportunity for spread tightening. We prefer high-yield credit over investment-grade credit; carry is more attractive in the former and likely to remain well supported by the healthy macro and fundamental backdrop.

We continue to see some risks for credit, which leaves us with only a moderately overweight view. The recent decrease in yields is beneficial for some companies looking to refinance, but low-quality companies need to see additional interest rate cuts to avoid costly refinancing rates. This means some distress remains in the riskiest part of the high-yield market, but we expect it will dissipate as rate cuts materialize, which could provide spread tightening potential in a positive macro environment (Figure 4).

Regionally, we now have a neutral view, closing our preference for European high yield over EM high yield. We see a smaller return differential between the markets, with elevated risks around French fiscal policy and more Fed cuts providing a potential tailwind for EM assets.

Figure 4

Commodities: Focused on gold and oil in a volatile world

We maintain our moderately overweight view on commodities, driven by positive views on gold and oil — both of which may be effective diversifiers amid elevated geopolitical risk. 

We believe gold prices can continue to be supported in 2025 as central banks cut policy rates, which is typically associated with more demand for gold. Central bank buying of gold remains strong, and we are now seeing increased retail demand in China and India, spurred by tax incentives.

We think recent price declines and a positive roll yield, which reflects the lower cost of longer-dated futures, warrant a constructive stance on oil. However, our optimism is tempered somewhat by the possibility that additional supply could come into the market and weigh on prices.

Risks to our views

Downside risks to our views include a reacceleration in core inflation, leading central banks to push back against the current implied path for interest rates, and downside surprises in the earnings of mega-cap stocks. We’re also keeping a close eye on the Middle East conflict — if it continues to escalate, it risks pushing up oil prices, leading to supply chain frictions and increasing macro uncertainty.

Upside risks to our views include an upward inflection in the global growth cycle together with a weaker US dollar. This scenario would lead to a catch-up for global laggards and stronger gains for risk assets. Another upside risk would be a scenario in which central banks cut rates faster than currently priced in if inflation declines more than expected. A final upside risk worth mentioning is a stronger-than-expected third-quarter earnings season, with expanding margins demonstrating productivity improvements.

Investment implications 

Consider sticking with global equity exposure — With the Fed having launched the easing cycle with a strong start, we are more confident in a soft landing characterized by moderating growth and lower inflation. We think allocators should consider a risk-on tilt despite expensive valuations and political noise as we expect positive fundamentals and monetary policy to support earnings.

Expect further broadening in the equity rally — We see upside potential in Japanese equities given that improved corporate governance should benefit earnings and that strong earnings expectations are already priced into the US market. US equities should see improved earnings prospects for areas outside of the US mega-cap tech stocks, which could benefit value, small cap, and some cyclicals. Among sectors, we favor financials, IT, utilities, and consumer discretionary over materials, staples, and communications. 

Consider favoring credit over duration in fixed income — Despite tight spreads, we continue to like credit for the carry, strong supply/demand technicals, and declining default rate, and we favor an overweight to high yield. We think 10-year US government bond yields will be rangebound around 3.25% – 4.25%.

Consider a small allocation to commodities — We see upside to gold and oil prices over the coming year. Geopolitics, retail demand in China and India, central bank buying, and lower real rates could support further appreciation in gold. Oil could benefit from receding recession fears and low inventories.