Optimism about AI’s potential has fueled gains in a relatively limited group of large-cap stocks, especially in the US. On the sentiment front, the recent run is likely overextended, driven by more bullish institutional positioning. There is certainly potential for AI to fuel a boom in the economy and in markets, but this is likely to play out over several years and be a complex process, allowing for productivity gains but also varied forms of disruption. What’s more, ascribing the right earnings forecast and valuation multiple to account for significant technological revolutions is hard, if not impossible. While we would not chase the rally in tech, we would seek balance in exposure to value versus growth in the near term.
Earnings breadth has been mixed across regions, but globally has moved into positive territory. We see this as grounds for some optimism, but our base case is that macro deterioration will weigh on earnings expectations.
China’s performance this year has come as a significant disappointment. The recovery has been uneven, with the goods sector still weak but services also stalling a few months after the post-COVID reopening. Structural issues, including in the housing market and local government financing, are holding the recovery back. Policymakers have confirmed the need for “more forceful” stimulus measures, but it isn’t clear whether the timing and magnitude of their efforts will suffice. That said, we think depressed valuations and positioning signal deeper pessimism than is warranted, and while we have tempered our own optimism, we are still comfortable with a moderate overweight view.
In Japan, positive momentum has reinforced our overweight view. Japanese companies have been able to maintain their pricing power amid rising inflation. Meanwhile, the Bank of Japan (BOJ) has taken a gradualist approach to its revision of yield-curve control, leaving overall policy very reflationary. Structural tailwinds remain in place, including improved corporate governance and increased corporate investment in productivity enhancements. On the flip side, the market has rerated significantly, to the point where some valuation measures (e.g., price-to-book ratios) have risen to median levels from compellingly cheap levels earlier this year.
We maintain our underweight view on the US market, where we see downside risks for lofty valuations and earnings expectations. Europe faces headwinds of its own, including weaker leading indicators of activity, hawkish commentary from the European Central Bank (ECB), and the weaker-than-expected recovery in China.
Regarding sectors, we favor industrials over financials. Despite the competent handling of US regional banking failures by policymakers, tighter regulations and capital requirements will have consequences for US bank profitability and valuations. We have neutralized our relative view on value versus growth over the quarter, but our longer-term view is that value factors will outperform in an environment where inflation and interest rates will likely be higher than in the last cycle.
Commodities for a volatile world
We maintain our moderately overweight view on copper and gold. Our positive view on copper balances very favorable long-term supply dynamics with expectations of lower demand from China’s reopening. Gold has retreated recently as banking and debt-ceiling risks have ebbed, but we think the precious metal should be a medium-term beneficiary of higher stagflationary risks, as well as the potential for geopolitical deterioration or de-dollarization. Meanwhile, our positioning indicators on gold are not stretched and we have seen increased gold buying by Asian central banks, which usually buy on dips.
Our view on oil remains neutral, as OPEC supply discipline has to be set against expectations of demand loss in a recession. We are also watching the impact of Russian oil, amid some supply leakage into world markets and fast-moving events related to the war.
Fixed income: Yield, diversification, and capital gains potential
We continue to see central banks effectively engineering an economic slowdown, and thus we retain our slightly bullish view on defensive fixed income. Market expectations for policy rates shifted higher during the second quarter as the Fed and other central banks reiterated their commitment to fighting high, sticky inflation despite evidence that inflation is falling. A “pause,” which used to mean the next move would be a rate cut, is now more like a “skip,” in which central banks wait to see the cumulative impact of tighter policy before resuming hikes. We’ve seen this already with the Bank of Canada and the Reserve Bank of Australia.
The market’s repricing makes US government bonds more attractive than European and Japanese government bonds. The Fed’s tightening campaign should benefit longer US maturities, which also continue to see robust demand from insurance companies and pension funds. Europe is still earlier in the hiking process and inflation is higher than in the US. As noted, we believe any tightening in Japan will be gradual.
Meanwhile, we are at the late stage of the credit cycle, characterized by an inverted yield curve, tighter credit conditions, and deteriorating fundamentals. Historically, these conditions have been reliable indicators of negative excess returns relative to government bonds over the following 6 – 12 months. Year to date, US bankruptcies have exceeded levels of any comparable period since 2010 (Figure 2). We think high-yield spreads should be at least 140 basis points (bps) wider than the current +430 bps spread, given the risks described earlier. We expect investment-grade credit to outperform high yield in this environment, yet high-yield spreads tightened during the second quarter while investment-grade spreads were relatively unchanged. Taking this into account along with the strong starting level of investment-grade fundamentals, we have raised our view on global investment-grade credit to neutral. We prefer emerging market hard currency debt over global high-yield corporate bonds, with more risk priced into the former.
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