- Global Investment and Multi-Asset Strategist
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Key points
- The global economy has remained resilient, shrugging off the US banking crisis and riding on positive sentiment from generative artificial intelligence (AI) and the potential for a soft landing. However, we continue to expect tighter credit conditions and restrictive policy to take a toll on the economy, and we favor defensive fixed income over equities and growth fixed income.
- Japan remains our top developed equity market. Japanese companies are benefiting from inflation, monetary policy remains easy compared with other developed markets, and shareholder activism is improving corporate governance. We have lower conviction on our China overweight given the debt overhang in the property market and consumer skittishness.
- Our base case of recession leaves us with slightly overweight duration stance overall and a preference for US duration. While we maintain our underweight view on lower-quality spreads, we have a more favorable view on investment-grade corporates given declining but still-strong corporate fundamentals.
- We retain our positive view on commodities, with a focus on copper and gold. While cyclical factors could weigh on oil and metals, we expect constrained supplies to support prices.
- Downside risks to our views include a severe credit crunch and recession in the US or Europe, and geopolitical risk involving China or Russia. Upside risks include a soft-landing scenario where central banks tighten policy sufficiently to quell inflation while not inducing a recession.
The global economy has been more resilient than expected, but we think recession is delayed, not defeated. In hindsight, the effects of tighter monetary policy were offset by excess savings, tight labor markets, the relative insensitivity of consumers and businesses to higher interest rates, and the breakout of generative AI. But these positives are now more than priced into equity valuations, and looking ahead, we see central banks continuing to hike rates and squeeze the economy.
Despite policymakers’ initial success at containing problems in US banking, this is a story that hasn’t fully played out. Banks face higher funding costs, larger capital requirements, and deteriorating credit conditions, including in the weak commercial real estate market. They are likely to reduce lending, the lifeline of the economy. Liquidity may be further impaired when, as part of the US debt-ceiling deal, the US Treasury issues $1 trillion in new bonds, whose attractive yields will draw assets away from bank reserves.
Against this backdrop, our multi-asset views remain somewhat defensive, with an underweight view on global equities relative to fixed income. We have reduced our view on Chinese equities to “moderately overweight,” as the consumer-led recovery in China has fallen short of expectations. Our view on Japanese government bonds remains at “underweight.” Japan’s government seems content to stand pat on yield-curve control and interest rates for now, as inflation is a net benefit to consumer wages and company margins.
We retain our underweight view on growth fixed income. Tighter lending standards are beginning to show up in higher bankruptcy rates, which are bound to hurt riskier credit, like high yield. While we see corporate fundamentals deteriorating broadly, we are more sanguine on global investment-grade credit, where starting levels for fundamentals are quite strong and elevated cash balances have helped avoid the need for financing. We also remain moderately overweight commodities, with a focus on copper and gold given supportive supply/demand dynamics.
Equities may have gotten ahead of themselves
We are slightly more cautious in our global equity view, moving from moderately underweight to underweight. Equity markets have gained ground this year despite the rise in real yields and conflicting signals from manufacturing and services activity indicators. While we’ve seen some cyclical disinflation, tight labor markets and robust consumption in many regions suggest there is still insufficient slack in the system to move core inflation sustainably back to target. Consequently, we expect the emphasis on tighter monetary policy to remain in place, further slowing the economy.
This makes it hard to rationalize the equity market’s gains year to date, all of which derive from forward multiple expansion rather than an increase in earnings growth expectations (Figure 1). Similarly, the growth segment of the market has outperformed the value segment, despite the negative historical relationship between the growth factor’s relative performance and rising rates.
Figure 1
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.
Figure 2
Risks
Upside risks to our views include the possibility that central banks slow the economy enough to moderate inflation without crushing labor markets and consumption, leading to a soft landing. We could also see long-lasting liquidity and cash buffers create an even longer lag between rate hikes and an economic slowdown, delaying the recession beyond our 12-month horizon. We’re also watching for the possibility that China's economy reaccelerates, with global spillover effects, and that the narrow rally in equity markets broadens out and becomes more durable.
Among the downside risks are a deeper recession as a result of financial accidents (e.g., a broadening of the banking crisis); a civil war in Russia or existential threats to Putin’s leadership, leading to military escalation and the prospect of unconventional warfare; and a petering out of China’s recovery, with consumption stalling alongside weakening industrial activity.
Investment implications
Stick with quality equities — Restrictive monetary policy has taken longer than expected to work through the system but will still weaken growth and pressure earnings. We think the focus should remain on quality in developed market equities as valuations have gotten pricier amid optimism over generative AI. We favor companies that can withstand inflationary and balance-sheet pressures and, from a sector perspective, prefer industrials over financials. We wouldn’t chase the rally in AI from here and are neutral on US tech.
Japan stands out amid developed market equities — Valuations have increased as flows move to this neglected market. However, we maintain that Japanese equities have more room to run with markets finally engaging with improved corporate governance and capital return to shareholders. China’s recovery has disappointed, but current pricing reflects more pessimism than warranted in our opinion.
Bond yields look relatively attractive — We think defensive fixed income could offer decent income, diversification, and capital appreciation. US government bond yields have the most room to rally. We favor high-quality fixed income given that spreads in growth fixed income are not compensating investors for recession risk.
Prepare for a wide set of possible outcomes — Markets have shrugged off various risks, including in banking, credit conditions, inflation, and geopolitics, but uncertainty still reigns. We favor gold in the face of stagflationary risk, geopolitical deterioration, or de-dollarization. We also think copper will play a large role in the energy transition but faces severe supply constraints.
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By
Andrew Heiskell
Nicolas Wylenzek