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 why 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’re 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. 

We changed 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 its 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 impact of the AI ramp-up 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 our underweight on China.

At the sector level, we have an overweight view on energy, financials, and consumer discretionary, and an underweight view on healthcare, 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 Fed and ECB campaigns to adjust rate-cut expectations from six to three and the Bank of Japan’s (BOJ) decision to end its negative interest-rate policy. Ten-year yields in the US and Europe rose around 30 basis points (bps),⁵ much more than in Japan, where expectations exceeded the BOJ’s measured announcement.

Now that these events have unfolded and volatility has dropped, we’re 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’s 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 it is 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-curve⁶ control as well as its ETF and real-estate investment trust 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 and 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’ve 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’re at or near a peak in default rates in high-yield markets, which has historically been associated with flat or tightening spread levels. We’re keeping a close eye on distress ratios,⁷ which typically lead default rates and have been coming down in recent months (FIGURE 2). Given spreads are already tight vs. history, we don’t think there’s 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.

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’s still a bit of premium left and the potential for some tightening in spreads. We’re also turning more constructive on the European macro outlook, which 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’ve 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 much 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’re 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. Other possibilities resulting from the lagged impact of tighter monetary policy include financial accidents in commercial real estate or other vulnerable areas, or the possibility of a recession. We could also see the Middle East conflict broaden, pushing up oil prices and increasing macro uncertainty. Finally, there’s the potential for US political turmoil precipitated by the lead up to a fraught election period.

Upside risks include an even more benign environment (vs. our base case) in which loosening financial conditions lift 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, as well as a resolution to the conflicts in the Middle East and/or Ukraine.