Market complications are piling up to start the year and weighing on equity and bond returns. It began with higher-than-expected inflation (the Consumer Price Index,² or CPI, hit 7.9% in February) and the Federal Reserve’s (Fed) firm response to it: a 0.25% interest-rate hike and, potentially, many more to come. Then it took another turn with Russia’s invasion of Ukraine creating a massive and distressing humanitarian crisis, while adding another layer of market complexity given Russia’s role as a global supplier of commodities.

So, where to from here? To state the obvious, we have no idea how the war in Ukraine will unfold and can only assess the likelihood of various scenarios. We think markets will continue to grapple with the trade-offs between inflation and growth, and the central-bank response. We remain convinced that inflation will be higher and stickier than expected. The war in Ukraine and sanctions on Russia only bolster this view, given the likelihood of additional supply-chain disruptions and shortages in agricultural, metal, and energy commodities. Higher energy prices could also weigh on growth.

Given our inflation outlook, we’re most bullish on commodities, including gold. We continue to favor a moderate overweight to global equities despite the somewhat worse fundamental backdrop. Why? As of this writing, we believe that consumer spending should remain resilient given the accumulation of savings and higher nominal wages, and companies should continue to benefit from relatively strong growth. In addition, COVID-19 restrictions are being lifted, and bearish sentiment is at an extreme. Finally, with geopolitical risk running high, central banks are likely to be cautious in removing liquidity and fiscal spending is likely to increase, which would benefit risk assets.³ The market has backed off its expectation of six Fed rate hikes this year, and we suspect that even the reduced expectations may still be too high (FIGURE 1).

In fixed income, we continue to see downside for total returns in the coming months. Looking at developed-market government bonds, we think Japan’s central bank is least likely to hike rates. We have turned marginally more negative on credit risk. Spreads are wider, and credit returns could be vulnerable to higher government bond yields should investors shed duration.⁴ Within credit, we continue to prefer floating-rate structures such as bank loans but favor an underweight to credit overall.

Equities: Favoring Japan and the US

We think Japanese equities are attractive, with more monetary and fiscal policy tailwinds than any other market and cheap valuations. What’s more, the yen could potentially prove to be a safe-haven hedge in a risk-off environment. In addition, Japan has long suffered from deflation and should benefit from higher global inflation.

We made similar arguments for Europe last quarter, but now European inflation has reached higher and less helpful levels, equities are expensive across a variety of metrics, and the region stands to suffer the most from the invasion of Ukraine. Europe is heavily reliant on Russian energy, and European energy prices had already skyrocketed prior to the invasion (FIGURE 2).

US equities look moderately attractive given a still-robust economic cycle and their relative safety from global concerns such as weak growth in China and Russia’s invasion of Ukraine. Corporate fundamentals are quite strong, and a ratcheting back of Fed tightening expectations should ease pressure on rate-sensitive growth sectors. EM equities may be a source of funding as China’s growth shows few signs of improvement, and Russia reminds investors of the perils of autocratic government decision making. Within EM equities, we favor commodity exporters such as Brazil.