The hawkish Fed and strong USD are weighing on risk appetites broadly—especially in EM. We’ll look for evidence of a reversal in the dollar (e.g., other central banks becoming more hawkish relative to the Fed) and a more forceful policy turn in China before revisiting our moderately underweight view on EM.
Given our concerns about Europe and EM, and about global equities overall, our preference for US equities is a relative one. Higher valuations and earnings expectations in the US reflect more optimism about its outlook vs. the rest of the world, which we think is justified given a strong labor market, resilient corporate fundamentals, and a high degree of energy independence. Inflation expectations are more contained, and there are signs of cooling in goods prices, as well as early signs from a turn in home prices that broader shelter prices could peak in coming months. If we see a global recession, cyclical stocks will underperform—also supporting the US on a relative basis.
Japanese equities could benefit from favorable valuations and a weak currency. Despite acute pressure on the yen and some concerns about upside risks to inflation, the Bank of Japan (BOJ) remains committed to yield-curve3 control, instead leaning into direct-currency intervention to defend the yen. Even if the BOJ were to tweak its yield-curve control approach, the policy mix would still be more supportive than in other regions when combined with likely fiscal expansion. If Japan can create the right kind of demand-driven inflation, especially via wage growth and employment of younger cohorts, it may be able to accelerate nominal economic growth.
Our favored sectors are materials and energy, where supply/demand tailwinds remain strong. Company fundamentals appear attractive in both sectors thanks to capital discipline, reasonable multiples, strong cash flows, and well-behaved credit spreads. Across sectors, we prefer companies with pricing power, long-term margin stability, and healthy balance sheets given their potential to fare relatively well amid cost pressures and volatility.
Commodities: Demand Destruction in a Slowing Global Economy
We maintain our moderately overweight view on commodities. We continue to see opportunity in the energy complex given structural supply challenges that have helped drive roll yields4 into positive territory (backwardation).5 However, we’ve shifted our view on industrial metals to neutral: We think demand erosion from a slowing global cycle will outweigh the benefits of supply bottlenecks; this means short-term pressure on prices is likely.
We have a moderately underweight view on gold as it faces a mixed picture as the balance of risks shifts from a stagflationary scenario toward a growth slowdown.
Fixed Income: More Positive at Higher Yields
We think the bond markets are ahead of the equity markets in terms of being priced for the Fed’s forecast peak federal-funds rate (as shown in FIGURE 1 above). The Fed’s median forecast of 3% inflation (based on the Personal Consumption Expenditures Price Index)6 and a federal-funds rate of 4.6% in 2023 implies a positive real rate of over 1.5%, which we would consider restrictive in real terms (and that, of course, is the Fed’s policy goal). Yields near 4% on US 10-year Treasuries and the Fed’s clear willingness to sacrifice growth make us confident that valuations of US government bonds are attractive. The key question is whether the Fed’s terminal rate needs to go higher to bring down inflation.
In Europe, we’re cautious on the rates market. Our macro team has a higher-than-consensus view on European inflation and ECB hikes and is below consensus on GDP, which suggests a more stagflationary environment than in the US. Fiscal spending is high and rising, which could heat up demand even as the ECB is trying to stanch it.
We lowered our view on investment-grade (IG) corporate bonds from moderately overweight to moderately underweight since spreads aren’t particularly wide given our base case of recessionary conditions. We also think spreads aren’t wide enough in growth fixed income to compensate for higher defaults in a recession. That said, all-in yields of around 5.5% in IG and more than 9% in high yield may be attractive for investors seeking income and as an alternative to equities.
We also see select opportunities in short-end credit, given low dollar prices and attractive carry, and in structured credit, where older vintage non-agency residential-housing assets may be well insulated from losses given the equity built up in these structures.