For much of the year, bad news for the economy has been good news for markets. More slack in the US labor market, for instance, was cheered by risk assets² as a sign that growth and inflation were moderating, and the Fed might achieve a soft landing. Now, though, the other side of this relationship is playing out: A stronger-than-expected economy has pushed the expected terminal interest rate higher for longer, causing stocks to struggle. Meanwhile, still-tight labor markets and rising commodity prices indicate ongoing inflation pressures, at a time when businesses and consumers have yet to fully absorb the impact of higher rates. This could mean a third phase of the narrative in which a weaker economy spells bad news for markets (FIGURE 1).

We think the fiscal impulse that has propped up the private sector could become a drag on growth in the US and Europe as they consolidate fiscally—although the impact may be less noticeable in Europe, where fiscal stimulus hasn’t been fully deployed on the ground. We also expect higher inflation risk globally as the path to further disinflation becomes more fraught. A worsening growth/inflation mix could chip away at margins. Meanwhile, global equity valuations are still expensive in absolute terms and relative to cash. We observe more regional divergence, with the US and Japan outperforming Europe cyclically, and valuations similarly disparate.

We maintain our overweight view on Japanese equities. While the market is no longer cheap, positive economic momentum has fed through to higher margins and earnings growth. The Bank of Japan's (BOJ) decision to add flexibility to its yield-curve³ control policy in July hasn’t challenged the market’s outperformance, partly because the yen has continued to weaken against the US dollar. In addition, Japanese equities continue to show good market breadth.

We have an underweight view on US and European equities relative to Japan. We upgraded our US market view slightly, considering the resilience of the economy and companies’ exposure to artificial-intelligence (AI) trends. But US valuations seem priced for perfection, making them vulnerable to a downgrade in growth expectations sparked by the resumption of student-loan repayments, auto-worker strikes, or any number of other catalysts. Corporate balance sheets still look solid, although we see some signs of weakening in net margins and interest coverage.

European valuations are attractive, and we have more conviction that the European Central Bank has reached the end of its hiking path as the economy has cooled. However, weak earnings momentum and downward adjustments in profitability—in what we believe to be a stagflationary base case—leave us downbeat on equity-market prospects. We also see cracks emerging in the service sector, a negative sign for the labor market and consumer resilience.

We’ve downgraded our China view to neutral, as we’ve been too optimistic on the potential for a cyclical uplift as well as on structural issues holding back sentiment and investors’ willingness to engage. We’re tracking a raft of recent policy measures and signs of cyclical green shoots that suggest we may be at peak pessimism, but also note there are fewer signs of a turnaround in consumer sentiment or the property cycle. The case for emerging markets (EM) ex-China is also finely balanced, with domestic monetary policy easing juxtaposed against a strong US dollar and inflation risks from food and oil.

Regarding sectors, we’re positive on financials and negative on materials. We expect financials to be supported by strong corporate fundamentals as well as continued positive sentiment, while we expect the materials sector to struggle given weaker return on equity and higher return volatility.

Government Bonds: Interest Rates Going Higher Still?

Several factors drove government bond yields around 50 basis points⁴ (bps) higher in the second quarter. First, longer-maturity real yields rose as markets embraced the Fed’s mantra of “higher for longer,” which translated into expectations of a higher fed funds rate⁵ for a longer period. Second, the term premium⁶—which compensates investors for duration⁷ risk—widened to reflect greater long-term inflation uncertainty and rising US public debt (which, among other things, prompted Fitch to downgrade US government debt in August). Finally, the BOJ took the first step toward tightening monetary policy by relaxing its yield-curve control and allowing 10-year government bond yields to rise to around 50 bps. While this doesn’t seem particularly dramatic on its own, 0% rates in Japan anchored rates in other regions to some extent.

Growing evidence suggests that the Fed is at a restrictive enough stance to slow the US economy.

So, are rates likely to go even higher? We remain moderately overweight duration overall, due to the mixed picture on global growth and attractive valuations in the US with real yields at 2.5%. Growing evidence that the US economy is getting pinched by higher rates suggests that the Fed is at a restrictive enough stance to slow the economy. European growth has notched down and looks recessionary. Therefore, we favor US and European duration relative to Japan (FIGURE 2). The risk is that the US term premium widens further, either in response to the Fed losing credibility in its inflation fight or because markets demand a larger term premium for being a creditor to a highly indebted government.

Credit: Not Out of the Woods, But Looking for Opportunities to Add on Weakness

As noted, the global economy has been surprisingly resilient, and inflation has come down quickly, particularly in the US, leaving us with less conviction around the severity of a potential recession and credit downturn. Still, we remain in the late stages of the credit cycle with compressed valuations, tightening credit conditions, and some weakening in corporate balance sheets and cash levels, albeit from very high levels (FIGURE 3). Despite the risks being somewhat skewed to the downside, spreads may remain rangebound for some time in the absence of a clear catalyst for widening—an environment in which we expect credit income to dominate returns.

Taking these competing factors into account, we’ve upgraded our view on credit spreads while remaining marginally negative on the asset class in the near term. There may be opportunities to add on weakness considering the more positive starting point for yields, which are a strong determinant of long-term returns. We prefer higher-quality credit in this environment, and, therefore, remain more positive on IG credit relative to high yield.

We have downgraded our view on EM hard-currency debt relative to global high-yield corporate bonds, a decision driven by the economic resilience in DMs compared to EMs, as well as our inclination toward a slightly less defensive position in credit.

Commodities: Taking a Shine to Copper and Gold

We maintain our moderately overweight view on commodities, driven by positive views on copper and gold. In the copper market, we expect favorable long-term supply dynamics and robust demand spurred by spending on the global energy transition. While we continue to monitor the challenging macro environment in China and its impact on copper demand, we’ve observed signs of sustained demand strength, particularly from the housing market.

Gold prices have remained stable in recent quarters, defying the typical correlation with higher real yields, which indicates underlying strength. We think gold could be a reasonably priced hedge in the context of increased stagflation risk, as well as the potential for geopolitical shocks. Concurrently, central-bank purchases in Asia persist as a source of positive demand.

We remain neutral on oil, which has been rallying in recent months with support from a bullish supply backdrop and an improving demand outlook. With the price near year-to-date highs and continued demand risks from a potential global economic slowdown, we prefer to stay on the sidelines and wait for opportunities to engage with the market.

Risks

Upside risks include a Goldilocks scenario for the US economy, in which growth remains at or above trend and inflation continues to move toward target, as well as a soft landing in which growth is below trend but unemployment doesn’t spike. For Europe and China, positive outcomes would include a reacceleration in growth, with DM central banks abstaining from further rate hikes or beginning to move toward rate cuts. In addition, further advances in AI or announcements pertaining to the technology could impact mega-cap valuations, with a disproportionate impact on equity markets.

Downside risks include a scenario in which overtightening of monetary policy or renewed financial stress shocks a prospectively weaker US economy into a hard landing. In addition, a bank or property crisis in China could create a negative skew for global growth. Finally, escalating tensions in the Russia-Ukraine war or with respect to US-China relations could have profound negative implications for markets.