Despite the steep stock market sell-off already this year, we see three reasons to believe the backdrop will remain negative and warrant a moderate equity underweight for the next 6–12 months:
1. The reversal of accommodative monetary and fiscal policy,
2. persistently high inflation, and
3. the risk of lower corporate earnings and multiples.
The US equity market, where valuations are still fairly high, might well be feeling ghosted by the Federal Reserve (Fed), with Chairman Jerome Powell having all but said the central bank will not come to the market’s rescue and will be looking for the economy to pass longer-term inflation tests before taking a less hawkish stance.
On the other hand, the US entered this challenging period in a strong position, with healthy household and corporate balance sheets, and Japan has the advantage of attractive valuations. Thus, we prefer a moderate underweight to equities, rather than an all-out underweight, and we favor the US and Japan over Europe and emerging markets (EM).
Turning to the bond market, we’ve raised our view on defensive fixed income from moderately underweight to neutral. We think market worries are shifting from stagflation to weaker growth, yet fed funds2 futures are signaling more rate hikes than the Fed’s hawkish forecast. Higher yields in high-quality bonds mark a departure from the return-free rate environment, and we think slower growth and the market’s expectations could limit future spikes in rates.
We still have a moderately underweight view on growth fixed income, with no tilts in any of the underlying sectors (as shown in our “Multi-asset views” below). We remain bullish on commodities, though we‘ve taken our view down a notch to moderately overweight, reflecting our belief that the cycle may put a slight damper on demand but structural issues limiting supply in energy and metals will prevail.
Equities: Favoring Japan and the US Over Europe and Emerging Markets
We maintain our moderate overweight view on Japan and the US. Japan’s valuations are the most attractive among major developed-market regions (Figure 1), and its weak currency is an advantage. In contrast to many peers, Japan could benefit from higher inflation given its secular backdrop of persistent deflationary pressure, and its market is under-owned by global investors.