Allocation Views: Optimistic on equities, mindful of inflation

Summary

In this month’s Allocation Views, strong corporate fundamentals and resilient growth fuel our continued optimism toward equities into June, despite persistent inflation and more restrictive monetary policy.

The capital expenditure (capex) super cycle is continuing unabated and benefiting a broad swath of companies involved in the artificial intelligence (AI) build out. 

Investor concern around return on investment from that capex has been suppressed by double-digit earnings expectations, which have held forward price/earnings (PE) ratios at acceptable levels and fueled market momentum.

Restrictive policy is a headwind for risk assets, as are rising input costs, but we believe the ongoing strength of corporate earnings outweighs these concerns.

Within fixed income, a hawkish policy pivot, alongside rising term premia, has pushed US Treasury yields higher. This has closed the valuation gap with international developed market government bonds.

Macro themes

Steady growth

• Robust earnings expectations fuel an optimistic post-conflict outlook, although earnings breadth has moderated.
• The US economy has proven resilient, while labor market data has stabilized.
• Leading economic indicators look healthy, but we are monitoring the impact of higher input costs. Euro-area indicators are weaker than other regions. 

Persistent inflation

• US inflation dynamics remain challenging. Core inflation is elevated, but some measures show pressures moderating.
• Core goods inflation is also above trend. Tariff pressures may have peaked but are currently offset by global supply chain tightness.
• We expect limited second order effects from the energy impulse, as conflict in Iran moves closer to a resolution.

Policy bifurcation

• There is an increasing bifurcation between supportive fiscal policy and restrictive monetary policy as markets assess the energy price shock.
• The Middle East conflict has catalyzed a recalibration of policy expectations, with a tightening bias in most regions including the United States.
• Fiscal policy is supporting growth but contributing to expanding deficits. US tax refunds are offsetting tariff headwinds, while energy support packages could also prove influential.

Portfolio positioning themes

Equity optimism

• Corporate fundamentals remain strong amid double-digit earnings growth expectations for the next 12 months.
• Conflict in the Middle East is moving toward resolution, and we would expect markets to look through any temporary setbacks.
• Sentiment and positioning have strengthened, but are not yet exuberant, remaining broadly supportive of risk assets.

Focus on US core equities

• We retain a preference for US large-cap equities, as artificial intelligence (AI) capital expenditure (capex) continues to drive equity markets.
• We trim emerging market (EM) equities exposure following recent strong performance but remain optimistic, amid healthy corporate fundamentals and exposure to AI themes.
• We have reduced exposure to Japanese equities, influenced by rising inflation pressures linked to higher import costs and fiscal stimulus effects.

Balancing duration exposure

• We expect demand destruction to have a greater impact on monetary policy decisions than market pricing suggests, decreasing the chance that central banks meet market hiking expectations.
• Resilient US growth and challenging inflation dynamics complicate Fed policy. We have added to US duration but remain underweight amid sustained upward pressure on yields.
• Excess returns for equities appear more attractive to us than credit, amid strong earnings and tight spreads.