Allocation Views: Risk On, Rates Up—Positioning for Growth, Yield and Diversification

Summary

We currently see heightened volatility in fixed income markets as higher energy prices and resilient growth push up bond yields.

This has pressured equity valuations and resulted in an increasingly positive correlation between stocks and bonds, while also highlighting the importance of additional diversifiers within investment portfolios.

In this month’s edition of Allocation Views, we explore how consistently strong economic growth and corporate earnings demand a positive attitude toward risk, even in the face of uncertainties such as geopolitics, persistent inflation and monetary policy tightening.

As our constructive view on equities holds firm, we also see increasing value in government bonds as markets price in multiple interest-rate rises, pushing yields to attractive levels.

Macro Themes

Strong Growth

• Macro growth remains strong, supported by robust corporate earnings power.
• The US economy has proven especially resilient. Estimates of US growth are above trend, while the labor market appears stable.
• Leading economic indicators look healthy and business activity has improved, but we are monitoring the impact of higher rates and input costs.

Complicated Inflation

• The US inflation picture remains challenged by a prolonged period of elevated core readings, despite improvement in recent data.
• We expect limited second-order effects from the energy impulse, as supply-driven inflation reduces real incomes and suppresses consumer spending.
• Core goods inflation has marginally improved. Tariff pressures have waned, but we are monitoring global supply chain tightness.

Tighter Monetary Policy

• Heightened tensions in the Middle East have catalyzed a recalibration of policy expectations, with a tightening bias in all major regions, including the United States.
• The market now expects a more hawkish Federal Open Market Committee (FOMC) as Federal Reserve (Fed) Chair Kevin Warsh focuses on reinforcing the central bank’s credibility.
• US midterm elections should have little impact on fiscal policy or bond yields, although debates on budgets and the debt ceiling may cause some volatility in bond markets.

Portfolio Themes

Cross-Asset: Risk-On

• Corporate fundamentals remain strong amid double-digit earnings growth expectations for the next 12 months.
• Macro growth remains constructive but is offset by a complicated inflation and policy backdrop.
• Sentiment and positioning are becoming more exuberant but, in our view, are not yet at levels of concern.

Equity Diversification

• Our equity exposure is tilted toward artificial intelligence (AI), reflected in overweight exposure to the United States, emerging markets (EMs), and Japan.
• Optimism around US earnings breadth is confined to large-cap stocks, as higher interest rates disproportionately affect small-cap earnings.
• Australian equities remain our least-preferred region due to a mixture of weak domestic growth, unsupportive fiscal policies and tight monetary policy.

Value in Duration

• We expect higher energy prices to create more demand destruction than market pricing suggests, decreasing the chance that major central banks meet market hiking expectations.
• We upgrade our view of US Treasuries as markets have appropriately priced in the US reflationary macro backdrop.
• Excess returns for equities appear more attractive than those for credit, amid strong earnings and tight spreads.