In brief
- The backdrop for cyclical assets remains constructive despite rising central bank policy rates and elevated oil prices linked to the Middle East conflict. Our base case assumes a relatively stable macro environment with steady nominal growth, low recession risk, and disinflation over the coming year as supply shocks fade.
- Macro risks continue to be skewed to the upside, toward higher inflation and higher growth. While we have become more hawkish in our policy rate views, we believe the market has overpriced the central bank hiking path, especially in Europe.
- Our positive earnings view —amplified by the AI supercycle —favors U.S. and Japanese equities, which we see as more resilient to current economic pressures. We lean into U.S. high yield for carry as well.
- Over the past quarter, rates have been sensitive to rising oil prices —arguably more than equities have —providing attractive value for long duration positions in Europe.
- We identify two main risks to our macro outlook: an aggressive Federal Reserve tightening cycle or a significant equity market sell-off.
Two countervailing macroeconomic forces are battling to define the current cycle. On one hand, a technology capex boom—a fast-paced AI build-out—is spurring economic growth and strong corporate profits. On the other hand, geopolitical strains threaten to weaken economic activity and shake investor confidence. Which force will ultimately prevail? We debated this question and considered the larger macro and market backdrop at our late-September Investment Quarterly. The tech capex boom is winning the day, our senior investors concluded. But we also discussed how the balance could shift, and how various asset classes are pricing a range of outcomes for the current macro contest, creating compelling opportunities for selective investors.
Where do we find opportunities in the current environment? Expectations for solid economic growth keep us constructive on equities, with a preference for the U.S. and Japan. Confidence in the corporate fundamentals of U.S. high yield companies enables us to capture attractive all-in carry despite tight spreads. A low volatility environment in certain currencies allows us to collect income through high yielding currencies. Finally, as bonds have sold off over the past quarter, global yields at multi-year highs look appealing. Given the relative strengths of the U.S. and European economies, we prefer a long duration position in Europe rather than the U.S.
Macroeconomic and policy views
The global macro environment provides solid support for cyclical assets—our base case scenario envisions resilient growth and robust earnings—even as central banks have shown that they are less willing to be accommodative.
In many ways, the U.S. economy has defied expectations. The AI capex cycle has exceeded consensus expectations and we believe will continue to do so through the next year. Labor markets are stronger today than last year (Exhibit 1). Consumers keep spending, a reflection of household equity wealth and a low savings rate. Overall, we expect the U.S. economy to grow at a trend-like pace, although we do see the potential for an upside surprise if third quarter strength persists.
Core inflation has been cooling in recent months. Escalating conflict in the Middle East would pose a significant risk, but inflation expectations remain well-anchored. The impacts of tariffs and AI on PCE inflation also seem past their peak. In this environment, we think today’s positive stock-bond correlation should normalize closer to neutral.
Despite better inflation news over the summer, high energy prices and the Federal Reserve’s (Fed’s) bid to restore its inflation fighting credibility mean that we now anticipate three Fed hikes in total, including the one just delivered. We do not think this derails an economy that is driven by a largely rate-insensitive capex cycle, particularly as the parts of the economy that usually crack first under higher rates – such as housing – are already weak.
What’s more, we think that financial conditions will not overly tighten in this rate adjustment period as the U.S. economic expansion continues. Credit spreads are still quite tight; long rates are at the top of their trading range and are biased downward; and we expect equities to continue to move higher. The more credible path to a meaningful economic slowdown would be an equity-led drawdown that depresses AI capex and reins in consumer spending as households tighten their budgets.
Once again, Europe’s economy is a laggard, though it is proving more resilient than many had expected. Recent growth reflects stronger activity in peripheral countries of the euro area (e.g., Spain, Italy) as well as government policies to cushion the energy shock. AI-related investment and German fiscal spending provide what could be durable structural support. But we still expect tighter European Central Bank (ECB) policy to rein in economic activity (we see one more hike later this year). Europe also faces the sharpest energy trade-off: if oil prices stay high, governments will struggle to keep shielding households from the effects of higher energy costs.
In Asia, corporate Japan is showing real momentum. Profits are strong and companies plan increased capital spending. Exports, especially semiconductors, benefit from the AI cycle. At the same time, underlying inflation is moving higher. We now expect the Bank of Japan (BoJ) to tighten further toward a roughly 2% terminal rate. In addition, we see a meaningful risk that it will need to keep going. One complicating factor for investors: the uncertain outcome of a tug of war between Japan’s dovish Takaichi government and a hawkish U.S. Treasury under the leadership of Secretary Scott Bessent.
In contrast, China’s growth looks stable in the mid-4% range, with strong exports and soft domestic demand. A faster policy response could emerge if growth lags behind the government target.
The trajectory of the Middle East conflict and its resulting impact on energy prices will inform investors’ perception of inflation risk. Several factors have so far kept the oil shock contained: resilient flows out of the Gulf through Hormuz and the pipelines that bypass the Strait, along with dampened Chinese oil imports (Exhibit 2). Further support to energy prices has come from the use of government strategic reserves stockpiles and increased oil production in the U.S. and other nations. (Helpfully, too, there was excess supply of oil before the conflict began.) We will track how sustainable this collective support will prove to be as oil prices continue to trade in an elevated “new normal.”
Fundamental asset allocation views
Our asset allocation views draw on four key themes: macroeconomic stability, a sustained AI capex cycle, structural Japanese reflation, and cyclical disinflation in major developed market regions.
While government intervention in markets has generated headlines, the past quarter has largely been marked by surprisingly low volatility in equities, rates (up until recently), and currency markets. The theme of macro stability helps underwrite our carry positions across the fixed income and currency spectrum, where we collect income amid robust fundamentals. We like the carry in U.S. high yield. Over the quarter, yields have moved higher but spreads have remained well contained, indicating no major deterioration in credit quality. (Exhibit 3)
Similarly, we initiated a FX carry basket of high yielders that are also energy exporters – USD, AUD, NOK – against low yielders that are also energy importers – CHF, JPY. In this trade we look to take advantage of the current environment of low currency volatility.
As we’ve noted, we take a constructive stance on equities amid solid nominal growth and low recession risk. Importantly, we anchor our outlook on a sustained AI capex earnings cycle rather than a bet on multiple expansion.
The U.S. remains our core overweight, with a 12-month target of 8,600 for the S&P 500. The market offers the broadest, most durable exposure to the AI capex and adoption cycle. At the same time, earnings momentum in the U.S. has started to broaden beyond the AI picks and shovels (such as market star Nvidia) to the hyperscalers and adjacent beneficiaries. We continue to believe that the AI capex build-out has ample room to run. Our optimism reflects supply backlogs, highly attractive data center economics and improving visibility into how capex will be monetized (a key investor concern). Finally, hyperscalers have the capacity they need to raise debt, even if it is at wider spreads.
We also overweight Japanese equities through a long TOPIX position. Japan’s corporate governance reform is durable, we believe, and both the policy shift and economic reflation should be positive for stock markets. Together these factors could further boost corporate return on equity (RoE) in a market that is attractively valued relative to its expected profitability (Exhibit 4).
We take a neutral stance on Europe and emerging markets. We think EM companies will continue to benefit from the AI cycle. But higher oil prices, a Fed on the move, and the risk of a firmer dollar can make for an unwelcome mix for emerging markets, especially where returns are narrow and positioning is crowded.
Compared with the last quarter, signs of equity market fragility have eased. That said, we remain mindful that more than 50% of the EM index is exposed to momentum while the comparable U.S. exposure is low and continues to decline – another reason we are neutral EM equities at this time.
Perhaps the biggest development over the past quarter has been the repricing of rates, which has created real value across DM duration for investors – like us – who see disinflation coming. As of this writing, the yield on the 10-year U.S Treasury has reached 5.1%, toward the top of our estimated trading range. Is that enough to make a bet on U.S. duration? Perhaps, but we think there are better places to lean in. A range of factors - expectations of higher U.S. economic growth, competition for AI financing, more reasonable market pricing of the central bank path, and a worsening fiscal outlook - weigh on a long U.S. duration stance, at least for now. We prefer to go long in Europe, where we believe market pricing of ECB policy has gone too far and the downside risks to growth are greater than they are in the U.S.
Where can we build resilience through this cycle? In our IQ, we had extensive discussions about portfolio resilience across a variety of market environments, including a positive stock-bond environment that is a real risk for us. Stocks, government bonds, and extended credit – the ingredients of traditional balanced portfolios – tend to sell off together when real yields rise and inflation moves above 3% (Exhibit 5). Global infrastructure and transportation, along with trend-following CTA strategies and commodities, can serve as useful portfolio diversifiers in these environments.
A variety of factors will shape markets over the coming year. Even as we acknowledge tail risks, we reaffirm our pro-risk stance. Despite pockets of vulnerability, the global economy and risk assets should prove resilient to the challenges ahead.