Differences in market levels and policy narrative at the end of the first quarter of 2023 compared with the end of the second quarter are sufficiently striking that it’s perhaps surprising they occurred in the same year. The first quarter ended with fears that stresses in U.S. regional banks would escalate into a full-blown crisis and increased odds of a second half recession. By contrast, the second quarter saw resilient growth, the containment of regional bank issues and a 7% rally in the S&P 500 as the artificial intelligence (AI) theme took hold – and the Federal Reserve’s (Fed’s) narrative shifted abruptly. Talk of an imminent pause in hikes was replaced by a hawkish commitment to a higher terminal rate in light of robust economic activity.

While such a sharp about-face may leave investors feeling a little dizzy, we believe that for the remainder of this year recession odds have fallen. The economy faces slightly subtrend growth, but with risks in both directions. To the downside, an inverted yield curve and tight credit conditions keep fears of a contraction alive. To the topside, scope for a cyclical inventory rebound, a slight recovery in real incomes and resilient corporate and household balance sheets may extend the cycle. We now view recession odds as slipping to 25% (from 35%) over the next two to three quarters, with a reacceleration of inflation remaining the most palpable risk this year and next.

At a global level, growth and policy differences are beginning to emerge. The U.S. is perhaps more resilient than expected, Europe has navigated a mild technical recession with little effect on asset markets, and Chinese growth has roundly disappointed. Japan, meanwhile, appears to be benefiting from strength in domestic demand amid economic reopening and supply chain normalization. By contrast, the specter of stagflation is forcing the Bank of England to hike rates, knowing it may amount to a slow-motion suffocation of UK consumer activity.

Such shifting fortunes are beginning to present tradable differentials in currencies and asset markets. However, at the aggregate level, the emergence of two-way economic risks disincentivizes investors from taking significant directional views. Increasingly, attractive cash rates present a further hurdle that investors must clear to take directional risk with confidence. As a result, we have generally higher conviction in seeking bottom- up alpha from securities selection within asset classes, and from selected relative value positions between assets, than we do in directional decisions at the asset class level. Over the next few months, our perspective may evolve; for now, portfolio flexibility seems prudent.

At the asset class level, we are overweight duration with moderate conviction, down from high conviction last quarter, and have upgraded our equity underweight to neutral. To be clear, we’re not issuing a call to rush out and buy stocks; instead, we believe that the earnings downgrade cycle of recent months is nearing an inflection point. Even as stocks rallied over the last quarter, positioning is not stretched, sentiment remains cautious, and earnings growth in the upper single digits would be consistent with our base case of subtrend growth and gradually declining inflation.

Equity valuations of 15.5x in MSCI ACWI are in line with the 10 year average and appear fair, given our base case. In a portfolio with a duration overweight that would outperform in more negative scenarios, we keep the flexibility to add equity risk – either on dips or selectively in our preferred markets of Japan and the UK – as stocks add convexity of returns in upside scenarios. As inflation recedes, we expect stock-bond correlation to decline, adding more support to balanced portfolios of bonds and stocks. Nevertheless, high cash returns make such portfolios more challenging to carry, particularly if market price action is directionless. As a result, we retain a modest overweight to cash.

Assuming no recession in the quarters ahead, credit has scope to perform well and in a balanced portfolio can mitigate some of the carry concerns. While U.S. default rates have ticked up from a historical low of 0.23% to 1.49% today, we believe spreads and especially all-in yields offer reasonable compensation, especially if credit exposure is managed with an “up in quality” bias.

In sum, our view on the economy is less cautious than it was a quarter back; however, this does not translate into sharp changes in portfolio positioning. Instead we recognize two-sided risk and believe blending duration longs with some expression of upside – stocks, credit or pro-cyclical currencies such as the euro – is a good starting point for multi-asset portfolios. Sticky or, worse, reaccelerating inflation is the key risk to this view. But a further steady decline in inflation, continued resilience from the consumer and a U.S. terminal rate in line with the Fed’s projections would support our portfolio tilts as asset markets grind out positive, if unspectacular, returns.

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