Our multi-asset allocations have become more cautious since late February, with equity risk-taking now some 75% lower than it was in January, while short positions in US and European bonds have also become lighter. This reflects our scepticism about forecasts of an economic ‘soft landing’.
A poll of our multi-asset team shows a 60% expected probability of recession in the next 12 months, with hawkish central banks and higher bond yields to boot. Expectations of rising earnings seem unlikely to be fulfilled in the more challenged macroeconomic environment we foresee.
Bonds don’t signal recession, equities do (perhaps wrongly)
US 10-year Treasuries are currently set for their worst first half since 1788, according to Deutsche Bank research. While 32% of the US yield curve is inverted, that does not mean that bonds are signalling recession. For that, 60% of the curve would have to be inverted.
Yet at the same time, markets expect the US Federal Reserve or the European Central Bank not to be able to hold their ground when it comes to a tightening of monetary policy. Instead, a sharp reversal of the rate rising cycle is expected from next year onwards.
Equity prices meanwhile clearly reflect investor worries: using a simple measure of what equities are ‘pricing’ suggests recession concerns are much greater in equity markets than on the bonds side.
However, we should remember that, firstly, 40% drawdowns not uncommon and current levels are ‘only’ half way there; and, secondly, and pulling in the opposite direction, that the stock market has priced nine of the last five recessions, that is, markets have often fallen significantly when in the end, a recession did not materalised.
A bounce is possible, but not a lasting one
Recent weakness could be followed by short-term relief rallies, but with earnings expectations yet to be corrected lower, we are wary of equities. Were it not for the positive contribution of expected earnings per share growth (by over 7% for the broad ACWI index), equity returns to date would have been weaker than the -22% recorded so far.
For now, Europe is our preferred short, facing geopolitical risk, inflation/supply chain challenges, policy pressures, and growth/earnings challenges. We have been cautious on European equities since the day before the Ukraine war broke out, reducing our exposure further in April and May.
We are positive on Chinese technology stocks (via our MSCI China exposure) and Japanese equities (held chiefly via our Topix exposure).
Asset class views as of 22 June
 Based on their behaviour over the past 11 cycles
 The disconnect between macro indicators (such as the ISMs) and EPS is notable
 Earlier in the year, we closed our long positions in both US small and large caps