A Period of Goldilocks is Back?

We turned positive USD and investment grade bonds in October 2022  just as Treasury yields peaked in mid-October 2022. In fact, the US 10-year yield is near our 12-month target of 3.5% after the rally. In addition, from a global context we turned overweight non-US equities including Europe and China last year. Since then we have seen material outperformance of both markets.

Why have bonds rallied and equities in particular non-US equities outperformed?

(1)    We forecasted that Fed hawkishness would result in a peaking Dollar, In fact the dollar peaked in the fourth quarter of 2022. This was part of the rationale for the upgrade to the USD bond upgrade as this was predicated on peak inflation, peak yields, and therefore, a peaking dollar.

(2)    A peaking dollar normally results in a period of outperformance of non-US equities. This loosens financial conditions for the world ex-US. Despite the uber bearishness around Europe illustrated by massive outflows in equities, our work revealed that the European countries had refilled their gas storage above 90% before winter. Since then we have seen a much warmer than expected winter. This cushions consumption and lowers recession risk for 2023. As a result, both the UK/Europe could avoid a recession.

(3)    China reopening – Non-US equity markets are more economically linked to China reopening. Of course, China equities have rallied strongly since the upgrade but importantly, our GDP forecasts are moving up.  We remain overweight China equities, and we have in fact, raised our GDP forecast from 4.5% to 5.1% for 2023.

(4)    US inflation continues to drop in-line with our expectations of falling headline inflation and stickier core inflation.

Hence, we reiterate our views: Overweight USD investment grade/US Treasuries, Overweight China, Europe, and EM equities relative to US equities, and investors can gradually add to dips in the coming weeks. The risk on earnings, inflation, and variants are issues to monitor but don’t change the asset allocation calls which are working.