Last month, fears of high inflation and rising rates were met head-on with the threat of a financial crisis and slowing economic growth. Yet equity investors have taken the turmoil in stride: The S&P 500 is near its 12-month high, and the VIX index is at a 17-month low.
But with the S&P 500 now trading at a valuation multiple historically associated with mid-teens earnings growth, we think that the market is pricing in a high probability of a near-perfect landing for the US economy.
Of course, it’s possible that the current contraction in bank lending, the previous Federal Reserve rate hikes, and the absence of additional macro shocks could combine to create a "Goldilocks" economy—not too hot, not too cold. US Treasury Secretary Janet Yellen speaks for the equity market when she says she expects moderate growth, and that the banking crisis could ultimately help the Fed to get just enough restraint with fewer rate hikes. But we doubt everything will work out so perfectly, and instead see an uncertain outlook for the growth, earnings, and inflation picture.
In this letter, we offer our perspective on the most robust way to position portfolios given current valuations and the potential growth and inflation scenarios. In short, we see high-quality bonds providing a better risk-reward than broad US equity indexes.
Within equities, we recommend diversifying beyond the US and growth. We prefer emerging market stocks, where valuations are lower, earnings are proving more robust, and a weaker dollar, lower US rates, and higher commodity prices should be supportive. In fixed income, we prefer high-quality segments including high grade (government) bonds, investment grade credit, and senior debt from financials. In commodities, we expect further upside for oil amid constrained supply, and gold given falling real interest rates. And in currencies, we expect the US dollar to weaken gradually as the US interest rate and growth premium over the rest of the world begins to erode.
