Even after falling 0.6% on Thursday on weaker US economic data, the S&P 500 has risen 7% since the March low, and the VIX index, at just over 17, is at its lowest levels in more than a year.
But with the S&P 500 now trading at a valuation multiple (18x 12-month forward price-to-earnings) historically associated with mid-teens earnings growth, we think 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 our latest Monthly Letter, we offer our perspective on the most robust way to position portfolios given current valuations and the potential growth and inflation scenarios:
Given the potential macro scenarios, we see better risk-reward in high-quality bonds than in broad US equity indexes. The most plausible scenario in which US equity markets perform well from here—sustained disinflation—should also be beneficial for bonds. However, bonds should also perform well in case of a steeper downturn in the economy. A resurgence in inflation would be bad for both asset classes, though this outcome would be worse for the growth equities that have performed most strongly this year amid disinflationary hopes. We therefore continue to prefer high-quality bonds, including high grade (government) and investment grade bonds.
China’s stronger-than-expected economic recovery should bolster emerging market equities. Within equities, we recommend diversifying beyond the US and growth stocks, and prefer emerging markets, including China. China’s economic rebound is on track, and we expect it to gain further traction in the months ahead. A weaker US dollar, rising commodity prices, and strong earnings growth should also be supportive for emerging market equities. The MSCI Emerging Markets index valuation, at 12.1x 12-month forward P/E, stands at a larger-than-average 36% discount to the S&P 500.
The US dollar looks likely to weaken further. The US has enjoyed a growth premium relative to the rest of the developed world in recent years, but we believe this will erode in the coming months and think other central banks are likely to start cutting interest rates later than the Fed. We retain a least preferred view on the US dollar. We favor the Australian dollar—which should benefit from China’s upswing—and this month we add a preference for the Japanese yen.
With Japan’s negative output gap expected to fully close by midyear, coupled with inflation staying above target, we expect the Bank of Japan to allow a further rise in Japanese government bond yields in 2H23. Moreover, the BoJ’s holdings of these bonds have ballooned to around 52% of the market (as of end-2022), which underpins an added urgency to modify its current yield-curve control regime.
A weakening US dollar should benefit gold, which we continue to see as an attractive portfolio diversifier. We also hold a positive view on commodities more broadly, and see upside for oil prices amid a tightening market.
To read more, see our Monthly Letter, “What is priced in?” To watch a short video on the main themes in this month’s Letter, click here.
Main contributors - Mark Haefele, Vincent Heaney, Alison Parums, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Bonds look set to outperform optimistically priced US equities, 21 April 2023.