Even if the US economy achieves a perfect soft landing, the upside for US stocks is limited, says CIO. (UBS)

Risk assets rallied recently, helped by reduced banking stress and further disinflation that led to expectations that the Federal Reserve will stop raising rates after May. However, in our view, there’s the continued possibility of growth slowing further and a rising risk for recession in the second half of the year due to tighter credit conditions.

Even with elevated downside risks, financial markets, and US equities specifically, look complacent. The VIX index fell below 17 and the S&P 500 20-day realized volatility is less than 9.5%—both at the lowest levels since November 2021.

Given this backdrop, we keep our overall asset allocation guidance unchanged with bonds as most preferred and equities as least preferred. We see a better risk-return trade-off for high quality bonds versus stocks. Our year-end base case price target of 3,800 for the S&P 500 implies about a –7% total return, while our bull case target of 4,400 implies a +7% total return.

Even if the US economy achieves a perfect soft landing, the upside for US stocks is limited. In contrast, IG corporate bond yields would have to rise by about 60bps from here to deliver a negative total return over the rest of the year. Thus, in a large majority of economic outcomes, IG bonds will outperform US equities and with less risk. The same should hold for agency MBS. We recommend increasing allocations to US IG bonds at the expense of US equities.

With the Fed hiking cycle nearing an end, it’s likely yields have peaked. We recommend investors adopt a barbell approach to their fixed income portfolio. They should actively manage liquidity portfolios with shorter-duration bonds to prepare for subsequent rate cuts that create reinvestment risk. They should also buy quality bonds with longer durations to hedge against further equity downside. We also recently upgraded HY corporate bonds and senior loans to neutral. Both have high correlations to equities, and we think reducing equity allocations versus high-quality bonds offers a more attractive trade-off.

Our cautious equity view is based primarily on US equities, which are relatively less preferred than other regions. This is consistent with our message to diversify beyond the US and growth. US large-cap growth stocks rallied this year and are again expensive relative to value and other regions. China’s reopening is accelerating, while cheap valuations and better earnings prospects coupled with likely US dollar weakness keep EM equities and EM USD sovereign bonds most preferred. Within US equity sectors, we are most preferred on consumer staples, industrials and utilities, while least preferred on financials, information technology, and consumer discretionary.

While the bank stress isn’t limited to the US, the consequences for growth will likely be greatest here. The decline of the US dollar during this stress period indicates a negative spillover to the rest of the world should not be large. That fact, in conjunction with peak rates, leads us to recommend investors position for US dollar weakness.

Consistent with our recommendation to invest in real assets, commodities overall–and oil and gold specifically–remain most preferred. In general, oil and commodities are already pricing in a high risk of recession, while supply constraints should become more binding as the year progresses, especially in light of China’s reopening.

Read the full report Yield and Income: Sticking the landing May 2023.

Main contributors: Jason Draho and Michael Gourd

This content is a product of the UBS Chief Investment Office.

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