The next few weeks could see us test the limits of how much risk equity markets can absorb. (UBS)

Investors today are facing a mix of good news and bad news. The good news is that we may be hitting the limit for US interest rate hikes in this cycle. The bad news is that we are just weeks away from hitting the limit for US government borrowing, and a compromise in Congress has yet to be reached, although as of this writing there are reports that a deal is close.

So far, equity markets seem to be focused on the good news. Despite the risks, the S&P 500 remains close to a one-year high, and the VIX index of implied equity market vola­tility is trading at 17, below the long-term average of around 20.

But with much of the good news seemingly priced in the market, the next few weeks could see us test the limits of how much risk equity markets can absorb.

In the US, debt ceiling negotiations are going down to the wire. We still think Congress will reach a last-minute agreement to raise the ceiling, but if it fails to do so, markets would react adversely. The current standoff is adding to market risks at a time when US economic growth is already slowing, credit conditions are getting tighter, and the health of some regional US banks is still a concern.

Against this backdrop, we see several ways investors can position:

First, we see better risk-reward in bonds than in stocks. In our view, defen­sive, higher-quality segments of fixed income—including high grade (government) and investment grade bonds—offer both attractive absolute yields and a hedge against growth and financial stability risks. Valuations are also appeal­ing on a relative basis: The US equity risk premium (based on the earnings yield) is now 44% below its 10-year average, meaning high-quality bonds are more attrac­tive than US equities.

Second, we recommend diversifying beyond the US equity market and growth stocks. We see the US as the most vulnerable regional market. Given a rally driven by only a handful of names, relatively expensive valuations in large-cap growth and technology stocks, and the negative impact of credit tightening on company earnings, we expect higher volatility in the months ahead, and see the S&P 500 at around 3,800 by December. We prefer emerging market stocks, which should benefit from peaking US rates, higher commodity prices, a weaker US dollar, and China’s recovery.

We also think investors should use the recent rally in tech stocks as an opportunity to review and manage their exposure to the sector. Investors who hold above-benchmark allocations to the sector should consider replacing direct exposure with capital preservation strategies, or rebalancing portfolios toward more defensive sectors, such as consumer staples and utilities.

Third, we maintain gold as most preferred and the US dollar least preferred. The US has enjoyed a growth premium relative to the rest of the developed world in recent years, but we believe this will erode and expect other central banks to continue hiking rates after the Fed has taken a pause. A weaker dollar and lower rate expectations should support gold prices, and we also see benefits in holding the yellow metal as a hedge against geopolitical risks and the debt ceil­ing standoff. We forecast gold prices to rise to USD 2,200/oz by March next year.

Read more in our latest Monthly Letter, “ Investing at the limit,” or watch a short video here.