September brought cautious optimism to markets, with yields backing up and value sectors rallying, as tentative signs of trade truce and expectations for additional monetary support by the Federal Reserve and the European Central Bank (ECB) buoyed risk appetite. In part, though, this was also a reversal of some of the extreme yield moves we witnessed in August. Nonetheless, the momentum was rather short-lived and both moves have stalled. So where do we go from here?

Economic data has been disappointing in recent weeks, but, in our view, it is still not pointing to a US or global recession. The US consumer is still solid, as is the labor market, and housing is showing signs of improvement on lower interest rates. Chinese data has held up, barring some expected trade-related weakness, and policymakers have started targeted stimulus measures. That said, Europe remains a weak spot and Germany is likely to show a second consecutive quarter of negative growth when Q3 data is released. Overall though, while risks abound – trade, Brexit, Middle East tensions, fragile sentiment – we do not see an imminent recession.

Sovereign yields have retreated from this summer’s lows, though their climb ended following the attack on Saudi oil production. We expect yields to remain within a broad range, and do not expect a sharp back-up given still soft growth and low inflation expectations. Credit spreads have held in well, and we maintain our preference over sovereigns.

The rotation from growth into value lasted only as yields rose. Following a number of similar false starts, we believe that a pick-up in inflation, and therefore rates, is needed for a more durable move. For now, we believe that growth and more defensive sectors will continue to outperform, as investor caution prevails late in the cycle. The same applies to regions: Upside potential in Europe is higher than in the US, if obstacles are cleared, but we believe that higher growth and earnings will continue to support US markets over the medium term.

Geopolitical uncertainties are likely to continue to drive headlines and asset performance. We still do not expect a sweeping agreement between the US and China in the short term, but a series of mini-deals starting in October are likely. The Brexit saga could end with a deal before the October 31 deadline, if enough tweaks to Ms. May’s Withdrawal Agreement are done, but the more likely scenario is a further extension with general elections in November – which is likely to yield the status quo. From a growth perspective, German fiscal stimulus is needed, and while we believe it will arrive, it might take some time. The latest Trump development with the Democrats starting impeachment proceedings could throw a wrench into these assumptions, but for now we maintain our positioning.

Equities
The risk-on move at the beginning of September showed that equity markets are more focused on (positive) trade developments and central bank support than on growth concerns. We believe that equities can continue to grind higher in the coming months and we maintain an overweight to the asset class, especially as some encouraging developments on trade could help. Nonetheless, volatility and quick reversals in risk appetite are unlikely to disappear.

The recent sector pivot showed that undervalued sectors can benefit in a higher rates environment, but we do not see this as a sustainable scenario for now. As such, we believe that more defensive sectors will continue to do well, even if they underperform over short periods, as investor caution persists. We prefer developed markets over emerging markets that remain more vulnerable to trade tensions. We expect US markets to perform better over the medium term, but European markets could benefit from ECB support and any hint of a German fiscal stimulus package or Brexit deal.

Valuations are not cheap, but they remain more attractive than fixed income. Nonetheless, we believe that some earnings growth will be needed as we enter the Q3 earnings season. Expectations have been downcast, lowering the bar for positive surprises.

Fixed Income
We believe that sovereign yields are likely to trade in a broad range around current levels, and could even drift somewhat higher again in the next few months on better trade news, higher inflation, or markets adjusting to reduced expectations for Fed easing.

We remain below fair value levels, with US 10-year Treasury yields trading around 1.7% and German Bunds around -0.6%, but with ongoing central bank support and little inflation pressures, we do not expect a sharp move upward. Indeed, US impeachment proceedings could even push yields lower in the short term.

Credit spreads have held in relatively well in recent weeks, and should remain contained even if sovereign yields drift higher. High yield has proved more resilient than investment grade in the US, while European Investment Grade (IG) has been stable as well. We remain more comfortable with the IG segment given ongoing growth concerns, though we see no systemic risk on lower ratings for now.

Emerging market debt has held up well given idiosyncratic events. Yield-providing hard currency bonds should remain in demand as long as the US dollar doesn’t strengthen too much. We maintain a preference for US over European sovereigns, and for credit over all sovereigns given valuations and carry.

Currencies
Currency markets have remained broadly stable, with some weakness in EUR following the broad ECB package and poor German data, and some improvement in GBP on expectations that a no-deal Brexit is less likely. The US dollar has maintained underlying support from safe haven demand, as have Japanese yen and Swiss franc. The yuan has remained in a range around 7, falling below as risk appetite and trade tensions improve, and reversing course as easily. Emerging market currencies have held up relatively well, but idiosyncratic risks remain.

Commodities
The recent attack on Saudi production sparked a rally in oil prices that faded once officials confirmed that production would be back to full capacity quickly. We believe that a slightly higher risk premium is likely to remain as security concerns persist, but believe that ample supply and slower growth are likely to keep prices capped.

Gold continues to see safe haven demand thanks to low rates and inflation. With ongoing growth fears and trade uncertainty, the momentum is likely to continue in the short term.

Alternatives
We continue to see a place for alternatives in portfolios, as we look for de-correlating and diversifying strategies to complement traditional asset classes, particularly with liquid alternatives.

Equity securities are volatile and can decline significantly in response to broad market and economic conditions.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.

Currency exchange rates between the US dollar and foreign currencies may cause the value of the investments to decline.

Alternative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions.

All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

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