Why Strong Earnings and Policy Support Keep Markets Resilient
Current Market Outlook
We are optimistic about global equities and recommend a modest increase in exposure. Strong corporate earnings are supporting higher valuations, particularly in the US. Monetary and fiscal policies remain stimulative, and trade uncertainty has eased. Overall, recession risks appear low, so we favor equities over bonds.
Regional Equity Preferences
We favor US and Japanese equities over Europe in developed markets. In the US, AI-driven growth continues, fueled by strong Q2 results from mega-cap companies, technological advances, and rising capital expenditures. In Japan, corporate earnings are improving, and companies are returning more capital to shareholders. Europe faces slower economic growth and weaker earnings prospects compared to these regions.
Duration and Credit Views
We maintain a slight overweight stance on both duration and credit. Within duration, the UK is moderately overweight, while the US, Japan, and the eurozone are slightly underweight. In credit, we downgraded high-yield bonds to neutral and raised our outlook on hard-currency emerging-market debt to moderately overweight. These EM bonds offer better valuations and a more defensive profile.
Commodities and Risks
We remain underweight on oil due to expected surplus as OPEC slows production cuts. We favor gold as a hedge against stagflation and ongoing central-bank demand, but suggest taking profits and waiting for a better reentry point.
Inflation spikes remain the main downside risk, which could disrupt the “Goldilocks” growth and inflation scenario. Other risks include a softer US labor market and geopolitical tensions. Upside potential comes from reasonable US trade deals with Europe, Japan, and China, as well as productivity gains driven by AI.
Market Performance and Outlook
Global equities rose nearly 7% in Q3 as optimism strengthened. Despite concerns about US fiscal health and central-bank independence, the US led global markets. Softer labor data prompted the Fed to resume easing, while AI innovations drove record revenues and earnings. Liquidity in financial systems also supported investor confidence.
Will this momentum last? Possibly. We believe fundamentals remain strong over the next 12 months. US mega-cap earnings continue to drive higher returns, and historical trends show that markets respond well after central banks resume rate cuts—even following long pauses.
Chart data from 1/31/70 to 9/30/25 shows that past performance does not guarantee future results. The indices used—MSCI World Index and Bloomberg US Corporate IG Bond Index-are unmanaged and cannot be invested in directly. The chart illustrates average returns 12 months before and after a Fed policy rate cut that follows a pause of at least four months. Data is divided into recessionary periods (recession within 12 months of the cut) and non-recessionary periods. (Data sources: The Art and Science of Successful Planning.)
Equity Diversification Strategy
We recommend diversifying exposure from growth-heavy US equities to more value-oriented non-US equities. Japan remains attractive due to improving earnings and shareholder-friendly policies. In contrast, Europe faces challenges. German fiscal support has not translated into broad earnings growth, while France and the UK confront budget pressures.
For emerging markets (EM), we favor debt over equities. EM equity gains relative to developed markets have mainly been driven by valuation multiples rather than earnings. China, the largest index weight, has seen positive sentiment from AI innovation and retail flows, even though underlying fundamentals have weakened.
Fixed Income Opportunities
Fixed income markets present opportunities to leverage regional differences in monetary policy and pricing. Our highest-conviction view is to go long on UK rates. Term premia appear to offset fiscal concerns, and a weaker UK economy could trigger further Bank of England rate cuts.
This outlook contrasts with Europe and the US, where further rate cuts may fall short of market expectations. In credit, we downgraded high-yield bonds to neutral as spreads reached historical tight levels. At the same time, we raised our view on EM debt to moderately overweight. About half of EM debt is investment-grade, offering a more defensive profile than high yield.
We are closely monitoring credit risks after isolated pockets of weakness appeared in US consumer finance, particularly among lower-income borrowers. So far, these issues seem contained and do not indicate broad systemic risks.
Equities: Still a Positive Vibe, Though Valuations Give Pause
We continue to hold a moderately overweight view on global equities. While the post-April rally has been strong and US equities are expensive, the global earnings picture is solid—though admittedly driven by US mega caps—and the policy backdrop is supportive, as central banks are easing globally, apart from Japan (FIGURE 2). While questions remain regarding US tariffs (e.g., a Supreme Court ruling on their legality), much of the uncertainty is behind us, and companies have mitigated some of the impact by passing on roughly half the cost to consumers or down the supply chain.
Chart data from 1/19 to 9/25 tracks earnings revisions breadth, which measures the difference between upward and downward earnings estimate revisions, divided by the total number of estimates. Indices used include MSCI USA, MSCI Europe, MSCI Japan, and MSCI Emerging Markets. Estimates come from the Institutional Brokers’ Estimate System. (Data source: The Art and Science of Successful Planning. For illustrative purposes only.)
AI Investments Driving Growth
We continue to view AI positively. Massive investments provide a near-term boost to the economy and may drive long-term productivity gains. Despite significant spending, large tech companies maintain strong cash flows and high margins.
However, valuations, especially in non-US markets, have risen. Policy uncertainty, including fiscal sustainability, monetary independence, and regulatory issues, also limits upside.
US Equities: Signs of Broader Recovery
In the US, we see early signs of a broadening earnings recovery. Rate cuts are expected to support small-cap and value stocks.
We’ve upgraded our US equities view from moderately underweight to moderately overweight. Gains remain concentrated among mega-cap and large AI firms, but EPS recovery is expanding. Lower corporate taxes, higher investment, productivity growth, and deregulation may help lagging companies. While valuations are high, strong returns on equity and robust earnings support market optimism.
Japan: Corporate Reforms and Shareholder Returns
We maintain a moderately overweight view on Japanese equities. Corporate governance reforms and restructuring provide tailwinds. Record-high buybacks and a relatively high dividend yield deliver strong cash returns to shareholders. Foreign investors shifted from net sellers to buyers in Q2, while market positioning remains balanced.
Despite strong nominal GDP, monetary conditions are loose. A potential rate hike later this year may slightly adjust valuations, which have softened after recent re-rating. Overall, ongoing reflation supports Japanese equities.
Europe and UK: Challenging Earnings Environment
We downgraded Europe ex-UK and the UK from neutral to moderately underweight due to weak earnings prospects. Recent market gains have largely been valuation-driven rather than earnings-driven. EPS for 2025 and 2026 remain subdued.
Germany shows some fiscal optimism, but broader earnings revisions and market breadth are weak. France and the UK face economic and policy constraints. A growing divide exists between Europe’s core and periphery: the periphery has stronger macro fundamentals, while the core struggles with key industries like autos and the strong euro.
Emerging Markets: Cautious Optimism
Our view on EM remains neutral. Recent rallies have been mostly sentiment-driven rather than earnings-based. Lower US rates, a weaker USD, and increased risk appetite support EM markets. In China, AI optimism partially offsets deteriorating macro and earnings fundamentals.
Sector Preferences
Sector-wise, we focus on earnings, technical and valuation rather than any single overarching theme.
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Overweight: communications, staples, utilities
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Underweight: materials, healthcare, industrials
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Neutral: technology, financials
OW = overweight, UW = underweight
Views have a 6–12-month horizon and are those of the authors and Wellington’s Investment Strategy Team. Views are as of 9/30/25, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This is not to be construed as investment advice or a recommendation to buy or sell any specific security.
Government Bonds: Divergence and Opportunity
In Q3, fiscal concerns pushed up 10-year yields across most developed-market (DM) government-bond markets. The US was an exception, where labor-market weakness overtook inflation as the dominant theme, prompting the Fed to pivot toward rate cuts.
We see overall duration as more attractive than cash for two reasons:
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The combination of real yield and “roll down the curve” offers potential positive excess returns across developed rates markets.
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Yields are pricing in excessive negativity on fiscal conditions, particularly in the UK.
Central banks are generally moving toward rate cuts, but the timing, size, and market expectations differ across regions. We identify opportunities in these regional differences for long-duration investments.
UK Bonds: Highest Conviction
Our top conviction is long duration in the UK. The UK has faced fiscal turbulence since 2022, when former Prime Minister Liz Truss approved tax cuts alongside heavy borrowing, triggering market volatility. Today, the term premium is higher than during that period.
The UK faces a fiscal shortfall, with rules requiring a balanced budget by 2029–2030. The upcoming budget announcement in late November will be closely watched. The consensus expects Chancellor Rachel Reeves to announce £30 billion (0.35% of GDP) in combined tax hikes and spending cuts. We believe the fiscal gap will be smaller and spread over several years through 2028.
Other Developed Markets
We maintain a bearish stance on the US, Europe, and Japan.
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US: Markets may have priced in too many Fed rate cuts, despite sticky inflation and low recession risk.
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Europe: The ECB has already cut rates by 150 basis points over the past year. German fiscal expansion offers some upside, but overall potential is limited.
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Japan: We remain short-duration due to accommodative monetary policy, rising inflation risks, and expected fiscal easing after the election.
Credit: Time to Shift from High Yield
Tight spreads limit upside in high-yield credit. We see isolated credit stress in US consumer finance, especially among lower-income cohorts, subprime borrowers, and 24–30-year-olds facing high unemployment and resumed student-loan repayments. However, there is no clear catalyst for broader spread widening.
Liability-driven allocators still find attractive all-in yields of 4%–6%. But given current valuations, we recommend moving up in credit quality, shifting from high yield to emerging-market (EM) sovereign debt.
Emerging Markets Debt
The EM macro backdrop remains favorable: Fed easing, a weaker USD, and loose financial conditions support EM debt. Its composition is roughly 50% investment-grade (IG) and 50% high yield, offering a more defensive allocation compared with equities.
US high-yield bonds are callable, creating a negatively convex profile relative to EM debt and IG corporate bonds. EM debt also provides a potential spread pickup versus global corporate IG bonds and high-yield bonds. In a stressed US economic scenario, EM debt spreads could benefit from longer duration relative to other markets.
Commodities Outlook: Oil and Gold
We maintain a moderately underweight view on commodities, driven primarily by oil. Rising oil prices and the return of OPEC barrels suggest a potential oversupply. This may create an attractive entry point for shorting crude, though the main risk is the negative carry.
We’ve removed our long-standing overweight stance on gold. While geopolitical risks and central-bank demand still support diversification into gold, recent price momentum has exceeded our target, and the technical setup looks fragile after a strong rally.
Investment Implications
Maintain a Slight Pro-Risk Stance
Policy uncertainty may be easing, but questions remain around fiscal sustainability and central-bank independence. Equities appear supportive, backed by loose monetary policy and strong earnings momentum. AI optimism remains a key theme.
Favor Earnings Growth Over Valuations
Within global equities, we prefer Japan and the US over the UK and Europe ex-UK. Strong macro conditions and robust earnings/margin prospects in the US and Japan may justify higher valuations.
Explore Regional Duration Opportunities
We hold a small overweight view on duration, but regional differences create higher-conviction opportunities. Yields in Europe, the US, and Japan reflect lower risk and smaller inflation premia than in the UK. Fed rate-cut expectations may be too aggressive.
Move Up in Credit Quality
We downgraded global high yield to neutral due to very tight spreads. Instead, we favor a small credit overweight in hard-currency EM debt, which has lower beta relative to equities and offers better carry than DM high-yield and investment-grade bonds.
Key Definitions
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Capital expenditures – Funds used to acquire, upgrade, or maintain physical assets.
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Duration – Measures a bond’s sensitivity to interest-rate changes.
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Stagflation – Slow growth, high inflation, and labor market weakness.
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Term premium – Extra yield investors demand for lending over longer periods.
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Spreads – Yield differences between bonds of similar maturity from different sectors.
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EPS growth – Projected earnings per share growth over five years.
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ROE – Net income as a percentage of shareholder equity.
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Yield curve – Plots bond interest rates by maturity to forecast economic conditions.
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Basis point – 1/100th of 1%, used for rate changes.
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Risk assets – Assets with high price volatility (equities, commodities, high-yield bonds).
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Convexity – Curvature of bond price/yield relationship.
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Bullet structure – Bond repaid in full at maturity.
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Carry – Difference between yield on longer-term bonds and borrowing cost.
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Beta – Measures security price sensitivity relative to a market index.
Indices Referenced
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Bloomberg US Corporate IG Bond Index – Tracks US dollar-denominated investment-grade corporate bonds.
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MSCI Emerging Markets Index – Large and mid-cap stocks across 25 emerging markets.
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MSCI Europe Index – Large and mid-cap equity performance in 15 developed European countries.
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MSCI Japan Index – Large and mid-cap Japanese stocks (~85% of free float-adjusted market cap).
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MSCI USA Index – Large and mid-cap US stocks (~85% of free float-adjusted market cap).
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MSCI World Index – Large and mid-cap stocks across 23 developed countries.
Important Risks
Investing involves risk, including potential loss of principal. Foreign and emerging-market investments may be more volatile and less liquid. Small- and mid-cap securities carry greater risk than large-cap stocks. Fixed-income securities face credit, liquidity, call, duration, and interest-rate risks. High-yield bonds carry more volatility and default risk than higher-rated bonds. Commodities can increase liquidity risk and volatility. Diversification does not guarantee profits or protect against losses.
FAQ
Q1: Why are US and Japanese equities preferred over Europe?
We favor the US and Japan because earnings growth, shareholder-friendly policies, and positive macro conditions support higher valuations. European markets face slower growth and weaker earnings.
Q2: How does AI impact US equities?
AI investments boost near-term revenues and long-term productivity, particularly among mega-cap tech companies. This supports strong earnings and market optimism.
Q3: Why focus on UK government bonds?
UK yields offer attractive opportunities due to high term premia and expectations of rate cuts, providing potential positive returns compared to the US, Europe, or Japan.
Q4: Should investors take profits in high-yield bonds?
Yes. Global high-yield spreads are very tight, limiting upside. Moving to higher-quality debt, like hard-currency EM bonds, can offer a better risk/return balance.
Q5: Why are you underweight on oil?
Rising oil prices and OPEC production changes suggest potential oversupply. This reduces long-term upside, though short-term trading opportunities exist.
Q6: What is the outlook for gold?
Gold remains neutral. Central-bank demand and geopolitical risks support it, but recent price momentum has exceeded targets, so waiting for a better entry point is wise.
Q7: Are EM equities attractive?
Currently, EM equities show limited earnings improvement. Much of the recent rally has been sentiment-driven, so selective exposure is advised.
Q8: How does EM debt compare to global high yield?
EM debt is about 50% investment-grade and 50% high yield, offering more defensive exposure than global high-yield bonds. Callable US high-yield bonds add negative convexity, making EM debt a favorable option.
