(UBS)
The geopolitical and economic environment has become more complex over the past month. Concerns about an escalation in the Middle East conflict and another upward surprise in US inflation have added to market volatility.
But as investors, we have no choice but to navigate portfolios through an environment that’s often full of “butterfly effects” that don’t care about earnings forecasts or valuation metrics.
Still, we find that a grounding in scenario analysis, built on understanding the most probable drivers of future market outcomes, is the best tool to help set our asset allocations. In our new Monthly Letter, we discuss our latest scenario analysis and what we think it means for investors:
In our base case, we expect a soft landing for the US economy. Economic growth is likely to moderate this year, and inflation should gradually resume its downward trend. That should allow the Fed to start cutting interest rates in September. We also expect the conflict in the Middle East to stay geographically contained. In our base case, we see the S&P 500 rising to 5,200 by year-end, and the 10-year Treasury yield falling to 3.85% as investors start to price a more meaningful Fed rate-cutting cycle next year. This implies an attractive risk-return outlook for quality bonds.
In a bear case, investors fear an overheating of the US economy. This scenario would see a combination of “too good” US growth, worries about US fiscal policy, and/or a sustained commodity price shock driving the 10-year Treasury yield to 6%. We would expect the S&P 500 to fall to 4,400 in such a scenario, and an allocation to alternative assets would likely be important to stabilize portfolios.
In a bull case, we consider a disinflationary boom in the US and a front-loading of AI growth. A bull case scenario would depend on investors’ optimism about artificial intelligence building further, at the same time as US growth stays robust and inflation resumes a downward trajectory. This could support a rise in the S&P 500 to 5,500—despite the 10-year Treasury yield climbing to 5%—helped by better-than-expected earnings growth.
What do these scenarios mean for investors?
Quality bonds (including investment grade) remain our preferred asset class given their attractive yields and the value they offer in a portfolio context.
We see the overall risk-return outlook for equities as balanced, and think investors should hold equity allocations close to strategic benchmarks.
Below the index level, we see opportunities in quality stocks, including those exposed to tech disruption and the AI revolution. For those who are underinvested in these trends, we think the recent market volatility may offer an opportunity to build exposure. Investors looking to diversify existing tech exposure can consider alternative growth themes like the low-carbon transition, healthtech, or the ocean economy; or small- and mid-cap stocks.
We also upgrade the UK equity market from least preferred to most preferred this month given favorable earnings momentum and an improving global manufacturing outlook. We expect earnings growth to accelerate this year and next, driven by improving profits for commodity-linked companies and banks, alongside a strengthening UK economy.
For investors able to tolerate additional risks like illiquidity, we also think now is a good time to diversify into alternative assets.
As markets swing between pricing different scenarios, volatility is likely to stay high. But by diversifying and balancing across global markets and asset classes, investors can manage that volatility and keep their portfolio on track.
Read more in the latest Monthly Letter, “ That butterfly effect ,” and watch a short video on these themes here.
