The persistent rise in the value of risk assets leaves investors with a dilemma: on the one hand, many valuation metrics point to stretched valuations, arguing for more defensive positioning. On the other, economic fundamentals look reasonably good (albeit more so in the US), suggesting they should stay along for the ride. Trying to hedge portfolios seems a reasonable way to reconcile the dilemma.
Exaggerated fears of a global recession following Liberation Day have thankfully turned out to be unwarranted. The US seems to have largely shrugged off the impact. The rest of the world, notably Europe and China, are nonetheless having to rethink their growth models now that exporting to the US is more expensive. We anticipate a recovery in global growth – of varying degrees – in the quarters ahead.
Investors with cash to invest in risk assets, however, may struggle to find good value opportunities. Forward price-earnings (P/E) ratios for major equity markets are all above average. The US market stands out, with a z-score of 1.6 (see Exhibit 1). It is notable, however, the z-score for the Russell 1000 Value index is at a similar level, while that for the NASDAQ 100 index is ‘only’ 0.5. That is to say, the reason large-cap US equities are expensive is because of pricy value stocks, while technology sector valuations are more reasonable.
The NASDAQ 100 forward P/E is nonetheless still 27.8x, not far below the nearly 30x level reached in November 2021 prior to the sell-off of the following year. That event, however, was triggered by the rapid rise/normalisation of the fed funds rate, whereas rates should be falling in the months ahead.
Multiples for the MSCI Japan index have expanded as the index price has risen more quickly this year than earnings expectations, which have been dampened by US tariff policy (as have those for European equities). We nonetheless find the market attractive due to the return of inflation, positive wage and consumption dynamics, a weaker correlation with the exchange rate, and expansionary fiscal policy. The likely arrival of Sanae Takaichi as prime minister (and the fiscal expansion that may follow), offers yet another reason to be optimistic. Japan has the highest year-on-year earnings growth expectations for 2026 of the major value-oriented markets (Russell Value, Europe, Japan; see Exhibit 2).
The tech part of emerging markets indices are now relatively more expensive than the NASDAQ 100 index after a 18% rally over the last month (versus 8% for NASDAQ). We are overweight emerging markets due partly to the superior earnings growth of the tech sector, as well as a recognition that a deprecating dollar has corresponded with an outperformance of emerging versus developed market equities in the past (both in local currency and US dollar terms).
Europe stands out as the market where prices have deviated the least from the long-run average. The difference in the valuations of MSCI Europe and Russell Value is striking when one considers that the sector composition of the two indices is similar; the average difference in weights between the two is just 1.4%.
The outlook for earnings growth is also similar, with Europe actually outpacing the US: consensus estimates are for 12.4% year-on-year growth in 2026 for MSCI Europe versus 9.6% for Russell Value, though this partly reflects the lower growth rate for the European index in 2025.
Credit spreads
Mirroring the expansion of P/E ratios, credit spreads have fallen back to pre-Liberation Day levels, which were thought stretched at the time (see Exhibit 3). The concern back in early April was that investors were not being compensated for the risk they were taking, and the subsequent rise in spreads proved this to be the case.
One would image the concern is if anything more pertinent today given that macro uncertainty has risen over the ensuing six months. Something is almost bound to go wrong, and it seems far more likely that spreads will rise rather than fall from here (see our note, Why opportunities to diversify within fixed income matter more than ever, for a discussion of options for fixed-income investors). Our overweight position in credit is concentrated in short-duration eurozone high yield in an attempt to maximise carry while limiting the risk of a significant widening in spreads.
Signs of complacency
For all the high valuations and macro uncertainty, one does see signs of complacency. Equity VIX and fixed income MOVE indices are near historic lows, the S&P 500 put-call ratio is well below average, and the cost of hedging a decline in the S&P 500 seems low based on implied volatility of S&P 500 puts (see Exhibit 4).
Those who minimise the importance of valuations in the short term note that high valuations can stay high for an extended period of time, and not everything must revert to its mean. Supporting the view to ‘grin and bear it’ are good (or at least good enough) economic fundamentals.
The US economy has largely shrugged off the tariff impact, and we are hopeful that growth in Europe will pick up next year as fiscal stimulus starts to kick in. The recent rise in gold prices arguably reflects the turnaround in the outlook for US policy rates as much as it does its appeal as another option to hedge risk exposures.
One could wait for a negative catalyst (such as the US government shutdown) to create some value in equities, but there is no guarantee that a decline in the markets will arrive soon enough or be large enough to offset money lost in the meantime by not being fully invested.
We are cognizant that risk assets have outperformed expectations since April thanks to the overreaction to the Liberation Day announcement, and that from here gains are likely to be more modest. But we still see broadly solid fundamentals and anticipate that multiples will compress due to earnings rising faster than prices rather than from a significant decline in markets.
Asset allocation views
- The prospect of the US Federal Reserve resuming monetary easing in the absence of a recession reinforced the positive momentum on risky assets : we maintain an overweight position on equities. The earnings upgrades that have followed a strong US earning season as well as the prospects of lower US rates continue to support our preference for US technology and emerging markets. Following the tariff agreement between Japan and the US, we have broadened our equity exposure geographically through a position on Japanese equities, which appear attractive in view of the strong dynamics for corporate earnings.
- As the equity-bond correlation is oscillating between positive and negative territory, inflation volatility increasing, and the diversification benefits from fixed income looking limited, we are keep our duration globally neutral. We maintain, however, in credit a long position on short-duration euro high yield, which provides attractive carry with limited risk.
- Despite the deterioration of technical indicators, we remain positive on gold, which should continue to be supported by the steady buying of emerging central banks and Fed rate cuts.
