Allocation Views: The deficit dilemma

Preview

Despite the positive newsflow as of late, much economic uncertainty remains across a medium-term horizon. Leading indicators of US growth have moved into regimes synonymous with negative equity returns, while consumer sentiment and CEO confidence remain weak and inflation expectations have risen.

A new dimension adding further uncertainty to the investment equation is the wide-ranging tax cuts that President Trump hopes will offset any drag on growth from tariffs. This may reduce the US Federal Reserve’s ability to cut interest rates in support of the US economy and expand the fiscal deficit, adding further upward pressure on long-term US Treasury yields.

Against this background, we remain neutral on equities in this month’s Allocation Views, as we assess the impact of ongoing tariff policy. Elsewhere, we favor cash over fixed income, as deficit concerns add uncertainty and erode the attractiveness of US duration.

Macro themes

Softening growth

• Leading economic indicators suggest growth is slowing.
• Forward-looking survey data indicate growth is likely to decelerate further. However, labor market data remains resilient.
• Volatile US tariff policy continues to fuel uncertainty, discouraging investment and depleting “animal spirits” over time.

Uncertain inflation outlook

• Significant progress has been made, although it has been bumpy, and inflation is still above targeted levels.
• Consumer survey data suggest a marked rise in inflation expectations, influenced by aggressive US trade policy.
• Markets are expecting transitory inflation, but we believe the macro backdrop is quite complex, adding to our uncertain outlook.

Divergent policy outcomes

• Fiscal policy in major economies such as the United States, Germany and China has become an influential driver of asset prices, notably US tax cuts.
• We expect a divergence of policy outcomes among Western central banks, as the Federal Reserve (Fed) adopts a “wait-and-see” approach to interest-rate strategy, against a changing US economic backdrop.
• Compared to developed economies, emerging market (EM) central banks have more room to implement policy easing, dependent on trade negotiations.

Portfolio positioning themes

Staying neutral, for now

• Positive news on tariffs has strengthened equity momentum, creating a more constructive setup in the near term.
• However, inconsistent US policy threatens to amplify uncertainty over the medium-term, dampening growth and fueling inflation. 
• Against this background, we are recalibrating expectations for equity returns against ongoing market volatility.

US (un)exceptionalism

• We retain our pessimistic view of the United States, particularly small-cap stocks, amid heightened uncertainty and lower earnings guidance.
• The appeal of some international markets has improved, notably Australia and Canada, as both appear likely to benefit from low tariff sensitivity.
• We are optimistic on EM ex China, recognizing relatively healthy earnings growth and a more constructive macro backdrop.

Selective on duration

• US duration may not act as a defensive hedge amid inflation uncertainty, fiscal sustainability concerns and higher-term premiums.
• Markets have scaled back expectations around the depth and duration of interest-rate cuts, curtailing support for bonds.
• Within global fixed income, we prefer eurozone duration while we monitor the impact of tariffs on inflation and growth.