Allocation Views: Looking through the energy cost shock—stronger earnings, lower tail risks

Summary and themes

In this month’s Allocation Views, we take a more optimistic view of equities in May against a background of waning hostilities in the Middle East and strong corporate earnings.

Open conflict with Iran has given way to tense diplomacy as both sides attempt to find a resolution that meets their objectives. Shipping through the Strait of Hormuz is likely to remain restricted for some time, but de-escalation has stabilized markets, which continue to look past the energy cost shock.

We expect pockets of volatility amid the ebb and flow of conflict resolution, but tail risks have reduced materially in recent weeks, meaning isolated setbacks should have minimal impact as markets trend higher.

Global macro conditions present a mixed picture but remain broadly supportive for risk assets, while earnings growth estimates have strengthened across the world, shrugging off geopolitical tensions and looking through macro uncertainty.

Against this background, we adopt a “risk-on” stance within our cross-asset positioning and improve our view of US core equities and emerging market (EM) equities. Within fixed income, our preference is to diversify international bond exposure while trimming US duration.

Macro themes

Steady growth

• Earnings breadth has moderated, but robust earnings expectations fuel an optimistic post-conflict outlook.
• The US economy has proven resilient, while labor market data is disparate but remains stable.
• Leading economic indicators remain mixed as business activity is crimped by higher input costs and waning confidence.

Moderating inflation

• We expect limited second-order effects from the energy impulse as conflict in Iran moves closer to a resolution.
• US inflation dynamics remain challenging. Core inflation is elevated, but some measures show pressures moderating.
• Core goods inflation remains above trend. Tariff pressures may have peaked but are currently offset by global supply chain tightness.

Policy bifurcation

• There is an increasing bifurcation between supportive fiscal policy and restrictive monetary policy as markets assess the energy price shock.
• The Middle East conflict has catalyzed a recalibration of policy expectations, with multiple hikes now priced in for most regions other than the United States.
• Fiscal policy in major economies is generally supportive of growth. US tax refunds will likely offset tariff headwinds, while energy support packages could also prove influential.

Portfolio positioning themes

Upgrading equities

• Conflict in the Middle East is moving toward resolution, and we would expect markets to look through any temporary setbacks.
• Corporate fundamentals remain strong amid double-digit earnings growth expectations for the next 12 months.
• Sentiment and positioning are not yet overextended, despite the recent strong market rally, supporting risk assets.

Rotating toward US core

• We improve our view of core US large-cap equities, given the conditions for market breadth have weakened in line with slower economic growth.
• Sustained optimism toward EM equities, amid healthy corporate fundamentals and positive exposure to artificial intelligence (AI) capital investment (capex) themes.
• We increase underweight exposure to European and UK equities, influenced by weaker macro backdrops in those regions.

International duration

• We expect demand destruction to have a greater impact on monetary policy decisions than market pricing suggests, decreasing the chance that central banks meet market hiking expectations.
• Resilient US growth and challenging inflation dynamics make Federal Reserve (Fed) easing less likely, in our view. We stay underweight US duration with a preference for international bonds.
• Excess returns for equities appear more attractive than credit, amid strong earnings and tight spreads.