Key takeaways:

• After a strong first half of the year, the  mood has shifted during the Summer as markets are adjusting to the reality of “persisting inflation & sticky rates”, a narrative which is adding pressure on equities and valuations.
• While equity and bond market volatility could persist in the short-run, particularly through a historically choppy September/October, we expect more positive market conditions towards the end of the year. Indeed, with the US & global economy cooling down in the months to come, central banks are expected to pause their monetary policy tightening. This would be a positive for equity and bond markets over time.
• We remain neutral on equities, rates and credit. Cash and bond yields are
  a clear competition to equities and our multi-assets portfolios reflect this reality. We are negative on the EUR and CHF against dollar. We upgraded Swiss equities to positive. We are keeping Gold as a diversifier.
• We continue to favour 3 main investment themes: 1) Diversify into the lagging segments of the equity market that carry lower valuations; 2) Use volatility at our own advantage by buying on pullbacks; and 3) Use the bear steepening of the curve to extend duration within fixed-income portfolios.

The big picture

The bull market which took place between October of last year and the month of July was driven by two strong trends: 1) Disinflation and; 2) The Artificial intelligence “mania”. Markets were embracing the prospects of a new “goldilocks” scenario with a cooler economy but neither too cold nor too hot, leading central banks to pivot their monetary policy towards a gradually less restrictive stance. 
However, the uncomfortable combination of rallying oil and US long end breaking up is disrupting this equilibrium and triggering concerns of another episode of “stagflation” fears.

This chart explains by itself why the market mood has been deteriorating over the last few weeks: growth forecasts moving down / world inflation going up

Indeed, projections by OPEC of a supply/demand imbalance close to 3 million barrels a day in the fourth quarter of the year has triggered a rally in oil prices. Meanwhile, the resilience of the economy and signs that inflation is stickier than expected have been pushing long-term bond yields to new highs. Indeed, the yield of the Bloomberg Global Aggregate Total return index is at its highest since the months that preceded the Great Financial Crisis.
Equity markets are now getting uncomfortable with those rate levels. We also note that the last leg up in yields has been accompanied by an outperformance of defensives over cyclicals. Key indices (S&P 500, Dow, Nasdaq) trade below their 50 day and 100 days moving averages. For the 1st time since March, the S&P 500 is down more than 5% from its high. Volatility is making a come-back with the VIX trading above 17. Global equities ex-US are faring even worse.
Interestingly, the pause by the Fed at the September FOMC meeting didn’t provide the boost some were expecting. As anticipated, the Fed held rates steady at 5.25% - 5.5% at this meeting, but kept the option of an additional rate hike on the table, maintaining its outlook for a peak Fed Funds rate of 5.6%.
The message from Jerome Powell was clear: The Fed will continue to keep rates elevated until inflation moves more convincingly toward 2.0%. The Fed's new set of projections also reduced the number of potential rate cuts in 2024, from 1.0% to 0.5% of cuts next year – implying that the elevated interest-rate environment may last longer than expected. Meanwhile, the Fed continues to reduce the size of its balance sheet through quantitative tightening.
Another concern for investors is the lag effects of the rise of interest rates on the real economy. Renewed weakness by US banks stocks seems to indicate that the most aggressive rate hike cycle in recent history will not leave the economy and financial system unscathed. This might explain the surprising statement by Fed Chair Powell, who said he would not call soft landing a baseline expectation, hence sharing his fears that keeping real rates elevated for a long period of time is creating some downside risks for the economy and the markets.

US 10y real yields (10y nominal yields - 10y inflation expectations) jumped to 2.11%, the highest since 2009

On a more optimistic note, US earnings revision trend remains positive. If consensus estimates prove true, the second quarter will mark the end of the earnings downturn. S&P 500 earnings are expected to turn positive in the third quarter and rebound further in 2024. The combination of positive earnings growth simultaneously with the Fed finally pausing could very well help equity markets to resume their uptrend. 
We also note that the amount of shorting in US equities by hedge funds since mid-August is the largest in six months and ranks in the 98th percentile vs. the past decade (source: Goldman Sachs). Meanwhile, the level of short gamma is the highest in a long time. We need to keep in mind that these kind of moves work both ways, so a possible bounce from here would force hedge funds and dealers to buy back the stocks they sold recently.
Last but not least, seasonality will soon turn positive There are only 100 days left in 2023 and we are getting closer to the most favourable period of the year for stocks. Almost 80% of the time, the S&P 500 records gains during the last 100 calendar days of the year.

Based on history, the S&P 500 will soon enter the most favourable months of the year

Source: Yahoo France

In the next section, we respond to the frequently asked questions from clients. We present our latest asset allocation decisions based on the 5 pillars of our asset allocation process. To conclude, we suggest three investment themes for the months to come.

The weight of the evidence

Our asset allocation preferences are based on 5 indicators including 4 macro & fundamental indicators (leading) and 1 market dynamics (coincident). The weight of the evidence suggests a neutral allocation to equities. Below we review the positive and negative factors for each of them.

Asset Allocation 

EQUITIES
We have a NEUTRAL stance on equities with a slightly positive view on the US, Japan and Switzerland (upgraded from neutral), a neutral view on the UK, EM Latam and China/EM Asia and a slightly negative view on Eurozone and other EMs.
As mentioned earlier, earnings revision has been a tailwind for equities during the first 9 months of the year and if consensus is right, earnings momentum will turn positive in 3Q and 4Q this year. From a valuation perspective, US equities large caps remain expensive both on an absolute and relative basis. Importantly, cash and bond yields create significant competition for stocks. Treasury yields now surpass stock dividend yields by the widest margin since the Global Financial Crisis.

For income, buy bonds

But this relative expensiveness is mainly explained by the high valuation multiples of the “Magnificent 7”. Valuations outside of this specific segment of the market appear less stretched (see chart below).

Valuations are more reasonable outside Technology (forward P/E ratio)

We are upgrading Swiss equities from neutral to positive due to their defensive characteristics and the fact the Swiss National Bank is probably at the end of its monetary policy tightening cycle.

FIXED INCOME
Within Fixed Income, we are maintaining a neutral stance on both Rates and Credit, with a slightly positive outlook on Investment Grade and a slightly negative view on High Yield.
While last year's rise in interest rates was primarily due to concerns about inflation, this year, higher yields appear to be driven by the market's improved perception of economic growth potential, resulting in real interest rate levels not witnessed in decades. Conversely, we recognize the potential for lower rates due to a global growth slowdown.  In this rate environment, we recommend gradually extending duration, as there is an attractive asymmetry in long-term rates, supported by expected moderation in growth and inflation. The resurgence of oil prices could temporarily weigh on short-term rates but increases the case for a long-term growth slowdown. 
Considering our concerns about the Eurozone's growth outlook and the potential conclusion of the ECB rate hike cycle, we are adopting a neutral stance on EUR rates. Within the credit space, our neutral stance emphasizes high-quality corporate bonds. We are avoiding the pursuit of higher yields in the High Yield sector due to overpricing relative to risk. In Emerging Market debt, we maintain a vigilant stance due to valuation and potential risk considerations. Higher oil prices and a strong US dollar pose challenges for oil-importing EM nations, especially Asian countries, while some Latin American countries may benefit.

The Bloomberg dollar index (DXY)

Source: TME, Refinitiv

FOREX & ALTERNATIVES
On the forex side, we remain negative on EUR and CHF (versus USD) and neutral on JPY, GBP and EM currencies (versus USD). The dollar index ($DXY) golden cross is now in place.

US 2- and 10-year Treasury yields moved to new cycle highs following the Fed meeting

Within commodities, we remain positive on gold, which continues to exhibit low volatility with other asset classes and should be a beneficiary of any tail risk event. We note that a significant gap has opened up between gold and real yields. Why? 1) With debt sustainability having become an ever-increasing issue, the market anticipates that real interest rates cannot stay at this level for too long; 2) Investors buy gold as an insurance against adverse circumstances (inflation, recession, etc.). But for gold to appreciate in dollar, a drop in real yields is probably required. In the meantime, gold remains a true diversification asset.
We also maintain our positive view on Hedge Funds. We like well-established Global Macro funds that have a multi-portfolio managers approach. We cautiously like Relative Value funds but are wary of liquidity conditions. We like having a core position in a diversified systematic strategy with a long-term commitment. We prefer staying away from Equity long/short and directional funds as their beta is too high. We do not like Event Driven funds as we believe the merger & arbitrage landscape will be very challenging in 2023.

Gold shrugs off yields

Investment conclusions

A “goldilocks” scenario, with a cooler economy but neither too cold nor too hot, would be a welcome outcome for the Fed - and the markets.
However, the uncomfortable combination of rallying oil and US long end breaking up is disrupting this equilibrium and triggering a rotation into the “persisting inflation & sticky rates” narrative, adding pressure on equities and valuations. 
Our core scenario remains unchanged. While market volatility could persist in the short-run, particularly through a historically choppy September/October, we expect the US & global economy to cool down in the months to come, leading to a Fed pause. This would be a positive for equity and bond markets over time. We thus keep a NEUTRAL stance on equities and believe that a market correction could provide opportunities to increase equity exposure. We are also keeping a NEUTRAL stance on credit and bonds. 
A balanced allocation to the three main asset classes is justified by the fact that bonds currently offer attractive real yields while equity market remains our favourite asset class for the long run. 
We continue to favour 3 main investment themes:

1)    Diversify into the lagging segments of the equity market that carry lower valuations;
2)    Use volatility at our own advantage by buying on pullbacks; and
3)    Use the bear steepening of the curve to extend duration within fixed-income portfolios.

Tactical positioning: our asset allocation matrix