Economy

Given the rising odds of another Fed move before year-end, and the uncertainty that additional easing can be delivered in Europe and Japan, we re-iterate our tactical call to maintain a below-benchmark duration stance.

The equity rally has been in a holding pattern, with some tactical fraying around the edges.

Investors are being forced into riskier asset classes by the TINA effect, but the gaping macro disequilibria makes it difficult for investors to see how we move back to equilibrium in a benign way. Monetary policy on its own is limited in its ability to soften the adjustment, but the good news is that the political pendulum is swinging toward fiscal stimulus.

Our primary argument for continued EM/China growth disappointments is that their credit growth is set to decelerate further and credit impulses will remain negative, depressing economic growth. Rising LIBOR could lead to a stronger U.S. dollar versus EM currencies. In Venezuela, the economic and financial situation will continue deteriorating hindering any further rally in its sovereign and corporate credit.

We put the odds of a Fed rate hike this year at slightly better than 50/50. But in the event of a rate hike, any sell-off in risk assets will be relatively short-lived and not as severe as the sell-off that followed the initial rate increase last December.

Xi Jinping has not overthrown China's consensual leadership model; The Communist Party is highly vulnerable to the emerging middle class; Factional struggles will re-emerge before the 2017 Party Congress; Economic structural reform is constrained by a host of factors; Geopolitical tail risks will remain elevated.

The populist backlash, if left unchecked, could spiral out of control, leading to severe losses for investors. Concerns about lax financial regulation, rising inequality, unfettered globalization, and fiscal austerity are understandable. Addressing these grievances will hurt corporate profits short-term, but could lead to a more resilient economy longer-term. Investors should position for modestly higher inflation and steepening yield curves. Near-term, equities are technically overbought, but will benefit from the shift to more stimulative fiscal and monetary policies.

Brazilian risk assets have rallied on the back of investor optimism about the impeachment of President Dilma Rousseff. But the political games have just begun. With all politicians looking to the October municipal elections and 2018 general elections, the Michel Temer administration is unlikely to impose fiscal and structural reforms. Debt dynamics are set to worsen, and we continue to short Brazilian equities.

True inflation rates in the euro area and in the U.S. are actually not that different, making the polarized divergence in expected monetary policy very difficult to justify.