Asset Class Analysis: Diversification Is Paying Off

April’s tariff-induced market swings feel like a distant memory, with the third quarter of 2025 among the calmest in years. US stocks rose more than 8%, and only one trading day during the quarter saw a decline more than 1%.

And for all the disruptions in the world, markets have held up.

Here, our multi-asset research team shares asset class outlooks based on bottom-up and top-down analysis. For a deeper dive, download the full Global Asset Class Convictions report.

Looking ahead, the market is walking a tightrope.

On the positive side, artificial intelligence spending is helping sustain growth that might otherwise have faltered. Additionally, the Fed is expected to cut rates twice by year-end, and long-term rates are projected to decline.

However, negative macroeconomic headwinds and inflationary pressures have almost offset that positive momentum. Over the next four quarters, slowing consumption growth, sluggish new home building, and fading stimulus measures will take their toll on the US economy. Trade negotiations and tariffs remain a wildcard without yet meaningfully affecting inflation. We forecast inflation, as measured by personal consumption expenditures, will rise to 3.0% in 2026 before easing.

We see the most relatively attractive opportunities in the basic materials, healthcare, and energy sectors.

Most US equity sectors look unattractive in our breakdown. To view the full sector-by-sector analysis, download the report.

The Morningstar Australia Index trades at a premium to our analysts’ bottom–up valuations—levels we’ve rarely seen in the past decade.

Large-cap stocks, particularly banks, appear priced for much more than the mid-single-digit earnings growth we expect. Small caps generally look more reasonably priced than larger companies. Our top-down analysis supports this assessment: elevated valuations suggest future returns may be more moderate as multiples normalize toward our long-term assumptions.

Our equity analysts see the most opportunities in the energy, healthcare, and consumer defensive sectors.

Overall, our China coverage is trading slightly above par based on our long-term assumptions. While basic materials, tech, and healthcare sectors are overvalued, we believe a handful of AI-related opportunities in the communications services sector remain undervalued, such as Tencent Holdings Ltd 00700.

We also believe the consumer cyclical and consumer defensive sectors remain undervalued and see some stabilization despite lingering low consumer confidence. We reiterate our outlook that consumer sectors will recover, taking longer than expected to do so.

We also note the market rally based on AI theme tailwinds has become unjustified for some companies, especially early-revenue businesses with unrealistic growth expectations or nothing to do with AI in their operations. We wouldn’t be surprised to see a correction.

From a top-down lens, European equity valuations are moderately unattractive, while we find moderately attractive opportunities at the stock level. That balances out to an overall Neutral score.

The macroeconomic situation in Europe has been improving steadily since the middle of last year, with 2025 GDP growth expected to be materially ahead of 2024 levels, even accounting for further tariff risks. With inflation around targeted levels, the European Central Bank has cut interest rates to just 2%, a level not seen in three years.

Business confidence remains low in Europe and tariff risks persist; however, low interest rates and the application of the German infrastructure fund could go some way to buoying European equity markets.

From a top-down lens, we view valuations as moderately unattractive, while we find moderately attractive opportunities at the stock level. From a macroeconomic perspective, the UK is in pretty good shape, with GDP growth forecasts pointing to an incremental improvement over 2024.

Inflation remains high relative to the rest of Europe and the Bank of England's targeted level. However, this reflects temporary effects that are likely to fall off by year-end. Interest rates are operating at elevated levels, giving the bank significant room to cut over the coming months, which could be a boon for UK equity markets.

Risks remain, but with a tariff agreement already in place with the United States, the risks are fewer.

The major development of Sanae Takaichi’s surprise election win as the new prime minister has driven the Nikkei to new highs and could improve the market trajectory in the short term. Takaichi is considered to support expansionary fiscal policy, favoring active government spending to stimulate economic growth while maintaining near-term monetary policy easing.

The market expects a weaker Japanese yen because the Bank of Japan will hike interest rates more slowly, despite recent inflationary pressure. This explains the recent surge in share prices, led mainly by exporters.

However, concerns remain that continued monetary easing and low interest rates in an inflationary environment could accelerate future inflation, especially due to rising import costs from a weaker yen. This makes it difficult for policymakers to maintain economic growth without letting inflation get out of control.

Therefore, we remain neutral on Japanese equities in the long term but think there may be short-term tailwinds.

We expect the near-term performance of government bonds to be dominated by their income component.

Among them, UK Gilts are the most attractive from a valuation perspective, but they lack a positive catalyst given persistently elevated inflation expectations and fiscal risks.

Despite spread compression and the associated downgrade, agency mortgage-backed securities remain a stable portfolio anchor given elevated all-in yields and still-expensive credit valuations. Even with recent rate cuts, interest rates will need to fall significantly before refinancing may affect agency MBS.

Inflation risks remain to the upside, which bodes well for treasury inflation-protected securities, or TIPS. At current levels, breakevens may not fully appreciate the level of inflation we could see in the next year.

Longer-dated municipal bonds continue to look more attractive than short-term, while muni credit continues be richly valued.

We maintain our moderately attractive view on emerging markets local currency but downgrade our outlook on hard currency to moderately unattractive.

Hard-currency emerging-markets bonds were among the best-performing fixed-income segments, returning over 10% YTD as of September 30, 2025. Local-currency bonds also posted stellar returns, driven by high domestic rates, a weaker dollar, and a supportive macroeconomic backdrop.

With credit spreads now testing historical lows, valuations appear unattractive. That said, carry still provides some yield enhancement relative to core rate curves, particularly in higher-yield segments. However, given the uncertain macro outlook and potential volatility in risk assets, shorter-duration exposure appears more sensible.

The quarterly report offers a deeper dive on the multi-asset research team’s asset class convictions. Download the report to unlock our long-term perspectives on: 

• Global equity markets
• Developed markets sovereign bonds
• US Treasury Inflation-Protected Securities
• The US dollar and Euro