While global equity markets have started the year with solid returns, high-risk and low-quality stocks, notably, have led this positive performance. Combining this with declining market volatility and cyclical sector outperformance, January has all the hallmarks of a classic junk rally.

We caution that in times of economic stress, these junk rallies are common and usually brief. They can also mask economic and fundamental risks. We see plenty of risks on the horizon for investors to take a defensive stance. Let's take a closer look.

In January, developed-market, large-cap stocks have risen about 6%, but returns have been far from uniform across securities. Lower-risk stocks have posted gains of less than 2%, while their higher-volatility counterparts have put up a 12% return, a spread of more than 1,000 basis points.

Viewed from a financial quality angle, developed, large-cap stocks with positive earnings have returned about 5%, while those with negative earnings have outperformed at more than 10%. The small-cap market has been even more extreme, where stocks with negative earnings, currently about 40% of companies, returned in excess of 16%-- more than double those with positive earnings.

A look at sectors also reveals a wide dispersion of performance. Cyclical sectors, like consumer discretionary, have returned more than 8% in January, while defensive sectors, such as consumer staples, have fallen more than 3%-- also a spread of about 1,000 basis points.

Interestingly, equity returns have not followed earnings revisions. Revisions on 2023 earnings have favored higher-quality names despite their poor stock performance. All in all, we see a textbook case of investors paying up for junk.

We think this adds up to some premature risk on euphoria. Inflation remains persistent, and interest rates will likely continue to rise. And, importantly, we don't think investors have sufficiently accounted for a likely political standoff over the US debt ceiling and the equity volatility that it would cause. All of that is reason enough to maintain a lower-volatility, higher-quality defensive posture in equities.

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