The resolution of the debt ceiling crisis and the lack of more negative surprises among regional banks has largely removed some key market risks, dampening volatility and supporting equities. However, our base case suggests little upside for equities globally. US stocks trade at valuations above long-term fair value despite a stalling economy, while investors in European equities face probable recession and likely higher interest rates.

As a result, we reduced our allocation to develop market stocks outside the US making our portfolios underweight to equities across all major regions. Let's take a closer look.

We think the US equity rally this year stands on somewhat shaky ground, as a small cadre of technology-related stocks have driven the gains in the S&P 500 index. If investors take profits from winning tech stocks to invest more broadly in equities, which is our base case, that would represent churn in the market rather than drive it up more resulting in limited upside for equities broadly.

Further, we think US interest rates will remain high providing limited support for stocks. Based on futures trading, investors have all but given up on a Federal Reserve rate cut this year. We believe the Fed is at or near the peak rate but believe the tight labor market and sticky core inflation will keep rates elevated into next year.

Outside the US, the outlook for stocks in Europe has worsened somewhat. Recessionary conditions are developing throughout the region and have already hit Germany. Yet thanks to sticky inflation, the European Central Bank appears set to continue increasing rates.

We think this increases the odds of the central bank making a mistake by hiking rates too much, instigating additional economic weakness. In China, the economic recovery appears increasingly sluggish leading to some speculation that the government will have to increase stimulus. However, we are skeptical that stimulus would be of a size that would meaningfully alter the sentiment from investors.

In our global policy model allocations that guide our multi-asset portfolios, we are underweight equities in the US, emerging markets, and now develop markets outside the US. We are encouraged by more durable fundamentals in the US for now, but we still expect an economy approaching stall speed that limits upside in stocks.

We maintained an overweight position to high yield bonds, given its attractive risk reward profile in this environment. We are also overweight in natural resources, which appear more attractive than emerging market equities. With interest rates in the US moving toward the high end of our expected range, we reduced our underweight to investment grade bonds.

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