Key highlights:
- The global macro environment is changing and offers opportunities and threats.
- Despite higher bond yields, rising oil prices and a new tariff war, we remain in a risk-on world.
- Global sovereign bonds are normalising to the new world after the abnormal post-global financial crisis period.
- Steepening yield curves are unlikely to derail the global economy, but central banks will be watching carefully and will want to avoid a financial or economic crisis.
- The Federal Reserve will raise rates if inflation surprises to the upside but probably not as much as markets expect.
- Corporate profits growth has been the key driver for equities and looks set to continue.
- Equities likely remain in a bull market with powerful cyclical and secular drivers, but market leadership is changing and volatility will pick up.
- We may be in an AI bubble but there is further to go, and the global economy will be a huge beneficiary of the disinflationary rise in AI-related productivity growth.
- Geopolitics, the “changing world order” and “fracturing economy” will be powerful influences on the global economy, markets, capital flows and policymakers for years to come.
- Commodities are in a long-term bull market, and gold looks very attractive after the sell-off.
- The dollar looks set to depreciate over the next few years with the yen, yuan, Asian currencies and gold among the winners. Sterling also looks vulnerable.
- Key risks include rising bond yields, a mistake by the Federal Reserve, AI disappointment, or a new geopolitical shock.
- We have adapted and evolved our investment strategy materially over the past two years and will continue to do so. This is not a time for complacency, dogma or inaction.
It would be easy and understandable to become more bearish in an environment of rising sovereign bond yields, renewed tensions in the Gulf, higher energy prices and yet another escalation of trade concerns. However, I remain optimistic that equities can continue to “climb the wall of worry” thanks to the resilient global economy, which is driving impressive earnings growth and bringing down valuations, together with the secular investment boom around AI and supportive fiscal and monetary policies. While it’s clear that threats to this rosy scenario are building and cannot be ignored, for now we very likely remain in a risk-on world.
Bond markets adjust to a new normal
Global government bond markets have come under renewed pressure in recent weeks, with yields on 30-year bonds reaching their highest levels since 2007 in several major economies. This is naturally a legitimate concern for investors and is reflective of several factors including rising deficits and debt levels, the shrinking of central bank balance sheets, solid global growth and elevated inflationary pressures. Importantly, however, this is not yet a bond market crisis, nor is it a material threat to the positive macro backdrop.
There are good reasons for investors to demand higher returns for holding longer-term government debt in the post-Covid world and in an environment that is very different to that which existed from the global financial crisis in 2008 to 2020. During this period, the world suffered from anaemic growth, persistent disinflation, excess savings, deflationary threats, consumer and corporate deleveraging, liquidity traps and zero-interest rate policies (“ZIRP”). Public sector spending boomed to counter falling private sector demand and real yields on bonds collapsed.
That was an abnormal period in history and the recent rise in both real and nominal yields is reflective of a return to a more normal economy with stronger nominal growth, an end to deleveraging, an AI-related investment boom, resilient consumers and increasing geopolitical risks. In addition, all major central banks have ended ZIRP and embarked on quantitative tightening in an effort to shrink their balance sheets, thereby removing a key support that had suppressed global bond yields. Real yields on 10-year sovereign bonds have returned to levels more consistent with the prevailing macro environment. The bond market is therefore sending a rational message: the world is riskier, government debt burdens are higher, inflation risks are rising and the political willingness to address fiscal problems is limited.
Consequently, upward pressure on sovereign risk premiums is likely to be a lasting feature of the multi-polar and post-pandemic age. Equities seem to understand this and are responding as appropriate given the buoyancy of corporate profits, compressing equity multiples, strengthening economic activity, steady labour market and a steepening yield curve. It is also important to note that the cost of capital for companies is not yet threatening the global economic expansion. Interest rates and bond yields are still below nominal growth and the aggregate return on capital, indicating that monetary conditions are still supportive. It would probably take a material additional rise in yields before an economic recession or slowdown or a sustained equity bear market becomes a real threat. Also, the sell-off in bonds has largely been concentrated at the long end of yield curves, which have little influence on household and corporate borrowing costs. There has been little evidence so far of a broader tightening in financial conditions that would threaten a major economic shock. Corporate bond spreads remain tight, and bond volatility has risen but not yet to worrying levels seen during the major bond dislocations of 2022 and 2023.
The central banks’ balancing act
How central banks and policymakers respond to these developments is an interesting question and there is some ambiguity here. Federal Reserve (“Fed”) Chair Kevin Warsh struck a somewhat hawkish tone in his recent Jackson Hole speech, but there is still uncertainty as to whether the Fed will raise rates in line with the current market expectations of three hikes over the next 12 months. Warsh is under pressure from President Trump to cut rates despite the strong growth outlook and risk to inflation from higher energy prices and a new round of tariffs. However, he will also be fully aware and has spoken about the potential positive impact on productivity from the capital expenditure boom underway, which should eventually help bring inflation down. Warsh has also embarked on a review of the Fed’s monetary policy mechanism, which includes possible changes to how they measure inflation.
Meanwhile, Treasury Secretary Bessent has made the Fed’s job more difficult by announcing unorthodox measures in an effort to supress rising rates and the yield curve. He has initiated a plan to use Treasury funds to buy longer-dated maturities, which appears to be blurring the lines between fiscal and monetary policy and has thus far had minimal impact on markets.
The most likely scenario going forward is that the Fed will raise rates in September if the August inflation data, due imminently, is worse than expected or will stay on hold if not. This would help to strengthen the Fed’s credibility as a central bank determined to keep inflation in check. Looking further out, given the enormous challenges facing the governments of the world’s largest economies and the record-high levels of global debt, I think the relevant central banks and governments will continue to pursue accommodative monetary and fiscal policies for some time to come, even if this results in higher and more volatile inflation. There is limited appetite for the tough policies needed to rein in unsustainable fiscal trajectories and the economic pain that would follow. This will likely mean higher longer-dated bond yields and steeper yield curves as well, but central banks will become concerned if a rapid sell-off threatens financial stability as it did in the UK gilt crisis in 2022. Should this happen, then central banks will almost certainly respond with intervention through a new round of quantitative easing and governments may well join in with innovative fiscal policies, such as those recently deployed by Bessent and including adjusting the composition of debt issuance.
A constructive case for equities
Corporate profits growth has been the key driver of equity markets over the past year or so and this looks set to continue. US companies delivered explosive earnings growth in Q2 with this strength broadening out, as evidenced by 10 out of the 11 S&P 500 sectors reporting a positive result. This is true globally as well with impressive earnings growth across a broad range of sectors and styles in Europe, Japan and emerging markets.
There are several catalysts behind this trend, including AI-related investment, lower tax rates and rising productivity in the case of the US, as well as reduced leverage and strengthening economic growth. Naturally there are concerns that record margins and booming profits are unsustainable and are set to become less favourable moving forward. This may be true in some areas, especially if global bond yields continue to rise, but the reality is that the global economy is experiencing a period of exceptional revenue and earnings expansion driven by a wave of AI-related demand and very supportive fiscal and monetary policies. Historically, every transformative technology has triggered a rush by businesses and consumers to adopt, deploy, and adapt to the new innovation, thereby resulting in a powerful new source of demand. Based on previous similar periods, it is also likely that this secular trend has much further to run. For example, global semiconductor sales measured in real terms rose fivefold between 1992 and 2000 when the internet revolution was at its most intense. By comparison, they have risen about 80% since 2025.
Given this, it could be argued that global equities, and US stocks in particular, have behaved rationally and even cautiously throughout the AI boom and recent years. Evidence of this includes the fact that valuation multiples have declined even as corporate earnings have surged. In addition, investors seem to have largely refused to get carried away and extrapolate today’s extraordinary and unsustainable earnings growth into the future. For example, valuation multiples for semiconductors have fallen sharply rather than risen following the spectacular surge in revenues and profits.
Overall, the macro background remains very supportive for global equities with solid earnings, improving valuations, accommodative monetary and fiscal policies, the secular growth trend around AI and still plentiful liquidity. The market rally has continued to broaden out beyond the US and into cheaper sectors such as value and cyclical stocks. I am especially bullish on Japanese, select European and emerging market stocks. All of these regions are benefiting from improving economic and profits growth as well as attractive valuations.
Asset allocation in a changing world
Given the clear long-term trend of rising government bond yields, it is sensible to avoid duration risk where possible when investing in fixed income. Having said that, yields will inevitably overshoot from time to time and there will be trading opportunities. G7 bond yields remain sensitive to both short-term rates and swings in the oil price, so additional care is required given the continuing uncertainty in the Gulf. Credit markets remain attractive for similar reasons to our positive view on equities despite tight spreads. However, we favour quality credit and keeping duration relatively short. The ongoing global economic expansion, an upturn in trade and the prospect of a weaker dollar also support emerging market bonds, although an active approach is preferred. Index-linked bonds also look like a good hedge against the risk of higher inflation volatility.
The commodity bull market remains intact thanks to the expanding global economy, the multipolar changing world order and fracturing economy, geopolitical instability and the AI capex boom, which is driving rapid demand for more energy. Gold prices have stabilised following the massive correction after the start of the Iran war. The key drivers that have driven gold higher over the past couple of years remain in place, namely the desire of global asset allocators and governments to diversify away from US Treasuries and the dollar, rising debt levels and deficits, the risk of currency debasement due to higher inflation and more money printing and geopolitical concerns.
China has been a very big and active buyer of gold over the past few months, looking to take advantage of lower prices. There is increasing speculation that China is planning to increase trade in a currency other than the dollar and perhaps one backed by gold. A return to some form of the gold standard would really add to the 1970s feel. Gold and commodities generally, including energy-related plays, remain attractive long-term opportunities as well as a good diversifier within a global portfolio.
A weaker dollar changes the landscape
The dollar has recently started to weaken again and is expected to gradually depreciate over the next few years. There are multiple factors at play: improving relative growth prospects away from the US, ever-expanding dual deficits, a desire to diversify away from US Treasuries and other dollar assets, the weaponisation of the dollar, the threat of currency debasement and a Fed that will likely turn out to be less hawkish than expected. In addition, other major central banks will probably hike rates faster and further than the Fed, including the European Central Bank and especially the Bank of Japan.
Indeed, the gradual normalisation of interest rates in Japan, as growth strengthens and inflation stabilises at close to the target 2%, could be a key feature of markets over the next few months. The yen, which is the cheapest currency by a long way, seems to have troughed and could be the major winner from dollar weakness over the next few years as domestic investors repatriate capital back to Japan and global asset allocators rotate out of the US to fundamentally more attractive and cheaper options. Emerging market currencies, and Asia in particular and including the Chinese yuan, also look set to appreciate versus the dollar and indeed sterling and the euro as well. A weaker dollar is bullish for global growth and equities as it adds a further reflationary pulse and is especially favourable for emerging markets.
Opportunity, but not without risk
In conclusion, the risk-on macro backdrop continues despite ongoing tensions in the energy market, the re-emergence of US tariff policies and increasing political instability. These headwinds are stagflationary if they persist beyond the near term, but they appear to be insufficient to outweigh the strong secular tailwinds and to slow the global economic expansion.
The main risk for investors is an acceleration in the trend of rising sovereign bond yields, especially if this becomes disorderly and threatens a financial or economic crisis. Other key risks include disappointment about the returns on the AI capex boom, an overly hawkish Fed or a new geopolitical event. I remain bullish on the equity outlook but acknowledge that volatility will most likely pick up as we start to move forward towards 2027. The evolving macro landscape favours a rotation away from the US and into other markets including Japan and emerging markets, although it is a risk to move too underweight US equities. It also makes sense to try to include assets that should provide protection in the event of some of the key risks materialising, and these include inflation hedges, real assets, commodity-related plays, gold and energy stocks. There is no shortage of attractive investment opportunities in the evolving era of the fracturing economy and multipolar political landscape, but there are many risks as well, which need to be carefully monitored and managed. This is something our team continues to do. Our investment strategy has evolved meaningfully over the past couple of years and will continue to do so, as required. This is not a time for complacency, dogma or inaction.
