Economies and financial markets remain resilient despite heightened inflation risks. These are shaping central bank policy and interest-rate expectations, pushing bond yields to levels not seen since before the global financial crisis.
Prospects for resolving the conflict in the Middle East continue to ebb and flow. Although reciprocal attacks between the US and Iran have eased, there appears to be little momentum for an agreement before the US midterm elections in early November. Iran has said it would consider reopening the Strait of Hormuz under the terms agreed in June’s ‘memorandum of understanding’. However, US strategic objectives appear to have moved beyond that agreement to include Iran’s nuclear programme. Hopes of a deal between Iran and Oman to reopen the strait have therefore faded. More positively, total oil exports from the Middle East are approaching prewar levels, although exports of refined products, such as petrol and diesel, and liquefied natural gas remain below them.
Despite geopolitical headwinds, the economic backdrop remains supportive. Business surveys point to positive, stable growth, while resilient corporate earnings and profits are helping markets navigate a difficult environment. Encouragingly, earnings growth extends beyond sectors supported by AI and related capital expenditure.
Challenges remain. With bond yields rising and interest rates expected to increase further, equities face greater competition from other asset types. However, interest-rate pricing continues to shift, and the strong correlation between oil prices and bond yields suggests that positive developments in the Middle East could ease inflation expectations and yields. The risk is that both sides settle in for a ‘long game’, with significant consequences for energy markets and the wider economy.
Nevertheless, our views remain constructive. Although monetary policy has tightened in several developed markets, it is not yet ‘restrictive’, and economies should be able to absorb somewhat tighter conditions. With strong earnings growth expected to continue into 2027, we believe equities remain the best use of our risk budget, provided central banks do not adopt a more aggressive stance.
At a glance – equities and fixed income
Equities
Fixed income
We believe the sharp rise in bond yields presents an opportunity to add modestly to duration, prompting a more favourable view of government bonds. Steeper yield curves have improved return prospects, while behavioural indicators point to markedly bearish bond positioning. Higher interest rates remain a risk, but more compelling valuations justify moving our government bond allocation to ‘Mildly Favour’. We remain alert to further bond-market volatility, particularly as budgets and elections bring fiscal stability into focus. Investment-grade, high-yield and emerging market bonds remain relatively unattractive, with spreads close to historic lows. Scope for capital appreciation therefore appears limited, leaving returns largely dependent on income.
