The rally: Refusing to yield?

Figure 1

It is also worth noting that higher yields are not inherently bearish for equities. Higher yields driven by stronger growth can generally be absorbed, while those driven by oil prices, inflation, or a higher term premium are more problematic, particularly if the increase is rapid. So far, the rate volatility has been reflected more in churn beneath the surface of the equity market than at the index level, with the global index largely flat for the quarter.

Over the next few weeks and months, we will be looking for some combination of strength in third-quarter earnings, stabilization in oil prices and long-term yields, easing in geopolitical risk, and limited risk of further monetary policy tightening. Alternatively, a meaningful equity correction without a deterioration in earnings could present a more attractive entry point.

Consistent with our broader equity stance, we have reduced our view on emerging market (EM) equities from overweight to moderately overweight, funded by a smaller underweight view on UK equities. Higher oil prices and US yields leave some EM equities with less scope for policy support, while earnings growth remains increasingly concentrated in Asian AI beneficiaries rather than reflecting a broad EM recovery. China and India have lagged the broader EM rally year to date, while Latin America has become more dependent on commodity prices and political outcomes in Brazil. On the other hand, the UK could benefit from more resilient energy-driven earnings and continued M&A activity supported by cheap valuations.

We are neutral on Japan. The market has seen broad-based earnings strength, reflected in upgrades across banks and industrials, as well as semiconductors and AI-linked segments. A stronger yen can create winners and losers within the market, rather than lead to broad weakness. However, significant macroeconomic and policy uncertainty is keeping us on the sidelines.

US equity valuations have contracted substantially, reflecting some skepticism about the strength of earnings, with the sharp rise in real rates providing an additional headwind. Continued earnings strength and a stabilization in bond yields could lead us to turn more bullish here.

Figure 2

Entry yields are a key driver of long-term total returns, and we think today's elevated levels offer a more compelling starting point than investors have enjoyed for much of the past decade. They currently provide attractive carry and may create potential for capital appreciation in certain sectors if growth moderates or inflation eases more quickly than expected. Higher yields could also improve the ability of government bonds to serve as a portfolio diversifier, helping to offset equity market weakness in a slower-growth environment.

Globally, differences in the pricing of fiscal risks — and any missteps by central banks as they take action — could lead to relative value opportunities. We maintain our moderately overweight view on developed market government bonds overall but are becoming more selective across regions to capitalize on this dispersion potential.

We moved from neutral to a moderately overweight view on US and UK government bonds. Yield levels look attractive given the potential for economic growth to moderate, which could support longer-duration bonds. By contrast, we moved from neutral to an underweight view on Eurozone government bonds, where ongoing fiscal concerns and elevated issuance may continue to weigh on valuations. We have moved to neutral on Japanese government bonds (JGBs).

Within credit, we continue to have a neutral stance. While all-in yields are attractive and spreads have widened somewhat recently, they offer limited compensation for downside risks. AI-related capex needs are increasingly being financed through credit markets, with AI-related issuance accounting for a meaningful share of overall year-to-date fixed income issuance. We are monitoring the extent to which this creates technical headwinds, AI concentration risk, and greater dispersion across issuers over time. Overall, the risk/reward profile appears balanced, which we think warrants a neutral view.

Commodities

We have moved our view on oil from overweight to neutral. Oil markets face a near‑term deficit of about 5 million barrels per day, even as flows through the Strait of Hormuz have increased. Physical energy flows have been more resilient than expected, although diesel and refined-product supplies have been more disrupted. We also expect the market to shift to a surplus over the medium term, while many countries have already drawn down inventories substantially. With geopolitics rather than fundamentals driving the market, the binary nature of the risks limits our conviction. Rates of carry on offer due to a sharply downward-facing futures curve (i.e., the contract price for delivery of oil in the future is lower than the current spot price) are very attractive in our view, but we are reluctant to lean toward long positions at current oil prices.

We maintain our neutral view on gold. We think the precious metal can play an important role in long-term portfolio construction, particularly as a potential diversifier during periods of dollar debasement. Over the shorter term, however, high real rates and further central bank tightening present a less favorable backdrop. Turning to flows, ETF demand for gold has recovered from its lows, while central bank buying remains positive but uneven.

Investment implications

Look for diversification opportunities — As the effects of AI, higher oil prices, rising yields, and policy uncertainty create greater dispersion across regions, sectors, and individual securities, we think active positioning may add more value than broad market exposure.

Stay constructive on AI but expect more moderate equity market returns — AI investment and productivity gains continue to underpin our positive view on the economic and earnings cycles, although we believe the pace of earnings will decelerate following a period of exceptional growth. We see more moderate upside for global and EM equities, with earnings remaining the primary driver of returns.

Consider adding duration as real yields rise — Markets have shifted from pricing central bank easing to pricing broadly synchronized tightening, pushing real yields higher. We think this repricing is overdone and has left global government bonds at attractive valuations. Regional divergences in yields may also create opportunities for active positioning.

Remain selective in credit, where spreads appear too tight — Spreads have widened somewhat, but we find little value at current levels. We think European credit has better fundamentals than the US in terms of debt service and leverage, and it is more insulated from significant US issuance. In EM debt, opportunities appear more likely to come from country selection opportunities than broad market exposure.