Over the last six weeks, we have seen bond yields rise sharply worldwide. Reading the news, you might think this is only a U.S. Treasury phenomenon, but sovereign bond yields have been rising in tandem worldwide.
Rising bond yields mean falling bond prices. Long-dated Treasuries are down 10% this year, while the global equity market is up 12%. So, fixed income portfolios are hurting while equity portfolios are doing well.
What is the market trying to tell us? Should we be worried about inflation, or about fiscal deficits and government debt? These factors play a role, but rising bond yields can also be an indication of solid economic growth. This is a key reason why the equity market is doing well despite higher interest rates.
Risks to the Equity Market
The fourth quarter of 2026 will likely bring a lot of market noise. The list of market worries is long. Political risk will stay omnipresent. Once the U.S. midterms are over on November 3, attention will shift to the French presidential election as French sovereign bond yields have been rising sharply as well.
The wars in the Middle East and Ukraine will continue to inject volatility into energy markets. Global bond yields are therefore likely to stay elevated. Add to these fears of central bank tightening, fiscal worries, and the narrative that AI-related bond issuance will crowd out other borrowers. Questions about the sustainability of AI capex, and thus of profits and stock prices, are also mounting.
The bond market, the IPO cycle, and possibly slower EPS growth ahead represent risks to equity valuations. Actually, over the past six months, the S&P 500 price-earnings ratio (P/E) has declined from 21.5 to 19.4.
Typically, changes in prices, not earnings, drive changes in the multiple. Large valuation declines are normally driven by falling prices. That historical context makes the current P/E compression all the more remarkable. Although the market is modestly higher, earnings expectations have risen even faster and therefore account for the entire decline in the multiple. The same pattern is evident across sectors: earnings strength, not price weakness, has driven multiple compression.
Economic conditions still argue against an imminent end to the AI capex boom that supports the global economy and risk assets. AI capex’s contribution to the global economy is plain to see. On average, it has added 50bps to U.S. GDP growth over the past four quarters. AI-generated wealth is supporting U.S. consumption: the U.S. savings rate has fallen to 4.1%, one of its lowest readings ever. The U.S. tech sector remains incentivized to invest. Hyperscalers’ return on invested capital is 24%, well above any reasonable estimate of their hurdle rate. Profit growth remains strong at 21%. As a result, their earnings multiples have fallen.
Despite the headlines, general market conditions do not seem to be in the red zone. The equity market decline has been very modest, while volatility has stayed low. True, equity valuations have fallen significantly, suggesting the market thinks current earnings growth is less sustainable, but P/E compression has been benign, driven entirely by stronger earnings rather than a drop in prices.
No precedent exists for a recession occurring imminently after a period of positive, accelerating corporate profit growth in the post-WWII United States. Corporate profit growth normally contracts before an economic slowdown. The trajectory of corporate profits is a major reason why we do not expect an imminent recession.
- Global Rate Hiking Cycle
- Bond Yields on the Rise
- Trump-Xi Summit
- A Big Beautiful Deal
- Who Controls the Strait of Hormuz?
- U.S. Midterm Elections
- Our Portfolio Positioning
Global Rate Hiking Cycle
The Federal Reserve raised interest rates by 0.25% at the September FOMC meeting, lifting the target range to 3.75% – 4.00%. FOMC members are unanimous in expecting a mild tightening cycle of no more than two additional 25-basis-point hikes.
The Fed projects inflation will slow considerably next year, consistent with our view that inflation’s underlying downtrend remains intact. The growth component, however, is inching toward tighter policy, driven especially by the manufacturing side, with real new orders and average weekly hours both firming. The data center buildout is a key driver behind this strengthening. Strong growth translating into inflation pressures is the main risk to a mild tightening cycle.
The European Central Bank (ECB) also raised rates in September, its second move in response to the energy shock. Policy remains driven entirely by energy prices, making the ECB’s next steps highly dependent on developments in the Middle East. President Christine Lagarde reiterated a meeting-by-meeting approach, noting the Governing Council has “not discussed future path” for rates.
Among European central banks, the SNB remains an outlier. Before the war in Iran erupted, Switzerland was bogged down in a deflationary trap, a predicament the conflict’s inflationary pressures changed. As a result, the SNB is far from considering a rate hike this week, instead enjoying the temporary reprieve from having to cut into negative territory. Indeed, our central bank monitor suggests the SNB should ease monetary policy further, a step it has been resisting. That is a key reason why we think the Swiss Franc (CHF) can continue to weaken against the Euro and the Yen after years of strengthening.
The Bank of Japan’s (BoJ) policy path remains distinct from other central banks. The September BoJ rate hike marked a step up from a semi-annual to a quarterly pace of tightening, and we continue to view the BoJ as in the early stages of its tightening cycle.
The yen weakened after the September BoJ meeting, as the guidance fell short of the market expectations built up beforehand. Still, the communication flagged an important shift in monetary policy stance from boosting inflation to now managing inflation overshoots.
We have been bullish on the yen for some time, as domestic conditions support a policy pivot. The question now is timing. Unfortunately for the BoJ, their shift coincided with other central banks turning to hikes, keeping relative rate moves unfavorable. The yen can stay under some pressure near term as global yields rise, but given how quickly yen rallies can unfold, as seen in early September, it makes sense to have some yen exposure.
Bond Yields on the Rise
U.S. Treasury yields across the curve have risen for much of 2026, as short-term rates have shifted from expecting Fed cuts at the start of the year to anticipating several rate hikes ahead.
In particular, concerns about the Warsh policy agenda may prove overdone. The market has given Chairman Warsh little leeway, conflating early-tenure communication challenges with lost credibility and, it seems, forgetting that Chairs Powell, Yellen, and Bernanke also faced criticism for their communication styles at the outset of their tenures. A rate hike may go a long way toward easing such concerns, particularly if it helps anchor longer-dated inflation expectations and flattens the yield curve. This would also potentially mute Secretary Bessent’s Treasury buyback efforts, which seem to have stoked, rather than calmed, bond market concerns.
A hiking cycle and higher yields need not be a death knell for equities, as they can reflect a solid business cycle and growing investment demand, even if higher yields are a valuation headwind. More damaging to the equity market would be supply-side driven inflation pressure, fiscal sustainability concerns, and monetary policy uncertainty.
Looking back in history, Fed hikes do not typically cause equity market corrections. Stocks have climbed through all seven hiking cycles since 1980, usually pausing after the first hike rather than peaking.
Valuations have already reset. Multiple compression has been significant and broad-based. With forward EPS growth near 20%, earnings are the cushion and we continue to expect to see the S&P 500 at higher levels by year-end. Most importantly, investor sentiment has fallen to the lowest level since the onset of the Iran War. And yet, global equities remain only 2% from their all-time high.
Indices have held up thanks to earnings growth, and we expect third-quarter earnings to be strong again, with median sector forward EPS growth for the S&P 500 currently running at 18%.
At this point, the question investors should be asking themselves is: Why aren’t equity markets falling on negative news? And what happens if all these negatives peak or even turn around? There are good reasons to believe that the current backdrop could improve. The past month was the worst of the year from a seasonality perspective. The market is about to enter what is historically the strongest quarter for equities. Expectations of higher yields and a hawkish Fed have already gone into overdrive, suggesting dovish surprises may be in order.
Trump-Xi Summit
The state visit showed respect and friendliness to President Xi. They extended the tariff truce deadline, but not much else, and underlying strategic tensions are as significant as ever.
The trade truce consists of U.S. sales of semiconductors and Chinese sales of rare earths. Otherwise, the economic foundations of the relationship continue to crumble.
Structurally, the decline of the U.S.-China economic relationship has removed a constraint on strategic disputes and conflict. Since the trade war began in 2018, the U.S. trade deficit with China has collapsed, especially in high-value goods.
China peaked at 22% of U.S. imports in 2019 and today stands at 11%, while the U.S. has increased trade dependencies on allies and partners in North America and Europe.
China doubled down on exports as a driver of growth but shifted away from the U.S. consumer market to pursue markets in Southeast Asia, Latin America, Africa, and Russia and Central Asia.
China’s critical vulnerability is that its domestic economy keeps flirting with a deflationary debt spiral. A rise in inflation from the global energy shock is not the right solution since it raises input costs but reduces sales abroad for Chinese industry.
China’s economy is showing dangerously weak investment and consumption trends today, and the Trump administration may increase tariffs and sanctions in pursuit of ceasefires and trade concessions. Those trends cannot go unaddressed over the last two years of Trump’s presidency.
However, if the Iran conflict continues to be managed, then China can increase government spending to boost growth. Combined with very dovish monetary policy, a significant increase in fiscal deficits can drive up nominal growth, keep Chinese consumer prices from relapsing into negative territory, and reduce real interest rates, which could quicken investment and eventually shake off deflation.
Therefore, we think Beijing will still likely increase fiscal stimulus in the coming 12 months.
A Big Beautiful Deal
Another risk for China is the vision business leaders like JPMorgan Chase boss Jamie Dimon are pitching for the Western world’s future, and it hinges on Europe rebooting its sluggish economy and strengthening its defense capabilities, which is also why we are positive on European markets.
Dimon wrote in an opinion piece in The Wall Street Journal and said: “I believe the U.S. should offer Europe a major inducement: If it executes meaningful economic and military reforms, including everything that we consider crucial for security and resiliency, the U.S. will negotiate one big, beautiful economic and free-trade agreement with Europe.”
“Many of the current disputes between Europe and the U.S. are minor compared with this agreement’s size and benefits. This pact could be extended to friendly democracies including Canada, Mexico, Japan, South Korea, Australia, and the Philippines.”
Seamless trade ties would be a “game changer” for the U.S. and its allies, allowing them to “set the global rules on trade” and binding them together “in the face of autocratic pressure,” Dimon wrote. However, the free-trade approach Dimon advocates contrasts with the more protectionist policies the Trump administration currently pursues. So, this is unlikely in the short term, but political winds could be changing.
Who Controls the Strait of Hormuz?
Gulf oil producers, with considerable support from the US Navy, are jamming crude through the Strait of Hormuz, right under Iran’s nose. Recent estimates show that Persian Gulf oil exports, including estimated “dark exports”, have recovered to 23.3 million barrels per day (mb/d) over the last week, in line with their 2025 average, as exports doubled in September. Increased Hormuz exports, including via ship-to-ship transfers, have driven this recovery in exports despite the attack on the Saudi East-West pipeline, which disrupted oil flows to Yanbu for nearly two weeks, and the continuing Houthi blockade of Saudi exports via Bab-al-Mandab. Despite the recovery in Gulf exports, crude prices remain relatively well supported, and we still worry about renewed escalation that damages more energy infrastructure.
Estimated crude exports accounted for nearly 90% of the September recovery in Persian Gulf exports, reaching 19 mb/d (108% of their 2025 average) over the last week.
Exports of refined products and LPG have grown too, but exports of the main products (diesel, gasoline, and jet fuel) remain at 50% of their 2025 average for two reasons:
First, infrastructure damage, as there are several refinery outages in the Middle East because of missile attacks, while crude production facilities have been largely spared from attacks. Second, refined products are more flammable than crude, so the physical risks of Hormuz crossing are greater for refined-product tankers than for crude tankers.
Among producers, Iranian exports are declining while exports from other Persian Gulf producers are rising. Saudi estimated exports more than doubled in September and rose above their 2025 average, reaching 11.6 mb/d over the last week, following the redirection of Red Sea exports to eastern ports and a rise in estimated dark transits. UAE exports also stand above their 2025 average, with likely further upside. However, satellite data show no seaborne exports of crude or main refined products from Iran in September.
We estimate that the global oil market is roughly balanced in September as Gulf exports recover and visible global inventories remain broadly flat, while OECD commercial oil stocks are similar to late February 2026 levels. The remarkable adaptation of both Mideast supply and China import demand supports lower oil prices, which could fall to $85 by year-end and to $80 in 2027. That said, we still worry about renewed potential escalation that damages more energy infrastructure, which could cause significant upside to prices.
Oil and petroleum product flows through the critical chokepoint averaged 13.1 million barrels per day last week, according to Kpler, a marine data tracking service. That’s just under 80% of the 17.1 million barrels that had traveled through the strait each day before the war broke out.
Total Middle Eastern crude flows through Hormuz and around it are even more impressive: back to 98% of prewar levels, according to JPMorgan. Given such a strong volume passing through the strait, Iran is clearly losing influence over it, making it more likely to negotiate an end to the conflict.
U.S. Midterm Elections
Betting market odds have swung decisively toward a Democratic sweep of Congress; Polymarket now puts the odds of Democrats winning both chambers at above 60%, up from just under 50% in late August.
Races that looked like toss-ups in late August have since swung toward the Democrats, with betting markets now predicting victories in Texas and Ohio, both red states, and crucial battleground states like Michigan, Alaska, and Maine. The energy shock is doing most of the work, as President Trump’s net approval on the economy has plunged to -28%. The average crack spread across gasoline, diesel, and heating oil feeds directly into pump prices and has moved closely with the odds of a Democratic sweep since the war began.
A toxic combination of higher energy prices, weak consumer confidence, and rising inequality gives Democrats an edge in the races for both the House and Senate.
A divided government is typically good for markets. History shows that when a sitting President loses both the House and the Senate, the S&P 500 makes solid gains in the next year. However, President Trump is not a typical President. His actions could add to market volatility. At the same time, a divided House makes major changes to fiscal spending or additional taxes unlikely.
Remember that President Trump can still veto any law or budget that a Democratic Congress might send to his desk.
Our Portfolio Positioning
We have not made any changes to the equity portfolio allocation as we are comfortable with a diversified position in these markets.
However, given the big moves in global bond markets, we have made changes to our global fixed income allocation. We don’t know how far bond yields can rise, but we are already at a level where forward-looking returns on fixed income portfolios start to look quite attractive. With government bond yields at current levels, we can expect 6-8% average annual returns again. Something we haven’t seen in decades. The 60-40 portfolio may be making a comeback.
DISCLOSURES
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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
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