The return from summer can be a challenging period for investment managers. The saying “Sell in May and go away” rarely resonates more strongly than in September, a month that has traditionally been marked by volatility and uncertainty. This year has been no exception, with markets thought by many to be overvalued and performance too concentrated. Our portfolio managers did not share those views. They have, however, been more cautious than in the second quarter, for one fundamental reason: interest rates are starting to rise.
Rates, which declined almost continuously from the 1990s until the reversal of 2022, are once again central to the concerns of both bond and equity investors. Financing costs have far-reaching implications and are shaped in turn by government debt levels, corporate funding requirements and monetary policy.
Our Investment Committee this month therefore focused primarily on long-term rates and their implications for market prices. In a sense, every member of the committee became a bond manager for a moment, just in time for the dreaded month of September.
Read also: What if Goldilocks is real? Growth, inflation and markets align
Macro and micro alignment provides a solid foundation
The starting point matters. The current backdrop is reassuring, both for the global economy and for companies. Growth is solid and positive economic data has become more widespread. That is enough to allay fears relating to the ’stag’ (or stagnant growth) part of stagflation.
The corporate picture is equally encouraging. Second-quarter earnings were excellent, and our managers broadly expect another solid season in the third quarter, driven by positive surprises and upward revisions to guidance. Equities are supported by both economic growth and rising profits (Figure 1). Whenever macro and micro fundamentals have aligned in the past, returns have been around twice as strong as when only one of these factors is supportive. That helps explain the market’s performance so far this year.
FIG 1. Equity returns supported by positive economic and corporate performance1
Rates test the rally
But despite this positive backdrop, our portfolio managers had become decidedly less bullish since the end of the second quarter. Across all asset classes, the concern is the same: rates are rising too quickly for the rally not to show some cracks.
Real yields, rather than persistent inflation fears, are driving the increases. Higher real yields can be the result of several factors:
- Stronger growth can boost investment and corporate borrowing
- Rising government debt can increase the premium demanded by investors
- And real yields will normally rise when central banks raise policy rates in the face of higher inflation.
Today, all three forces are at work. Long-term rates are increasing rapidly, bringing into focus a critical threshold: the point at which real yields converge with potential real growth (Figure 2). In fact, that threshold has already been crossed in the US, the UK, the eurozone and Japan. This raises the risk of a deterioration in growth prospects and also has the potential to weigh on technology valuations. Historically, whenever real yields have exceeded real economic growth by 0.1%, real GDP growth has slowed by around 0.2 percentage points over the following 12 months. While such a slowdown may be insufficient to trigger a recession, it can represent a meaningful headwind for economic activity.
FIG 2. How rising real yields can impair growth2
Read also: Growth up, inflation up – it’s risk-on across asset classes
Can policymakers tame yields?
Monetary policy can be used temper this rise in rates. The question is whether central banks – the US Federal Reserve (Fed) in particular – will raise rates enough to persuade markets that future growth prospects will deteriorate rather than improve. Recently, long rates have risen alongside short-term rates (Figure 3), which is far from unusual.
The end of the Fed’s forward guidance has resulted in long-term rates being relied on to reprice fundamental risks, just as government debt-to-GDP ratios have exceeded 100%. Rate levels have consequently become critical for the economy, financial markets and sovereign creditworthiness.
How can central banks lower long-term yields? There are two options: the hard way and the harder way.
The hard way would be to raise policy rates and signal further increases clearly enough to convince markets that policymakers intend to trigger an economic slowdown. In the US, the difficulty is that the Treasury funds its debt predominantly through the T-bill market – which is precisely where those increases would bite in terms of debt-servicing costs. Such ‘higher short rates, lower long rates’ periods have historically occurred only 7% of the time – not impossible, but definitely rare.
Rising yields have become the main source of market risk. The key question for investors over the months ahead is whether or not the Fed is capable of managing that risk
The harder way would involve a more limited increase in policy rates to contain debt-servicing costs, together with a return to active control of long-term yields if their rise were to threaten market stability. This path would be more challenging for markets, as it would likely involve another increase in long-term rate volatility. Investors may be tempted to view the Fed’s September hike as a one-off recalibration, yet history points in the opposite direction. Tightening cycles are generally lengthy affairs, unfolding over many months and delivering cumulative rate increases.
The paradox of 2026 is that risk increasingly seems to come from bonds rather than equities.
While AI has improved visibility on corporate growth and earnings prospects, rising yields have become the main source of market risk. The key question for investors over the months ahead is whether or not the Fed is capable of managing that risk.
FIG 3. US short-term rates tend to move in tandem with long-term yields3
Our positioning for equity, fixed income, convertible bond and multi-asset strategies4
Overall core positioning reflects a constructive but increasingly selective risk-on stance, supported by resilient global growth, strong earnings expectations and continued investment around AI, while acknowledging the constraints from higher real yields and rate volatility.
Balancing strong growth and earnings dynamics with the constraints of higher real yields, valuations and evolving macro risks, our current positioning4 across asset classes is as follows:
Multi asset. Market exposure in All Roads was decreased to around 155% since our last Investment Committee meeting. Our views on cyclical assets remain constructive, while AI valuations, inflation and rates volatility remain key risks. Allocations to cyclical assets such as high yield, equities and commodities were reduced to 40% from 43%, with defensive allocations (including sovereign bonds, inflation and tail hedges) increasing from 57% to 60%.
Fixed income. Our Global Fixed Income team remains neutral on sovereigns with an overweight to emerging market (EM) hard-currency debt. It favours EUR and UK sovereigns to US rates, with a tactical long position in US linkers as an inflation hedge. In credit, exposure to investment grade and high yield is neutral, with a preference for US over EU high yield. We also focus on fallen angels and European real estate, and we cap our exposure to hyperscalers in line with market weights. Our Asia Fixed Income team has reduced its duration overweight to the lower end of the range, mainly in investment-grade (IG) credit. Yields remain elevated on record-high US Treasury yields and there are decent spread buffers. Strong technicals, improving fundamentals and near-zero defaults in Asian high yield remain (HY) supportive of the asset class. We favour Asian HY for spread compression, to provide a spread cushion versus US HY and for greater alpha opportunities. We remain overweight India, financials and selected industrials. The team increased diversification and rotated towards more defensive names.
Convertible bonds. Our Global Convertible Bonds team recently reduced risk as higher rates are bringing markets to a crossroads. We remain positive on the US and neutral on Europe and China, and favour selective AI-related opportunities across Japan and Asia. Our primary focus is on semiconductors, AI hardware and infrastructure, high-performance computing, AI software, cybersecurity, strategic autonomy and energy transition themes. We prefer structural growth beneficiaries while maintaining lower volatility exposure versus equities. Our portfolio is underweight autos, food and beverage, China consumers and broad consumer spending.
Equities. Our Global Equities team believes that strong EPS growth expectations for 2026 and 2027 continue to support equity markets despite higher interest rates. Near-term risks such as the US midterm elections, AI-related news flow and Fed communication appear largely reflected in market expectations. We are overweight technology, with selective exposure to AI beneficiaries across the US and Asia (primarily Japan, Korea and China). We are neutral industrials while increasing healthcare exposure, and we are underweight European consumer discretionary. The Sustainable Equities team is positioned for a broader, performance-driven market while maintaining high-quality exposure to structural AI beneficiaries. Industrials provide exposure to the AI capex cycle, complemented by high-quality defensive franchises. We have an overweight in software companies with durable competitive advantages and strong pricing power and a modest underweight in banks while maintaining selective exposure to high-quality financials and reducing exposure to perceived AI disruptors. We are constructive on consumer spending, favouring digital consumption, platforms and discretionary spending over traditional staples. The Asia Equities team is fully invested. Recent volatility has provided an opportunity to consolidate holdings and increase conviction in exceptional and resilient growth companies. We are overweight technology, industrials and platform technology, and underweight real estate and utilities. The portfolio is increasing exposure to financials to reflect the higher interest rate and inflation outlook, and growing conviction in core holdings. Finally, our Swiss Equities team is also fully invested but has added a number of names in order to reduce risk. We are overweight healthcare, industrials and IT, and underweight communication services, consumer discretionary, financials, real estate and utilities.
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