The global economy has remained stronger than many expected. Business activity continues to expand, corporate profits have held up and investment in areas such as artificial intelligence remains significant.
However, the outlook is not without risks. Inflation remains above central bank targets in several regions, energy prices are volatile and government borrowing costs have risen. These factors could keep interest rates higher for longer and make financial markets more sensitive to disappointing economic or company news.
What higher bond yields mean for investors
Government bond yields have increased as investors have adjusted to the prospect of persistent inflation, substantial public borrowing and continued demand for capital.
Higher yields can put pressure on share prices because they increase companies’ financing costs and make future profits less valuable in today’s terms. They also mean that high-quality bonds can once again provide a meaningful level of income.
We believe this improves the case for holding good-quality fixed-income investments. However, uncertainty over inflation means it remains sensible to avoid taking excessive exposure to bonds with very long maturities.
Equities remain supported, but selectivity is important
Company earnings have generally been resilient. Demand remains healthy in several areas, particularly digital infrastructure, automation and artificial intelligence.
Yet the performance of major equity markets has become increasingly dependent on a relatively small number of large companies. This does not necessarily signal an imminent downturn, but it reinforces the importance of diversification and careful company selection.
In this environment, we favour businesses with dependable earnings, strong balance sheets and the ability to invest without relying excessively on borrowing.
Artificial intelligence enters its next phase
Investment in artificial intelligence is extending beyond the best-known technology companies. Semiconductor manufacturers, data centres, networking businesses, software providers and power infrastructure companies are all benefiting from increased demand.
The long-term potential is considerable, but expectations are already high. Technology companies are forecast to generate substantial additional cash flow over the coming years. For those forecasts to be achieved, their customers will need to demonstrate that spending on AI produces genuine productivity gains, higher revenues or lower costs.
The next stage of the AI investment cycle will therefore be less about how much is being spent and more about the returns that spending produces.
Opportunities differ by region
The US continues to benefit from strong economic momentum, resilient profits and investment in technology. However, valuations are high in parts of the market, increasing their sensitivity to changes in interest rates and earnings expectations.
European shares are generally less expensive, although economic growth is weaker and political and fiscal uncertainty remains a concern. The UK economy is subdued, but its equity market provides useful exposure to financial, energy and other cash-generative businesses.
In Asia, Korea and Taiwan are benefiting from semiconductor demand, while India continues to offer attractive long-term growth supported by domestic consumption and investment. China retains significant industrial strengths, but property weakness and fragile consumer confidence remain obstacles. Japan continues to make progress on corporate governance, although higher interest rates may create a less supportive short-term environment.
Energy, inflation and gold
Energy markets remain an important source of inflation risk. Although crude oil supply conditions have improved, pressure on refined products such as diesel could still feed into transport, agricultural and industrial costs.
China’s weaker domestic demand and excess manufacturing capacity may offset some of this pressure by keeping the prices of manufactured exports competitive.
Gold continues to offer diversification against geopolitical uncertainty, inflation and currency weakness. However, its short-term appeal is less clear now that cash and government bonds offer more attractive yields.
Our current view
Economic growth and company earnings remain broadly supportive of investment markets, but the balance of risks has changed. Inflation, energy prices and government bond yields are likely to play a greater role in determining returns.
We continue to see opportunities in equities, particularly among businesses with strong finances and durable sources of growth. We also believe higher bond yields have improved the long-term return potential of high-quality fixed income.
The present environment calls for diversification, selectivity and a clear distinction between attractive long-term themes and the price investors are being asked to pay for them.
The value of securities and the income from them can fall as well as rise. Past performance should not be seen as an indicator of future returns. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.
