View From The Top: Renormalisation

View from the very top: Forget hysteria – we are in a process of renormalisation. The low bond yields and zero interest rates of the recent past were the exception. An economy that is growing robustly while inflation remains under control should be able to handle government bond yields of over 4%, the current developed world average. A higher cost of capital does create a tougher environment for all asset classes, but we believe the AI investment cycle will keep the economy growing while central banks will take a credible approach to keeping inflation expectations anchored. These dynamics minimise the risk of either recession or financial accident. Investors should not be complacent, particularly given strong equity market returns in recent years, but the new normal investment landscape and the possibility of stock market pullbacks create a plethora of opportunities. Our mantra is to stay disciplined yet continue diversifying across all asset classes.

Asset Allocation:

Equities: Markets have proven resilient even though government bond yields have pushed higher in the past month. Equities remain supported by ongoing and broadening earnings momentum, with the impending third quarter earnings season being the next catalyst for driving further consensus upgrades. There is no reason why equities should not outperform in a higher rate environment – per the playbook of the late 1990s – although investors should be prepared for drawdowns given recent market strength. We believe that a balance between growth and value is the best way to navigate the current environment. Follow the earnings (upgrades) and see selloffs as opportunities. Stock pickers should benefit.

Fixed income/ Credit: The adjustment process of higher bond yields has been painful for many fixed income investors, but it is important to recognise that the upward trend in yields means that this asset class is now offering more normalised levels of income again after many years of being priced at close to zero – even if returns may remain limited in real terms. We can see a case for adding some duration while focusing on high-quality investment grade credit. Investors need to remain mindful of rising risks lower down the spectrum (when businesses need to refinance at higher-than-previous levels) as well as in the private credit market, where US defaults are at their highest in three years, according to Fitch.

Currencies: Recent upward moves in the US Dollar correlate with higher Treasury yields, although the Dollar remains below its 52-week high, and is lower than when the current Trump presidency began. With most major economies embarking on monetary tightening policies, the biggest currency beneficiaries should, arguably, be those whose economies are growing most quickly (i.e. America). We remain mindful of mean reversion across the FX space and note that a stronger Dollar clearly has adverse implications for some emerging market currencies.

Gold: Many asset classes are now paying increasingly attractive yields. Gold, by contrast, offers no yield, which partially explains why the precious metal has fallen by over 20% from its 2026 peak. We continue to see gold as a crucial portfolio diversifier and hedge both against government intervention in financial markets and other macro instabilities. Central bank purchases of gold remain supportive.

Alternative assets: Hard assets perform another important role in portfolio diversification, in our view. Not only do they offer some income-generating characteristics, but they can also provide resilience in the face of uncertainty. It is important, however, to remain selective across this asset class. We favour uncorrelated strategies with a quality bias.

Fear sells, and it always has done. Financial commentators like to cling to round numbers, more for symbolism than fundamentals. Witness events in recent weeks. The yield on 10-year US Treasury debt crossed the symbolic 5% level on 16 September for the first time since 2007. It remains above this level at the time of writing. The world has not ended. Indeed, the MSCI World Index of global equities closed the month just 2.7% below its all-time high. Forget hysteria; we are in a period of renormalisation.

Take a step back. There is absolutely no reason why a well-functioning economy cannot prosper with yields at current levels. A 5%+ yield on 10-year US Treasury debt (or comparably yielding paper in other geographies) is normal, and yields were consistently above this level until the start of Great Financial Crisis (GFC). A quick history lesson would show that Treasuries of this duration rarely fell below 5% over the period 1976-2007. Think, therefore, of the post-GFC period as the exception, a function of excess saving, limited growth, persistent disinflation and the pursuit of zero (or low) interest rate policies.

Investors should recognise that the era of cheap borrowing and abundant capital that lasted from 2008 to 2021 is well and truly over. The good news is that the renormalisation process has, in our view, been orderly - and has given market participants a chance to re-adjust. If there were a relevant playbook, then consider the late 1990s – an era characterised by persistent technological innovation, limited pressure to deleverage and relatively subdued inflation. Equities did well in this period of higher fixed income yields; it was a time of exuberance for many. The comparison is imperfect, not least because public debt burdens and fiscal pressures are substantially greater today. Nonetheless, for bears, the onus is to demonstrate why something is broken.

No-one should be surprised by the recent moves we have seen in bond yields. Three interlinked factors provide the explanation. The debate is less about unsustainable deficits – this is a problem for another day – and more about strengthening growth in the face of persistent inflation and a credibly hawkish US central bank. Have no doubt, America’s GDP growth is accelerating. AI investment is helping. S&P’s most recent US purchasing managers index (PMI) for manufacturing stood at its highest level since 2021. Strip out this post-pandemic bounce and PMI has not been this high since 2015. Consumers are continuing to spend, and unemployment is only just above 4%. The Atlanta Fed estimates that third-quarter GDP growth is currently running at an annualised rate of around 5%.

Nominal GDP growth in excess of inflation is the sign of a healthy economy. The latest reported PCE rate (personal consumption expenditures, the Fed’s preferred measure) stood at 3.4%, implying real GDP growth of around 2.0%. Understandably, however, the Federal Reserve is keen to return inflation to its target level, particularly given near-term upward pressures. Ongoing uncertainty in the Middle East is unhelpful in this respect, and unlikely to dissipate soon.

However, it is important to recognise that the currently hawkish stance of Fed Chair Kevin Warsh is partly about signalling. Most crucially, it is helpful to keep inflation expectations anchored, hence the commitment to 2.0% inflation as “a firm, fixed target.” Do not forget that Warsh will ultimately be judged on his long-term track record. Policy decisions should not be influenced by political pressures, particularly given the possibility that President Trump might become a lame-duck leader, should the Republicans fare badly in November’s mid-terms. Voters tend to punish presidents that are unsuccessful at winning wars.

Think of the Federal Reserve’s 25 basis point hike in interest rates last month as being a form of pre-emptive insurance – not only the sign of a central bank being willing to act in the face of rising energy prices, but also perhaps evidence that, with hindsight, 2025’s cuts were unnecessary. This is a reset from the Fed, a demonstration of the Volcker principle of saying what you are doing and then doing what you say.

Diligent investors may want to look at inflation breakevens. As a reminder, inflation breakevens represent the inflation rate investors expect over a given period. They are calculated by comparing the yield on a standard government bond with that on an inflation-linked bond of the same maturity. 2-year and 10-year breakevens in the US have remained stable throughout most of 2026 and fell in September. The stability of breakevens provides some reassurance that markets do not currently perceive an imminent loss of monetary credibility.

As noted previously, fear does sell. Talk to most economists (and we had this discussion with several in the past month) and consumer surveys are seen as being decreasingly relevant. People are either reluctant or simply don’t have the time to respond and may not reveal their true views, particularly in a heightened and febrile political environment. Rather than concerning ourselves with a University of Michigan consumer forecast for US inflation at 4.6% one-year out, it might be more constructive to look at the 6-month trimmed mean – i.e. excluding outliers – print for PCE from the Dallas Fed. On this metric, inflation is below 2% already. Truflation metrics also suggest prices are rising at around a 2% annualised level.

Frame current reported headline inflation metrics as being partly a function of still-fragile global supply chains. Now imagine that there is eventually some form of Gulf settlement. This would reduce oil, freight and diesel related price pressures – even if it won’t fully eliminate the broader forces driving yields higher (i.e. economic expansion). Project further ahead, and the growing ubiquity of successful artificial intelligence deployments should be a boost for productivity, driving inflation lower. There are clear causes for optimism. A declining-inflation and robust-growth economy represents one highly plausible outcome for the next 12 months.

The OECD recently upgraded its forecasts for global economic growth, with the organisation calling for higher US growth than any other G7 nation. It raised its estimates for American GDP growth to 2.2% for 2026 and 2.1% for 2027 (from 2.0% and 1.8% in June). Better prospects for world growth also help explain why higher bond yields are a global phenomenon – i.e. this is not a uniquely US problem. The Bloomberg Global Aggregate Bond Index is above 4.0%. Many central banks are following the Fed playbook of commencing tightening cycles.

What might end the party? It is fair to recognise that a combination of increasing government borrowing and ongoing AI infrastructure investments is pushing up the global cost of capital, creating a tougher environment for all asset classes. We worry less about the risk of policy error, and more about what might happen were the AI bubble to burst.

As many as four interest rate hikes are currently being discounted for the next 12 months in the US (based on Fed Funds Futures), but such a pace of rate increases looks unlikely to us. The odds favour inflation falling over the course of 2027 for the reasons outlined earlier. Kevin Warsh is proving increasingly effective in his signalling and has said that he is unwilling to enforce conditions that are too restrictive.

History suggests that economic booms typically end owing to policy error or financial accident. Do not discount the possibility of the latter, particularly as companies now must refinance at higher rates than in the past. However, a recession looks unlikely to us. Not only is the current business cycle young by historic standards, but the AI investment story constitutes a source of strength.

Any slowdown in AI development would be a threat both to the economy and investor sentiment for the simple reason of its deep interconnectedness with both. AI is one of the few sectors of investment that is making a genuine contribution to economic growth – any sudden slowdown, without obvious substitutes, could be felt well beyond the sector. Some may think of AI as being a bubble, but self-interest will likely keep the cycle going, particularly with many in the West being reluctant to see China pull ahead.

It remains important to ensure that the AI cycle does not get out of control, with over investment in excess capacity resulting in inefficient capital allocation. However, the risk of falling share prices may enforce necessary capital discipline. Discipline is therefore an appropriate note with which to close: stay disciplined; also diversify and be ready for the final quarter of 2026.

Alexander Gunz