Following a summer in which equity markets reached new highs, the central question is no longer whether economic growth will continue, but whether it can be sustained in an environment of higher interest rates and rising valuations. Strong corporate earnings and the global wave of investment in artificial intelligence continue to provide support, although elevated expectations are setting an increasingly high bar for further positive surprises. At the same time, the battle against inflation has not yet been fully won, while government deficits, substantial funding requirements and geopolitical tensions are exerting upward pressure on long term interest rates. At the annual gathering of central bankers in Jackson Hole, the new Chair of the US Federal Reserve, Kevin Warsh, emphasized that price stability remains the priority and that financial markets should place less reliance on firm guidance regarding future interest rate decisions. Strong fundamentals may support further market gains, but the margin for disappointment is narrowing.

This balance between optimism and caution was clearly visible in financial markets during August. Global equities rose by 2.4%. Japan was the strongest developed market, returning 3.7%, followed by emerging markets at 3.4% and the United States at 2.7%. The euro area gained 1.0%, the United Kingdom was unchanged, Switzerland declined by 0.3% and China fell by 0.4%. Earnings growth among US companies was the strongest in four years and broadened to include a wider group of businesses. This helped equity markets withstand the impact of higher financing costs.

Bond markets told a more cautious story. At the beginning of September, the US ten-year Treasury yield stood at 4.78%, while the thirty-year yield reached 5.27%. The German ten-year government bond yield rose to 3.37%, while the Japanese ten-year yield moved above 3%, its highest level since 1996. During the six months to the end of August, the ten-year yield rose from 4.07% to 4.78% in the United States, from 2.78% to 3.37% in Germany and from approximately 2.18% to 2.94% in Japan. The rise in yields was therefore an international development and not solely the result of concerns about the US budget. Investors are demanding greater compensation for inflation risk, rising government debt and the substantial amounts of capital required by governments and companies. Commodities once again attracted attention. Gold rose by 10.6%, while Brent crude oil gained 3.8%. Oil was supported by uncertainty surrounding global energy supplies and key transport routes. An improvement in shipping conditions could ease pressure on oil prices, inflation expectations and long-term interest rates, while renewed disruption could quickly have the opposite effect. In the case of gold, demand for protection against inflation, government debt and geopolitical uncertainty outweighed the headwind from higher interest rates.

The macroeconomic environment remains complex, although growth has so far proved resilient. Real private domestic final demand in the United States grew by 4.2% year on year in the second quarter. This does not point to an economy that is slowing rapidly and gives the Federal Reserve little reason to ease its policy stance prematurely. Against this background, the reasons behind rising interest rates are becoming increasingly important. Higher interest rates driven by productive investment and robust economic growth have very different implications from an increase caused primarily by budget deficits and concerns about the sustainability of government debt. Limited attempts to contain long term interest rates are therefore likely to provide only temporary relief while inflation risks, demand for capital and government bond issuance remain elevated.

Over the coming months, attention is likely to shift from the direction of economic growth to its quality. Equities may continue to find support in earnings growth, although high expectations leave markets increasingly vulnerable to disappointment. In bond markets, a further rise in interest rates could tighten financing conditions, while developments in oil and gold will provide an indication of the extent to which geopolitical risks are influencing inflation expectations. The next phase of the cycle is therefore likely to depend less on liquidity and more on productivity growth, sustainable profit margins and companies’ ability to absorb a higher cost of capital.

Within our strategy, we are maintaining an overweight position in equities, as economic growth, healthy corporate balance sheets and robust earnings momentum continue to offer the strongest foundation for long term returns.

Please find the Asset Allocation update for the month of August attached.