Q3'S MPS market highlights

The big picture

This has been an unusual quarter in so much that strong earnings and investment in AI have supported equity markets, while the Middle East energy shock has revived inflation fears, prompted central banks to return to tightening and driven long-dated bond yields sharply higher.

Middle East conflict and the renewed energy shock

The conflict involving Iran and disruption to the Strait of Hormuz have arguably been the single most important macroeconomic influence during Q3. After some easing early in the quarter, tensions intensified again and disruption to shipping became severe. By late September, only a fraction of the previous number of vessels were recorded crossing the Strait, compared with roughly 125 large commercial vessels per day prior to the conflict.
Consequently, Brent crude oil prices have spent significant periods at, or above, $100/bbl, while European gas, diesel and jet-fuel prices have also risen materially. This has transformed what initially appeared to be a geopolitical risk into a genuine global supply-side inflation shock. Energy-importing economies, such as the UK and eurozone, are particularly exposed. Higher oil prices have supported energy equities and commodities but weighed on consumer sectors and long-duration bonds.

The global rate-cutting cycle has been thrown into reverse

Perhaps the biggest change in the macroeconomic investment environment during Q3 has been the reassessment of the interest-rate outlook. The Federal Reserve raised rates by 25bp on 16 September, taking the target range to 3.75–4.00%, as still-elevated inflation outweighed solid economic growth. The European Central Bank also raised rates in August and September, taking the deposit rate to 2.50%. The ECB continues to forecast average inflation of 3.0% in 2026, remaining above target into 2027. The Bank of England held Bank Rate at 3.75%, but the vote was notably hawkish at 6–3, with three MPC members favouring an immediate increase to 4%. UK CPI reached 3.1% in August, and the Bank expects further upward pressure from energy prices.

Bond yields surge as inflation and fiscal concerns combine

The reassessment of rates has triggered a significant global bond sell-off. During Q3, 30-year US Treasury yields moved above 5%, UK 30-year gilt yields approached 6%, and German 30-year yields moved towards 4%. Several factors are at work: higher inflation expectations, central bank tightening, substantial government borrowing requirements and rising term premia have all contributed. Europe has also developed an additional sovereign risk dimension. Concerns about France’s fiscal position and political instability have driven the French–German 10-year yield spread towards 120bp, recently reaching its widest level since the eurozone crisis in 2012, when it reached 129bp.
Higher risk-free rates are tightening financial conditions independently of central-bank actions. They are increasing mortgage and corporate financing costs, while placing pressure on more highly valued equities and heavily indebted governments. Conversely, prospective returns from government bonds have become considerably more attractive.

Exceptional earnings and AI investment keep equities remarkably resilient

The counterweight to almost all the negative macroeconomic news has been corporate profitability. Q2 earnings, reported predominantly during Q3, were exceptionally strong.
Over the quarter, around 85% of reporting S&P 500 companies beat analysts’ expectations, substantially above the long-run average of roughly 68%. AI spending by hyperscalers has increasingly translated into cloud revenues, order backlogs and earnings growth. This has eased some of the earlier concern about whether enormous AI capital expenditure would generate adequate returns.
Investors should remember that the value of investments and the income from them can go down as well as up and that past performance is not a guarantee of future returns. This report is only for use by a financial adviser or a client who has received advice on investing in this managed portfolio service. It is not for use by non-advised investors or any other third party. For full important information and key risks, please refer to the end of this document.
The upside surprises have not been confined to technology. Earnings growth has exceeded expectations in sectors such as energy and defence, as well as in financials, particularly banks. 
By contrast, sectors with greater consumer exposure have faced stronger headwinds, so the positive earnings surprises have not been universal. 

Trade tensions remain elevated despite greater clarity on tariffs

Trade policy remained an important background risk throughout Q3. On 24 July, following the expiry of the temporary global tariff regime, the US introduced new tariffs of 10%–12.5% on imports from around 60 trading partners, including China and the EU. The measures cover the overwhelming majority of US imports, although significant exemptions apply to areas including energy, food, fertilisers and certain industrial products. The immediate market reaction was relatively contained because many of the measures had been anticipated and several existing trade agreements effectively capped the increases. Attention subsequently shifted towards US–China negotiations and the future of the trade truce, which is due to expire in November. Tariffs remain an additional source of inflation and uncertainty, but during Q3 they were overshadowed by the much larger energy shock. Nevertheless, a renewed deterioration in US–China relations would be an important risk to consider in Q4.

Asset allocation highlights

Inflation and higher rates weigh on bonds

More persistent inflation, driven largely by the 30%+ increase in oil prices, together with higher interest rates, has proved challenging for fixed-income assets. Government bonds, investment-grade corporate bonds and global high-yield bonds all delivered negative returns over the quarter.

Alternatives face significant headwinds

Alternatives also suffered in this environment, with both global real estate investment trusts and global infrastructure declining sharply over the quarter.

Earnings deliver a strong foundation for equity markets

The robust earnings environment has helped to support equity markets over the period. Large-cap US companies delivered strong returns, as did Japanese equities, with returns for sterling investors also boosted by the yen. The broad UK market held up well, with mid- and small cap stocks outperforming their larger-cap peers. By comparison, emerging markets, Asia ex Japan and Europe ex UK equity indices delivered modestly negative returns.

Market outlook

There is no doubt that the macroeconomic outlook has become more challenging over the past three months.  The conflict in the Middle East, its impact on energy markets and the hawkish tone adopted by many developed-market central banks are likely to weigh on growth.

Government bonds: markets price in further policy tightening

Bond markets are already pricing in significantly tighter monetary policy. If hostilities end and the affected trade chokepoints reopen, there is a reasonable chance that not all of these anticipated rate increases will materialise. If global government continued to run significant (and expanding) budget deficits then further pressure is likely to be demonstrated across government bond markets.

Global Credit: limited signs of stress

Although credit spreads remain tight there is little sign of any significant pick up in the credit default cycle. Unless economic growth slows materially, we don’t expect this to change over the medium term. Against this backdrop, the additional yield from owning global credit relative to government bonds remains attractive. We are conscious that there continues to be significant issuance from technology companies to finance AI related capital expenditure. This doesn’t currently seem to be causing indigestion within the corporate marketplace.

Global Equities

From a risk-asset perspective, companies continue to perform well, with many exceeding analysts’ earnings expectations. It would be difficult to describe broad market valuations as cheap, but there are clear areas of opportunity. We will continue to tilt portfolios towards these areas where appropriate.

Alternatives; diversification continues to be a key focus

Global infrastructure assets continue to benefit from structural shifts, whilst trading at attractive valuations. These assets also provide diversification from more traditional asset classes and continue to be useful from a portfolio construction perspective.

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Past performance does not predict future returns. The value of investments, and the income from them, can go down as well as up and clients may get back less than the amount invested.

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