The third quarter was a good reminder that the stock market is not the economy. 

Despite worsening economic data, higher energy prices and rising interest rates, global equities reached new all-time highs. Strong earnings momentum, driven by all things AI-related, and continued enthusiasm from retail investors buoyed equity markets, even as government bond markets sold off in response to these concerns. The two main themes discussed in note, geopolitics and AI, remained firmly in the driving seat.

The relief in oil markets we previously mentioned proved short-lived. We remain somewhere between a ceasefire and an all-out war. Nevertheless, the movement of crude oil through the two maritime chokepoints, the Strait of Hormuz and the Bab al-Mandab Strait, remains constrained. More importantly, supplies of distillates, notably diesel, have been further restricted by war damage to refineries in the Middle East and Russia. Existing stockpiles helped offset the initial impact of the war, but there is clearly a limit to how far reserves can be drawn down.

Higher fuel costs squeeze household budgets and raise the cost of producing and transporting goods around the world. For central banks, the question is how much of this feeds through into core inflation. The US Federal Reserve raised its policy rate by 0.25 percentage points to a range of 3.75% to 4%. The European Central Bank and Reserve Bank of Australia also raised rates, to 2.5% and 4.6% respectively. Notably, the Bank of England has yet to raise rates, although we think it is likely to follow suit.

Meanwhile, AI remained a powerful influence on equity markets, with the IT sector again delivering strong returns. However, picking individual winners gets harder each quarter as share-price volatility increases. Certainly, the “Magnificent Seven” has been whittled down to the “Magnificent Three” (Nvidia, Apple and Amazon).

In our last commentary, we alluded to the volume of new debt being issued by companies to fund the AI capex boom. This, alongside the historically high and growing budget deficits of many countries, has contributed to a marked rise in longer-dated government bond yields (which move inversely to prices) and newspaper headlines such as “UK pays highest borrowing cost in 20 years”. In fact, this is a global phenomenon, and the UK is far from the worst of the G7 countries in terms of debt metrics. Nor does the rise appear to be driven solely by fears of higher inflation: comparing conventional and inflation-linked bond yields gives an indication of market-implied inflation which is largely unchanged over the last six months. Rather, the large and continuing supply of bonds appears to be the major factor. As we never tire of saying, “asset prices are driven by the balance (or imbalance) between buyers and sellers” and at the moment there are more sellers of bonds (reducing prices/increasing yields).

Looking ahead, we see equity markets caught between two opposing forces. On one hand, there is very strong earnings growth, albeit concentrated in a narrow group of companies benefiting from AI capex, alongside seemingly unshakeable demand for equities from US retail investors. On the other, there are high and rising energy prices, increasing borrowing costs and persistent inflationary pressures.

We can only repeat the conclusion from last quarter’s commentary. We have not changed our stance from Q1. We prefer to remain cautiously positioned, even at the risk of missing some upside. We remain underweight equities relative to our benchmark, retain our underweight in US equities across all portfolios and remain alert to opportunities where we feel the potential return justifies adding risk.

Patience is rarely the most exciting part of investing, but in this environment it can be a very useful discipline.

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