So far, so firm

A smaller shock, a longer squeeze

The economy has found ways around some of the disruption. Rerouting, inventory drawdowns and additional oil supply outside the Middle East have softened the impact of impaired shipping through Hormuz and the Arabian Peninsula. Investment has also held up: US capital spending is broadening beyond AI, while European business surveys and demand expectations have also improved.

That adaptation helps explain why activity has surprised positively on both sides of the Atlantic. It does not remove the energy constraint. Refining bottlenecks are keeping transport fuels expensive, and low European gas stocks leave the region exposed ahead of winter. Crude prices alone give an incomplete account of the costs reaching businesses and households. Consumer sentiment indicators are starting to reflect these strains, putting the recovery in spending power under closer scrutiny as winter approaches.

The length of inflation's duration now deserves as much attention as its peak. Underlying price pressures are easing gradually, but energy costs remain high and growth is firm enough to give central banks room to act. We expect limited but broad-based tightening this year and next. The timing and the pace at which inflation recedes significantly will determine how far central banks need to go.

Our central scenario remains one of continued expansion, with US growth slightly above 2% and a modest European recovery, delivering close to 1% GDP growth. Investment is doing much of the work. US consumption relies partly on household savings, while Europe's recovery still depends heavily on public spending in Germany. China's weak domestic demand adds to the case for distinguishing investment beneficiaries from businesses dependent on a broad consumer rebound.

The earnings support is real

Second-quarter results have strengthened the case for equities. Earnings growth has broadened beyond technology, and estimates have moved higher across the main regions. Companies have continued to deliver despite the energy shock. This gives us a reason to maintain exposure even as the interest rate hurdle rises.

The next reporting season will test whether that earnings momentum can extend into 2027. Expectations have risen with the rally, leaving less room for disappointment. We will watch whether higher energy costs start to erode margins and whether management teams maintain their investment plans.

Within AI, converting orders into revenues and cash will become a more demanding test. Hyperscalers backlogs are growing faster than revenues, but investment continues to weigh on free cash flow expectations. Suppliers of scarce capacity can capture part of that spending before the companies financing it earn a return. Memory, advanced packaging and power infrastructure remain areas of interest. The software rebound is already rewarding companies monetising AI. Sustaining it will require evidence that those revenues can grow.

Earnings are broadening outside the familiar technology leaders. Electrification, automation and selected industrial businesses benefit from investment programmes, with improving conventional equipment demand providing further support. A further broadening of earnings would give the equity advance a wider base. Owning the same investment theme in several markets, however, does not necessarily diversify its risks.

Higher yields change the bargain

Central banks are only part of the explanation for higher yields. Governments continue to borrow heavily, and corporate issuance is increasing as investment needs grow. Bond markets must absorb both. Even a pause in policy tightening would leave these financing demands in place; clearly, the AI investment cycle is reshaping credit markets, especially on large-scale debt financing.

Higher yields offer better entry points in selected sovereign maturities. We retain a neutral overall bond stance and a preference for core European debt, where market pricing already allows for considerable policy tightening. This is a selective duration position, with attention to the price paid for protection.

Credit offers less scope for enthusiasm. Much of the improvement in fundamentals is already reflected in tight spreads. Equity investors can participate in rising profits; bondholders have more limited upside once spreads have compressed. We prefer European investment grade to US investment grade, we remain cautious on US high yield and retain a positive view on emerging-market local-currency debt. Carry is useful, but it does not erase interest rate or refinancing risk.

Some gains are worth protecting

We remain slightly overweight equities, with preferences for Japan and emerging markets and neutral grades for the United States and Europe. Japan offers exposure to the investment cycle alongside improving governance and domestic support. Asian earnings momentum and valuations underpin the emerging market allocation, with China's weaker domestic economy requiring selectivity.

Europe's energy dependence remains a constraint on our regional appetite. Stronger activity has not removed that vulnerability, which supports some preference for US exposure within our recent adjustments. Across portfolios, we have moderated risk after the rally, while retaining the underlying investment convictions. September's difficult historical seasonality in a US midterm year reinforces that prudence alongside positioning and higher yields. The calendar informs the size of our exposures; it does not determine the investment case.

Precious metals remain part of the allocation, supported by our scarcity convictions, alongside liquid alternative strategies. With several assets exposed to rising yields, diversification requires attention to common risks across the portfolio. For now, we keep exposure to businesses delivering growth and take some gains where markets have rewarded us. Firm convictions leave room for a lighter risk budget.