As we moved through the final summer months towards autumn, investment markets were dominated by a combination of geopolitical disruption, higher energy prices and renewed pressure on government bond markets.

Tensions involving Iran continued to impact shipping through the Strait of Hormuz, a key route for global oil and liquefied natural gas exports. Before the conflict, around one fifth of global oil and gas supplies passed through the Strait, meaning interruptions have had consequences well beyond the region, raising transport costs and increasing the risk of more persistent inflation.

Higher energy costs can push up prices across the economy, making it harder for inflation to fall. This may limit central banks’ ability to cut interest rates, even when economic growth is weak. While oil flows have recovered at times, shipping conditions remain fragile, with lower vessel traffic and elevated security risks continuing to leave markets sensitive to further developments.

Stocks and bonds

Global equities faced a more challenging environment as higher bond yields made safer investments appear more attractive. This put particular pressure on companies whose expected growth and profits lie further in the future, while businesses generating reliable cash and profits today proved more resilient.

The main bond market risk during the quarter was sensitivity to changes in yields. When yields rise, existing bond prices fall, and the implication is larger for bonds with longer maturities. The repricing of higher yields was global in nature as US treasuries, UK gilts, European government bonds and Japanese government bonds all experienced upward pressure on yields.

The rise in government bond yields also weighed on corporate bonds. While corporate bonds typically offer a higher income than government bonds to reflect the additional risk of lending to companies, this extra return may not fully offset losses when government yields rise sharply. Longer dated corporate bonds were most affected, as their prices tend to move more significantly when interest rates change.

Why is there increased scrutiny on government debt now?

Over the past few months, markets have been increasingly impacted by the focus on rising bond yields and their effect on investments, government spending and GDP growth. This focus has increasingly shifted towards the long end of the yield curve, meaning bonds with maturities of 10 years and beyond. Investors are asking for greater compensation to lend to governments for extended periods, reflecting concerns over fiscal discipline, inflation uncertainty and the volume of debt governments need to issue to create growth in their underlying economies. This additional return is often referred to as the term premium.

The large increase in yields over the past few months has led to governments and central banks intervening in bond markets to try and ease the burden on long-term yields.

In the United States, the Treasury has increased the size of its buyback operations, where the government repurchases existing bonds from investors before they mature, with a focus on longer dated bonds. These operations can support market functioning and demand for long dated Treasuries. The Treasury hopes this will help limit the rise in long term yields and, over time, reduce the cost of servicing US government debt. With the US midterm elections approaching, developments in borrowing costs, household finances and economic confidence are likely to remain an important focus for the administration.

In the United Kingdom, the Bank of England has adjusted how it reduces the gilt holdings it accumulated through its earlier quantitative easing programme. Rather than selling all these bonds back to investors, it has paused sales and plans to hold some of its longest dated gilts until they mature. Keeping these gilts until maturity means fewer long-dated bonds are available for sale, which could help limit further rises in long-term interest rates. This differs from the US approach, although both measures can reduce pressure on longer dated bond yields. In the UK, this may help limit the cost at which the government needs to borrow in the future, although it does not remove the underlying fiscal challenges or guarantee lower yields.

Another key area of change over the quarter occurred in Asia, with Japan working with the US to control currency movements. Japan and the United States have undertaken coordinated action to support the Japanese Yen, following a period in which the currency approached multi-decade lows against the US dollar. Supporting the yen may reduce the need for Japanese institutions to sell foreign assets, including US Treasuries, to raise funds for currency intervention. It illustrates how currency and bond markets are increasingly interconnected, especially when government borrowing needs are high.

Implications for portfolios

Higher government bond yields create a more demanding investment environment, but they also create opportunities.

Government and corporate bonds now offer a higher starting income than they did for much of the previous decade. However, the wide dispersion in economic conditions and central bank policy across countries means that active selection is key to maximising the return opportunity whilst reducing risks as much as possible.

Within equities, as interest rate expectations continue to influence share prices, companies are likely to perform differently depending on the timing and reliability of their cash flows, their starting valuations and their prospects for future growth. The low interest rate and low inflation environment that supported many areas of the market in the recent past is unlikely to provide the same broad tailwind going forward. This makes active management and detailed research increasingly important, helping to identify the areas where expected returns offer the most attractive balance of opportunity and risk.

From an alternatives perspective, greater uncertainty and pressure on valuations may lead to more frequent periods of market volatility. Alternatives can help provide diversification because their returns are often less closely linked to traditional equity and bond markets. They may also access opportunities that can generate returns in a wider range of market conditions, including during periods of market weakness. For instance, Gold may remain useful in this environment, particularly when investors are concerned about fiscal discipline, currency purchasing power and geopolitical risk. Infrastructure will benefit from its inflation protected earnings as inflation expectations rise. Finally, defined returns can produce positive returns for investors in flat to slightly downward markets. All of these are beneficial to helping provide positive performance for investors, allowing investors to reach their long-term goals.

Conclusion

The quarter has reinforced the importance of diversification, selectivity and active management in navigating an increasingly uncertain investment environment. While geopolitical tensions, inflationary pressures and rising government borrowing costs continue to create challenges, higher bond yields and opportunities across equities and alternative assets offer potential sources of return. Maintaining a balanced, flexible approach, with a focus on diversification and resilience, remains key to managing risk and supporting the long-term financial objectives of our portfolios.