By Daniel Morris, Chief Market Strategist; Nathalie Benatia, Senior Market Strategist; Chi Lo, Senior Market Strategist, Asia Pacific
Key points
- Growth fuels rate risks
- Market pricing gaps
- Appetite for gold
Strong US growth raises rate risks
Oil prices have been the tail wagging the market dog recently and this is likely to continue until the situation in the Middle East stabilises. At the same time, artificial intelligence remains a key factor. Rising interest rates are typically negative for technology and small cap stocks – the Russell 2000 index has indeed lagged over the last few weeks. But tech stocks have done comparatively well as the positive earnings outlook has offset the impact of higher rates.
There is a new risk, however, for US government bond yields (and indirectly for global yields). The renewed acceleration in US business activity, as shown by the Purchasing Managers’ indices, points to continued, above-trend economic growth, at a time when inflation remains above the Federal Reserve’s 2% target. The risk of the economy overheating is rising, so even if oil prices fall, bond yields may remain elevated. Equity markets are likely to initially welcome such an environment: relatively higher growth and inflation is supportive for stocks. But if market expectations for the fed funds rate rise further, the adjustment could be painful.
Market mispricing?
Government bonds have faced significant pressure, with long-term yields hitting multi-decade highs in September. This stems from a cocktail of geopolitical instability, higher energy prices, inflation expectations, heavy sovereign debt levels, and tighter monetary policies – which all likely reflects a fundamental rise in term premia. With yield-insensitive buyers (central banks and reserve managers) retreating, the ‘scarcity premium’ is fading, prompting investors to demand higher yields for holding long-duration assets. This shift has been amplified by regulatory and legislative changes (Dutch pension fund reform; German debt brake reform) and increased competition from heavy corporate bond issuance, particularly from the so-called hyperscalers.
We see a clear disconnect in Europe and the UK between market pricing and economic reality. Current market expectations for policy rates seem overly aggressive, particularly in their reaction to supply-side shocks. Much of this gap centres on the ‘neutral rate’ – the theoretical rate that keeps an economy stable. Markets appear to be pricing in an artificial intelligence-driven productivity boost (and thus a rise in the neutral rate at some point), but central bankers remain cautious. And since they have consistently emphasised a data-dependent approach, present market pricing may be overshooting. We expect these excessive expectations to adjust to align more closely with the central banks’ approach, potentially reducing long-term bond yield volatility.
Gold – beyond rate hikes
The gold price has held up well in the face of a resilient US economy and rising bond yields. This does not mean that interest rates no longer matter – rather, it suggests the market is placing greater weight on investors’ appetite for the precious metal. If the Federal Reserve hikes rates again, the gold price will likely correct, but we expect it would be limited. With seasonal demand rising and central banks and other official institutions continuing to buy, the medium-term risk-reward balance for gold seems skewed to the upside.
Reserve managers have continued to add gold, buying into lower and/or more stable prices as they look to build strategic positions. Notably, China added another 20 tonnes in August, bringing its total purchases this year to 80 tonnes. Gold exchange-traded funds have also been rebuilding positions towards the highs reached earlier this year.
Investors appear to be looking beyond the next data release and the potential missed gains from holding gold instead of income-generating assets. Attention has shifted toward the medium- and long-term role of gold as a potential way to make portfolios more resilient against a mix of macroeconomic, policy and geopolitical risks.
Implementation ideas
Flexibility within euro credit
The euro credit market remains resilient, supported by strong fundamentals and solid quarterly earnings, despite geopolitical tensions and elevated energy prices. While the risk premium on corporate bonds remains low, current market trends are supportive, offering elevated absolute yields and an attractive income. Tactical duration positioning could potentially be beneficial, particularly given the market has already priced in expectations of future European Central Bank interest rate hikes. An agile, flexible approach could help investors capitalise on opportunities across the euro investment grade credit spectrum, including high yield and subordinated debt. Active allocation and selectivity across sectors and credit ratings remains the primary way to drive potential returns.
Inflation and rates fluctuation protection
Geopolitical tensions are sustaining high levels of inflation uncertainty, particularly due to volatile energy prices, while financial conditions remain restrictive. The distinctly hawkish turn by various central banks means short-dated inflation-linked bonds look attractive, given their near-term growth potential and inflationary risks. Given that multiple interest rate hikes are already embedded in market pricing, both inflation indexation – bonds where the principal is linked to inflation – and the potential returns investors can earn from holding the bond offer potential attractive opportunities through year-end. Short-duration strategies can potentially help protect against the risk of higher inflation as they are less sensitive to interest rates compared with all-maturities strategies.
Environmental solutions enabling AI development
The artificial intelligence revolution is not just about investing in semiconductors and technology. Behind the rapid growth of AI is a significant build-out of critical enabling infrastructure, particularly power and water. Rising data centre demand requires more electricity generation, stronger and smarter grids, transformers, battery storage, energy efficient cooling, and reliable water infrastructure. Meeting this growing demand while supporting the transition towards a lower-carbon power system will require significant investment in environmental solutions. We believe this creates a broad, multi-year potential investment opportunity in the providers that enable the continued expansion of AI.
Asset Class Summary Views
Opinions draw on investment team views and are not intended as asset allocation advice.
| Rates | ||
| US Treasuries | = | The Federal Reserve raised its key rate to 3.75%-4.0% and adopted a hawkish tone. Markets now expect official rates to peak around 4.50%/4.75% |
| Euro – Core Govt. | = | Recent hawkish talk from the European Central Bank has led markets to expect the deposit rate will rise to 3.25%/3.5% from 2.50% today. We do not think such hikes are necessary. Valuations are attractive, but there is a clear lack of momentum |
| Euro – Govt Spreads | = | Risk premia for French and Italian government debt have risen. Key factors for France are tied to the outcome of the 2027 budget debate in the short term and presidential elections in the medium term |
| UK Gilts | + | Continued underperformance due to excessive concerns about the outlook for inflation and fiscal policy. The end of Bank of England gilt sales to the markets may provide some short-term relief on longer-dated UK government debt. |
| JGBs | = | The Bank of Japan is on a hiking path but broadly in line with expectations |
| Inflation | + | Inflation break-evens spreads have risen in line with oil prices in the short term, but longer-term break-evens remain close to ECB and Fed targets and therefore at attractive levels. Short-duration strategies still potentially effective in protecting against risk of higher inflation due to low interest rate risk |
| EM Hard Currency | Yields still at attractive levels but macro risks remain significant and selection is key | |
| EM Local Currency | = | With the outlook for energy prices still uncertain, rate cuts are on hold for now. |
| Credit | ||
| USD Investment Grade | + | Risk premia higher than pre-Iran crisis but fundamentals so far supported by a strong economy. Technicals a little weak with significant upcoming supply, especially from hyperscalers |
| Euro Investment Grade | + | Search for yield supports positive technical backdrop. Fundamentals are very good with more upgrades than downgrades. However, risk premia remain very tight and unlikely to reduce |
| GBP Investment Grade | + | Attractive yields on offer for long-term sterling investors. Gilts have been an ongoing source of volatility but an end/pause to Bank of England debt sales may provide short-term relief |
| USD High Yield | = | Overall, fundamentals have improved but higher official rates may put pressure on some sectors going forward |
| Euro High Yield | + | With yields around 6.75%, the asset class remains attractive, but risk premia remain low and new issuance is on the rise. Dispersion is increasing and selection is key |
| Equities | ||
| US | + | Technology and AI continue to drive returns, while US business activity remains resilient amid a broader manufacturing recovery. However, higher inflation and interest rate expectations remain risks to returns |
| Eurozone | + | Improving earnings momentum and relatively light positioning are supportive, but higher energy prices, tighter monetary conditions and geopolitical proximity offset the improving relative setup. Within the region, we prefer bank stocks. |
| UK | = | Higher interest rates remain a drag on growth momentum. Defensive sectors are likely to fare better, while the commodities sector is also supported |
| Japan | = | Corporate fundamentals remain supportive, but valuations have rerated and the market is undergoing a positioning-driven de-risking phase. BoJ policy and yen uncertainty also argue against a directional view. Bank stocks look attractive. |
| China | – | Policy support and attractive valuations provide a degree of downside protection, but consumer trends remain subdued and visibility on a sustained earnings recovery is still limited |
| Emerging Markets | + | Valuations are attractive on a forward earnings basis |
| Sector | + | Preference for energy-related stocks to reflect positive view on commodities. |
| Investment Themes* | Long-term positive on AI buildout, grid electrification and carbon transition strategies |
* BNP Paribas Asset Management has identified several themes, supported by megatrends, that companies are tapping into which we believe are best placed to navigate the evolving global economy: Automation & Digitalisation, Consumer Trends & Longevity, the Energy Transition as well as Biodiversity & Natural Capital; source: BNP Paribas Asset Management.
