Insight Investment

Artificial intelligence is not only transforming the economy, but also increasingly reshaping bond markets as hyperscalers issue debt to fund unprecedented levels of investment. We believe this trend is creating growing concentrations in parts of the corporate bond market, including those that are widely used to construct pension liability discount curves. If this trend persists, and if highly rated hyperscalers were to face widespread downgrades, the impact could extend beyond credit markets and into pension funding metrics. As AI-related issuance continues to grow, pensions may want to take a closer look at how these issuers influence their discount curves and overall funding position.

The last few months have served as a reminder that monetary policy divergence and relative growth dynamics remain key drivers of currency markets. A hawkish shift from the Federal Reserve, resilient US economic data and the ongoing AI-led US exceptionalism narrative supported broad dollar strength against most major currencies, while higher energy prices and weaker growth expectations weighed on many importing economies. Looking ahead, we continue to favour the US dollar against lower-yielding currencies in the near term, factoring structural concerns around US fiscal policy and policy credibility into our longer-term outlook.

Markets appear over-anxious about further rate hikes, but we believe volatility in rates markets is likely to remain elevated as the Fed shifts towards a less predictable communication style. Historically, the Federal Reserve has tended to look through energy-driven inflation shocks unless they trigger persistent second-round effects or cause longer-term inflation expectations to become unanchored, neither of which appears evident today. While a prolonged conflict with Iran could change the outlook, our base case is that the Fed remains on hold, with the next policy move more likely to be a cut than a hike. We believe the front end of the curve looks increasingly attractive, while Chair Warsh’s restrained communication style could keep markets volatile and create opportunities.

In our view, high yield emerging market corporates remain one of the more compelling opportunities in credit markets. Attractive absolute yields, favourable valuations relative to developed market high yield and a backdrop of negative net issuance continue to support the asset class. With demand competing for a shrinking pool of bonds, we believe spread tightening remains a realistic prospect, while investors can benefit from strong carry as they wait. The market's resilience this year, despite a stronger US dollar and elevated geopolitical risks, underscores the strength of these fundamental and technical drivers, and, in our view, a backdrop of negative new issuance and steady inflows continues to support the asset class.

Investors are currently faced with a choice in high yield markets. Some are focused on the tight level of credit spreads and are waiting for better levels, while other are increasing their allocations based on the high level of absolute yields. Ultimately, in our view, corporate fundamentals appear robust, default rates have been low, and disciplined credit selection can help avoid many of the market’s weaker credits. With demand continuing to outpace issuance, we believe the current imbalance may provide a favourable backdrop for high yield, potentially supporting return opportunities for investors.

Valuation differences across sectors continue to dominate investment grade credit discussions, with technology standing out as cheap versus sectors such as capital goods. We believe the challenge is that the AI infrastructure build out suggests a substantial issuance pipeline remains ahead and further spread widening could erode the sector’s yield advantage. Although technology has grown as a proportion of major indices this year, its overall weight remains modest. We therefore remain selective, focusing on the largest issuers and retaining a small overweight until either valuations become substantially more attractive or new issuance starts to ease.

The 60/40 portfolio is no longer the unquestioned answer to diversification. Investors are increasingly looking beyond traditional asset classes and searching for assets that genuinely improve portfolio resilience. In our view, the future belongs to total portfolio approaches that combine assets with differentiated sources of return and diversification, helping reduce dependence on any single market outcome. As a result, investors are increasingly turning to absolute return bonds, equity downside strategies or even strategies that exploit inefficiencies in currency and commodity markets.

Markets are focused on the inflationary impact of higher energy prices but, in our view, are paying far less attention to the demand destruction they can cause, especially when accompanied by rising interest rates. We have revised our 2026 European growth forecasts materially lower and remain sceptical that the ECB will deliver the two further rate hikes currently priced by markets. Instead, we expect just one additional hike before inflation pressures fade and for the ECB to ease in 2027.

Tariffs are increasingly looking like a structural feature of US economic policy rather than a short-term negotiating tactic, as trade policy shifts from executive action to a more durable legal framework. The administration’s willingness to deploy new and largely untested trade tools underscores its determination to advance its agenda ahead of the midterms. While the political window for major unilateral action may be narrowing, trade policy uncertainty remains firmly in place.