Stocks had soared in Q2; a hard act to follow in Q3, with the environment far more challenging for investors than three months ago. Oil prices topped $100/barrel again in September, as hopes for a long-term resolution to Trump’s Iran conflict faded; high oil prices have kept inflation stubbornly above target; and central banks are hiking interest rates in the US and Eurozone to fight back, helping send bond yields sharply higher. That looks like a remarkably challenging backdrop for stock markets: yet global equities ground 1% higher in the quarter, with US stocks ending September within touching distance of all-time highs. How can this make sense - shouldn’t we expect stocks to fall in such a situation?
Of course, the picture is more complex: stocks aren’t just reacting to rising interest rates or high oil prices: they are pricing in strong future earnings too.
Perhaps the most striking aspect of the last quarter has been the resilience of global growth. Despite the challenges of high oil prices, inflation and rising interest rates, the economy appears in reasonable shape. Forecasters and survey indicators see the expansion continuing into 2027, helped by the boom in AI capital investment and robust consumer spending: stagflation avoided, with the economy in reflation mode instead. And while energy has become more expensive, supply chains have proved flexible, with Middle Eastern crude oil reaching the global market at close to pre-conflict levels.
Supply pressures are more acute in some energy products, notably diesel, where prices have reached record levels in the US and UK, hurting motorists and pushing up transport costs. High prices at the gasoline pump put political pressure on the Trump administration too as mid-term elections approach, with polls suggesting a change of control in Congress.
Decent nominal economic growth, along with the extraordinary pace of AI capital investment and a surge in profits for energy companies, are driving strong corporate earnings: a market grinding sideways, while earnings climb, starts to appear meaningfully cheaper. Higher energy prices can squeeze consumers and corporate profit margins, albeit offset by stronger energy sector earnings; and higher bond yields tend to reduce how much investors will pay for future earnings. In combination, these shifts have driven a stealthy valuation correction: despite sitting close to all-time highs, US stocks trade on a price-to-earnings ratio significantly lower than a year ago.
Higher interest rates push up the cost of capital and can depress valuation ratios, but it’s worth noting that over the long run, stocks tend to do a little better after interest rate hikes than they do after rate cuts. For US equities back to 1982, performance over 6 months, a year and 2 years has on average been better after Fed rate rises than after cuts. This isn’t necessarily surprising: central banks tend to raise rates when growth is strong or an economy is overheating, and to cut when it’s in a downswing. Interest rate hikes may have contributed to the quiet correction in equity valuations, but they don’t tell us nearly as much about overall equity direction.
Beneath the index headlines, we also have a complex story of concentration and dispersion, partly concealing a modest but widespread market correction. Global stocks advanced just over 1%, led by Japan (up over 5%), the US (+2%) and UK (+1.6%), but this is by no means the first quarter in recent years when market leadership has been narrow, with the index propelled by a handful of high-momentum stocks and sectors doing all the heavy-lifting.
Energy stocks rallied over 13% in the quarter, far and away the market leaders: the UK market, with a weighting over 11% in the Energy sector, is a key beneficiary. A few other sectors achieved 3-4% returns (IT, Communications, Healthcare) but 5 of the 11 market sectors saw negative returns in the quarter: both sectors sensitive to the economic cycle (Industrials -6% and Consumer Cyclicals -4%) and especially sectors sensitive to higher bond yields (Consumer Defensives -2%, Real Estate -6%, Utilities -8%). Small Cap companies, after a healthy start to the year, also retreated. The global index, and the US market, may have made gains overall but the average stock has fallen.
Year-to-date, only Energy and Tech stocks have outperformed the market, with both up well over 30%. No other sector has achieved double-digits (in USD terms). This is challenging for active managers, wary of over-weighting expensive AI stocks reliant on a continuing capital investment boom, or energy companies, where earnings could retreat as soon as the Iran crisis is resolved. While geographical diversification could have helped a bit, notably for managers investing into Japan, diversification outside oil and technology has been penalised; even the strong emerging market equity performance in the first half of the year was heavily dependent on companies central to the AI investment theme.
The quiet correction has been a little less quiet in bond markets. Bond yields have risen across the board, pushed higher by inflation continuing to run ahead of target, by central banks hiking short-term interest rates and indicating more rises to come, and by persistent concerns over government finances. Headlines have highlighted the highest bond yields since the Global Financial Crisis of 2008, US Treasury yields topping 5%, and longer-dated bonds in the US and UK breaking through 6% yields. For investors with long memories, these levels may look more like a return to normal, after almost 20 years of post-crisis repair, rather than a move into unprecedented levels.
This has been a painful adjustment for investors with significant holdings of bonds, particularly of longer-maturity bonds. Global bonds in aggregate returned around -2.5% in the quarter, with longer-dated bonds falling 5-8% in the UK and US. There were few safe havens in fixed income: US inflation-linked bonds (TIPS) fell over 3%, and riskier bonds - which tend to be shorter-maturity and therefore less sensitive to interest rates - also fell: High Yield lost 2%, and Dollar-denominated Emerging market debt lost almost 4%.
Corporate bonds sold off too, but without a major shift in credit spreads, which remain tight by historic standards: markets are demanding only modest premiums from risky borrowers for credit. There are signs of differentiation, with credit spreads for some AI-related borrowers widening a little, as debt issuance picks up to fund the AI capital investment boom and lenders start to question the future returns it can generate. There is no sign of widespread credit deterioration, but the specific spread-widening among AI-related issuers should be on investors’ radar.
The question for investors is at what point higher interest rates and higher bond yields tip the balance of appeal from stocks to bonds. We may not be there yet, but after a decade and more ruled by the mantra “There Is No Alternative” to equities, higher bond yields will prove tempting for some: higher starting yields for bonds typically correlate strongly with higher returns achieved. Perhaps today’s higher government bond yields will start to appeal as an opportunity rather than a threat: there is some portfolio appeal in owning an asset that has potential to rally if the economy finally slows and inflation falls, which pays 5% or so a year while we wait.
A superficial reading of media coverage might lead us to think of the UK exchequer as uniquely challenged, with shockingly high bond yields and no room for fiscal manoeuvre. Undoubtedly, most advanced-economy governments face difficult decisions on the balance of tax and spending, and pressures from aging populations, mounting health and retirement costs, and a need to increase spending on security. But the gilt market has fared slightly better than other major markets over the last quarter. While UK bond yields rose 65bps to 5.4%, US bond yields rose further, by 80bps to 5.25%, almost erasing the differential between Gilt and Treasury yields that has persisted since early 2025. The rise in Eurozone bond yields has been significantly more painful: French government bond yields have shot higher, from 3.5% to 4.8% over the quarter. France now faces a cost of borrowing above Spain, Italy and even Greece. Meanwhile, the UK reported the highest GDP growth in the G7 in the first half of this year, and speculation is building that the Burnham administration will try to reset Britain’s trading relationship with the EU, modifying one of the major impediments to UK economic growth.
Investors' perceptions may be anchored on recent experience, but it’s worth noting the long-term picture: UK government bond yields were above 5% for the entire period from late 1963 to late 1998, and traded around 5% for another ten years beyond that until the Global Financial Crisis. Today’s economies carry a bigger burden of debt to service, but bond yields look perfectly normal in the long run. Nearly twenty years on, are we finally seeing the traces of the Global Financial Crisis fading?
So apparently strong equity indices conceal a weaker underlying picture. Strong earnings from the AI segment and energy companies boosted a narrow chunk of the market and flattered the index, while many sectors retreated and valuations overall have cheapened. Meanwhile higher bond yields offer a meaningful alternative source of return, with a viable role to play in portfolios as potential protection in a slowdown. Perhaps the question is how the narrow leadership in equities will evolve: a broader recovery across more market segments, or last quarter’s quiet correction becoming a louder one? A prudent investor does not forecast binary outcomes like this, but constructs diversified portfolios to weather whatever the future may hold.
N.b. All content is based on data at the time of writing on 12/10/26.