The rise in oil prices and interest rates marks a shift in the landscape for investors, who must now contend with potentially more persistent inflation. Erik Fruytier analyses here the implications of this new environment for the equity and bond markets, whilst also reviewing the risks associated with artificial intelligence valuations.
The two key variables today – oil and inflation – depend to a large extent on the political agenda. How do you factor this constraint into your investment strategies?
Oil is currently the main driver of global inflation. Energy costs are reflected in the cost of inputs such as fertilisers or raw materials in industry. This inflation is quite volatile, particularly as energy costs are subsequently passed on to the cost of services such as the transport of goods and the use of agricultural machinery. At the same time, consumers are beginning to face widespread price rises and, inevitably, are demanding pay rises. This is when so-called ‘core’ inflation begins to rise, particularly as it is much more difficult for central banks to curb.
Interest rate rises do not clear the Strait of Hormuz but serve to curb demand for energy by slowing down the economy. Central banks must therefore be extremely cautious before raising their key interest rates. Like them, we are closely monitoring geopolitical developments to anticipate any developments that might cause oil prices – and therefore overall inflation – to fall sharply once again.
But things are not going as hoped. The Gulf crisis is becoming bogged down, and central bankers have no choice but to raise their key interest rates. Given the unpredictability of the parties involved in this conflict, investors cannot afford to take positions that are too extreme in terms of investment, as a reversal could occur very quickly. We therefore remain invested but with a sufficiently diversified allocation. Our main scenario remains that a negotiated agreement can be reached between the parties involved. However, as the conflict drags on, we are taking care to adjust our allocation to cope with more sustained inflation and, consequently, a higher interest rate environment.
In the third quarter, the markets held up well despite the rise in oil prices and higher interest rates. What factors might explain such resilience?
Equity markets have indeed held up well, but the bond market has suffered from rising yields. Equity markets are supported by resilient economic growth in Europe and robust growth in the United States. Investment in artificial intelligence is massive and is benefiting many sectors. US consumers are also continuing to spend, despite sentiment surveys indicating concern about their purchasing power. Equity markets have benefited above all from the very strong corporate results published over the summer, which have led to upward revisions in profit forecasts for the year. At the same time, whilst share prices have certainly risen, they have not done so as much as the upward revision in profits. Consequently, valuation multiples on the major stock markets have eased, and this easing of multiples has helped to absorb the negative impact of rising interest rates on valuations.
Despite recent announcements from Anthropic, AI continues to drive the stock markets. Where do you see potential risks today of a disconnect between valuations and expected earnings?
It is now a certainty that AI will be used by a vast number of businesses and consumers. We can draw a parallel with the advent of the mobile phone or the internet, where it became clear fairly quickly that the technology would be ubiquitous. It is therefore not a question of the volume of usage, but rather a question of the price users will pay, and to whom they will pay it. It is difficult to say at this stage which business model will prevail: the Chinese ‘open’ model or the American ‘closed’ model. The market will ultimately decide who the winners and losers are.
However, at this stage, there is still a need to invest in the infrastructure required today to make AI more widely accessible. Companies offering IT, technical and energy solutions will continue to benefit from this roll-out. Then, in a second phase, it will be necessary to select the players with the right business model to monetise these investments. There will likely be different service levels, and therefore different pricing structures, depending on users’ needs.
Among the developments shaping the global economy, which ones do you feel are still poorly reflected or poorly integrated by the markets today?
Unfortunately, climate change seems to be a trend that the markets are choosing to ignore. It is difficult to quantify the consequences of this failure to act, but it is increasingly likely that people in different parts of the world will have no choice but to adapt, however painful that may be. This will entail costs but will also, as in every crisis, create opportunities. I believe this trend is not well reflected in stock market indices because it is difficult to quantify and, quite simply, because the majority of governments are not keen to quantify it.
Another major trend is the general ageing of the population. In most developed economies, the ratio of older people to younger people is rising dramatically. By 2050, according to OECD projections, a large proportion of Western economies will have around one person aged 65 or over for every two people of working age. Today, the ratio is still only one to three! And in the countries with the fastest-ageing populations, the ratio could even reach one person aged 65 and over for just 1.3 people of working age. This will have enormous consequences for social security costs and economic growth in the countries concerned. The productivity of the working-age population will need to rise rapidly to support the non-working population; thanks to AI and humanoids, solutions are emerging that could help achieve this, but it will be absolutely crucial to ensure a gradual transition in order to maintain a certain social balance.
In your portfolios, which areas do you currently find the most challenging in terms of asset allocation?
Allocating to Swiss bonds is difficult because the yields available on high-quality bonds are very low. Furthermore, the SNB is likely to raise its key interest rates once or twice in 2027, which will also weigh on the performance of Swiss franc-denominated bonds. Given the significant interest rate differential between the Swiss franc and the US dollar, it is costly to implement a currency hedging strategy. Consequently, buying US dollar-denominated bonds and hedging the currency risk does not yield much of a return.
How are you approaching the bond markets today following the rise in yields?
The US and European bond markets currently offer more appeal than the Swiss market, given their yield levels. Adjusted for inflation expectations, however, the Swiss market may still remain attractive. But for private investors, it is difficult to generate interest in bonds with a nominal yield close to zero. US rates have risen sharply and are now reaching levels that will appeal to investors when choosing between shares and bonds. The problem is that rates are currently continuing to rise sharply, leaving investors in a wait-and-see position. However, the absolute yields on high-quality bonds, at around 5.5 to 6 per cent, are attractive enough in the medium term that some asset allocators are likely to start taking a greater interest in them.
It must, of course, be assumed in such a scenario – all other things being equal – that central banks, and in particular the US Federal Reserve, will take the necessary steps to keep inflation in check.