Making sense of higher yields

The recent sharp rise in government bond yields has prompted questions about the outlook for equities, inflation and portfolio resilience. Higher yields can be viewed as a warning sign, yet the reasons behind rising yields are as important as the move itself.

In our view, higher yields appear to reflect a combination of resilient economic growth, changing expectations for interest rates and increasing demand for capital across the global economy. From large-scale investment in AI infrastructure to a reassessment of future monetary policy, the forces driving yields higher are closely linked to continued economic activity and corporate investment.

Against this backdrop, we remain cautiously constructive on equities. While higher interest rates can create valuation headwinds, robust earnings growth and improving profit expectations across a broader range of sectors continue to provide meaningful support for equity markets. At the same time, elevated uncertainty around inflation and policy means investors must be selective and ensure portfolios are well diversified.

In this quarterly, we explore what’s driving bond yields higher, why we continue to favour equities over credit, how we are positioning portfolios to broaden sources of growth, and why building resilience is just as important as pursuing opportunity.

The defining story of the past quarter has been the sharp rise in government bond yields. At first glance, higher yields can appear threatening for investors; rising borrowing costs increase the cost of capital and can create headwinds for risk assets. However, understanding why yields are rising is as important as the move itself.

We believe the rise in yields has been driven less by concerns around fiscal sustainability or inflation, and more by a combination of resilient economic growth, changing interest rate expectations and growing competition for capital. In that context, we remain cautiously optimistic on equities and continue to favour them over credit.

There are some key macroeconomic questions investors need to consider when assessing today's bond market. The first is whether yields are rising because investors are becoming increasingly concerned about government debt and fiscal deficits. We believe that while these concerns are reasonable, they have not been the primary driver of the move higher in yields this year.

It may be helpful to consider this in the context of the term premium, the additional compensation investors demand for holding longer-dated bonds. If fiscal fears were dominating market sentiment, we would expect to see a significant expansion in the term premium. Instead, we think term premiums have remained relatively stable, suggesting that growing concerns about debt are not the main explanation for higher yields.

The second factor is the role of real interest rates. When we consider bond yields in the context of inflation expectations and real rates, the evidence points towards a real-rate story. In other words, yields have risen not because investors are demanding greater protection against inflation, but because they are reassessing the level of real returns available in the economy. Expectations for monetary policy next year have completely altered, moving from the market anticipating cuts to the possibility of a number of hikes.

At the same time, economic growth has remained resilient. Stronger growth naturally supports higher real interest rates and gives central banks less reason to cut aggressively.

The growing competition for capital has been an increasingly important factor. The world's largest technology companies (so-called hyperscalers) are investing heavily in AI infrastructure, data centres and semiconductor capacity. To finance these investments, many have turned to debt markets and collectively issued billions in credit this year.

This surge in issuance creates a supply-and-demand dynamic. Capital is not unlimited and as demand for it increases, investors require greater compensation for providing that capital; higher yields balance that equation. In other words, more demand for capital means lenders can charge a higher price for providing it. In bond markets, that ‘price’ is the yield.

In that respect, today’s rising bond yields are not necessarily signalling economic weakness. They reflect an economy where investment demand remains robust and where capital is being allocated towards large-scale growth opportunities.

The important question for us is whether higher bond yields represent a threat to equity markets. For now, we believe the answer is no.

While higher yields do increase the cost of capital and can pressure equity valuations, earnings growth has been sufficiently strong to offset that effect. Importantly, earnings momentum is no longer confined to a handful of mega-cap technology companies. Positive earnings revisions and improving profit expectations are becoming increasingly visible across a broader range of sectors, although company-level dispersion remains high.

This broadening of earnings strength is encouraging as it suggests that the market's foundation is becoming more diversified. Credit spreads remain relatively tight, and, in our view, investors are not being sufficiently compensated for taking on additional credit risk. Equities, by contrast, continue to benefit from supportive earnings trends and a constructive economic backdrop. As a result, we continue to favour equities over credit within risk assets.

This view has informed portfolios over the past quarter. Over recent years, global value strategies – that have been a key component of our portfolios - have become increasingly concentrated in areas closely tied to the AI theme, particularly semiconductor companies. These companies are trading at historically low valuation levels due to current earnings; regardless of one’s views on AI, semiconductor manufacturers remain highly cyclical businesses. While we remain positive on the long-term implications of AI, we are also conscious of the importance of diversification.

With that in mind, we have fully redeemed our investment in the passive global value ETF. The allocation has been recycled into active management with exposure to non-AI related traditional value-oriented stocks.

The objective is not to reduce equity exposure, but to broaden the portfolio's growth engines. Increasing exposure to more traditional cyclical value opportunities helps ensure that portfolios are not overly dependent on a single theme, no matter how compelling that theme may be.

Rising bond yields should not automatically be interpreted as a warning signal. When yields rise because inflation expectations are becoming unanchored or because markets are losing confidence in fiscal sustainability, risk assets typically face a more challenging environment. That is not what we see today.

Instead, we believe higher yields are largely reflective of stronger growth, higher real rates, changing expectations for monetary policy and significant demand for capital from the technology sector.

Against a backdrop of resilient earnings and broadening profit growth, we remain cautiously optimistic on equities. For long-term investors, we believe it’s important to stay invested in the market, while ensuring portfolios are sufficiently diversified to participate in growth wherever it emerges.

There’s currently a tension between earnings and valuations; which signal should investors pay attention to? While valuations remain elevated, it’s important to understand what has driven market returns.

Over the past five years, equity gains have not primarily been the result of investors paying ever-higher multiples for the same earnings. In fact, valuation multiples today are lower than they were five years ago. Instead, the market's performance has been driven largely by strong earnings growth. In other words, companies have generated significantly higher profits, and those profits have been the main source of returns. That matters because earnings-driven market gains tend to be more durable than gains driven by valuation expansion alone.

The key question now is whether today's earnings can continue to justify current valuations. There is little margin of safety, both in terms of expectations around future earnings and what people are prepared to pay for them. This is particularly relevant for the hyperscalers at the heart of the AI investment cycle. Investors will increasingly ask how much they can spend, how long they can sustain elevated levels of capital expenditure, and whether there is a risk of overinvestment or excessive leverage.

We are constructive on equities but will keep a focus on whether earnings expectations remain achievable. The sustainability of earnings growth will be the critical determinant of future returns.

The outlook for inflation today is nuanced. On one hand, inflation has proved stickier and more persistent than many expected. The sources of inflation have also evolved. Earlier in the cycle, inflation was driven largely by strong consumer demand and post-pandemic spending patterns. Today, the challenge is increasingly supply-driven, reflecting factors such as tariffs, energy markets and geopolitical tensions.

This distinction matters because supply-side inflation is typically harder for central banks to address. Interest rate policy can cool demand, but it has much less influence over disruptions to supply. As a result, inflation has remained more stubborn than policymakers would like.

At the same time, there is a credible path for inflation to move lower again if geopolitical tensions in Iran ease. Many of the supply pressures that contributed to elevated prices have begun to fade, while tighter monetary policy is gradually feeding through to economic activity.

Rather than trying to predict exactly how inflation will evolve, we believe portfolios should be built to withstand a range of possible outcomes. This means continuing to diversify the sources of protection and resilience within portfolios.

Traditionally, government bonds have acted as a shock absorber during periods of market stress. While duration still plays an important role, its ability to protect portfolios can be more limited when inflation remains elevated and bond yields are volatile. As a result, we continue to look for additional forms of protection that are less dependent on any specific economic outcome. We believe that duration – bonds – is once again an exposure to be deployed tactically.

Gold remains an important component. It has historically performed well during periods of heightened geopolitical uncertainty and can provide support when investors seek safe-haven assets. However, gold's effectiveness varies depending on the nature of the shock.

A further tool is tail-risk protection. Unlike some traditional defensive assets, its effectiveness is not dependent on whether the catalyst is an inflation shock, a growth shock or another macroeconomic event. The key factor is the severity of the market sell-off. If equity markets experience a significant drawdown, tail-risk strategies are designed to provide protection regardless of the underlying cause. That makes them particularly valuable in an environment where market uncertainty is becoming more diverse.

Our view on inflation is two-sided. It remains persistent enough to warrant caution, and to tactically hedge against unexpected, underpriced upside risks, yet there is also a plausible path towards a continued decline closer to central bank targets. Rather than taking a binary position on which outcome will prevail, we are focused on ensuring portfolios remain resilient across a range of scenarios.

That means maintaining a diversified set of shock absorbers, including some physical gold, selective duration exposure and tail-risk strategies, each of which can provide protection under different market conditions. We do not aim to predict the next shock, but to ensure portfolios are prepared for it.

Going into last year, we positioned the portfolio to be robust in the face of multiple different outcomes. There were plausible paths to both extremely strong and extremely negative outcomes, particularly in the US. In the end, the groundwork we had done previously in positioning the core of the portfolio for a broadening-out of equity markets bore fruit, with some of our highest conviction areas of opportunity, namely Japanese, EM, and value equities, all driving positive returns. Our other more tactical position in gold miners was one of the stronger contributors in the portfolio. Our thesis going into the year was that the gold mining stocks were set to continue a period of ‘over earning’ and that there was sufficient support for the underlying metal from central bank buying for us to have a meaningful allocation to both assets.

We entered this year remaining constructive on global growth and therefore on equities, continuing to tilt the core of the portfolio to the areas of opportunity mentioned above, but maintaining targeted exposure to US growth stocks through the Nasdaq ETF and the Call Spread on the S&P 500. Again, we are trying to build a resilient portfolio given the continued levels of uncertainty and higher valuations, without taking a big bet on any one particular outcome. The first two months of the year delivered returns consistent with this theme playing out with strong returns from some of 2025 leading investments, including EM, Japanese, value, and small-cap equities.

Despite continued uncertainty around the path for the conflict in Iran, and the impact on energy prices due to the significant disruption in the Strait of Hormuz, investors seem to be largely disregarding any significantly negative outcome and are focused on other matters. Earnings are once again in the spotlight and for good reason – we have seen significant upward revisions in earnings, both realised and expected. This, along with a seemingly benign jobs market leading indicators suggesting that demand led inflation may be cooling, has been fuelling renewed interest in stocks.

We continue to see the environment as one which is conducive to own equities, and see macro, earnings, and price momentum as being supportive of risk assets in the near term. This being said, we recognise that there is relatively little margin of safety in both valuations and earnings in many parts of the market. Something we have been focused recently is diversifying the sources of return in the portfolio, as well as ensuring that we are being very intentional with the risks we are taking.

We have taken a few actions in the portfolio recently in response to changing market conditions. Firstly, we have invested in government bonds again, taking a small position in a 10-year US treasury bond. Although a deflationary slowdown in which bonds deliver strong returns is not our base case, we recognise that the probability of this has somewhat risen and as yields have risen on the back of investors repricing inflation risks, a starting yield of c. 4.5% provided an attractive entry point.

Away from geopolitics, the AI theme has been driving markets again, in particular pushing up the prices of semiconductor stocks both in the US and emerging markets. In addition to taking some profits in the semiconductor names, both through EM and global exposure, and slightly reducing our underweight to the US through investing in the S&P 500 equal weight, we have also fully redeemed from the gold miners in the portfolio. Our investment thesis played out, and we have rotated the exposure into broader industrial metal mining equities – a sector that with the same compelling Capital Cycle characteristics in terms of supply and a broader set of demand drivers.

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