Beyond the conflict, what landscape should investors expect?

The investment landscape reflects risks from geopolitics and rising energy prices, offset by strong corporate earnings and a technology-driven investment cycle. Looking beyond the Middle East conflict, we set out the outlook and portfolio roles for equities and bonds.

Despite geopolitical turmoil and restricted energy flows, equity markets have continued to rise this year, with emerging markets leading performance, while sovereign bond markets have struggled to deliver positive returns. Equities have proved resilient, supported by a solid macro backdrop, benign financial conditions, and above all, strong earnings dynamics. Technology and artificial-intelligence-related stocks have remained the dominant performance driver.

As the quarterly reporting season ends, new catalysts are emerging. While the Middle East conflict will remain a key consideration, the broader question is whether interest-rate dynamics, corporate earnings momentum and valuations can continue to support risk assets. Below, we examine five key investment questions and outline our portfolio positioning and outlook.

Can earnings keep driving stocks higher?

We believe they can. Despite a strong first quarter, earnings revisions for 2026 and 2027 have continued to rise, led by emerging markets, Japan and the US. This remains a key support for equities, particularly as valuations in some developed markets are becoming harder to justify as they are once again above long-term averages. Still, we remain constructive on the technology sector, where valuations offer upside. Strong AI investment in data centres and record demand across semiconductors and cloud/software continues to drive earnings.

Equities have proved resilient, supported by a solid macro backdrop, benign financial conditions, and above all, strong earnings dynamics

Emerging markets offer a more compelling outlook: stronger earnings momentum than in developed markets, more attractive valuations, and supportive investor positioning, especially if the US dollar remains soft. Our equity overweight is therefore expressed through emerging market equities, where performance looks set to broaden beyond AI-driven markets. South Korea stands out, as AI infrastructure spending accelerates and corporate governance gains traction. China and South Africa also offer compelling valuations and earnings. Chinese earnings growth is expected to recover in 2026 and 2027, supported by exports, AI investment, easing competition, and energy resilience, while South African miners, around 40% of the country’s index, should benefit from structurally strong gold demand. In short, earnings continue to underpin global equities, but we remain selective because their quality and geography matter.

Do government bond yields threaten equity valuations?

A rise in sovereign bond yields tends to pressure equity valuations. After the recent bond sell-off, yields in many major economies are at multi-year highs. However, the impact of higher rates on equities depends on whether they are rising because of stronger growth, which generally translates into higher real rates, or higher inflation expectations. It also depends on the volatility of yields across bond maturities.

The main driver of the recent rise in yields is higher inflation expectations, and markets have priced in some tightening from central banks. In the US, market pricing implies roughly one Federal Reserve rate hike, while in Europe it reflects around three increases. Today’s situation is different from 2022, when central banks faced high inflation coupled with deeply negative real rates and so had to raise policy rates precipitously, sparking volatility and hurting equities. Central banks are unlikely to tighten policy above current market expectations and should instead be able to lower rates. Also, while inflation risks could rise if Strait of Hormuz disruptions persist, this is not our base case. Higher yields may create temporary pressure, but we do not expect a sustained fall in equity valuations.

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Are bonds still reliable portfolio diversifiers?

Recent years have highlighted a shift. The previous economic cycle was dominated by low inflation, demand shocks, and economic growth concerns. Sovereign bonds were effective diversifiers because growth shocks typically pushed real rates lower and supported bond prices.

In 2022, an energy supply shock raised inflation and forced abrupt central bank tightening. The corresponding fall in the prices of sovereign bonds then amplified portfolio losses rather than cushioning them.

No asset is defensive in absolute terms but only relative to a specific type of shock. Sovereign bonds tend to work well when the dominant risk is a growth shock – for example around the Great Financial Crisis. They are less effective faced with an inflation or supply shock.

No asset is defensive in absolute terms but only relative to a specific type of shock

The recent environment is different with greater geopolitical fragmentation, more frequent supply-side shocks, higher fiscal uncertainty and more volatile inflation. Energy disruptions, conflicts, supply-chain fragmentation, Covid and tariffs all created meaningful supply shocks within a short period. These had direct impacts on monetary and fiscal policy, and financial markets. As a result, and since the Covid pandemic, the correlation between stocks and bonds has increased.

Recent market moves follow the same logic; inflation concerns and the repricing of rate-cut expectations have pushed yields higher. As a result, sovereign bonds have provided little diversification this year. Instead, we have kept our overweight portfolio allocations to gold, as a diversifier and cushion against equity volatility and geopolitical risks. Despite short-term price consolidation, we see structural support for gold prices thanks to demand from central banks and private investors.

How to invest in fixed income?

Current high sovereign bond yields are attractive for buy-and-hold investors. Under our base scenario, we see limited further upside and expect lower interest rates over a 12-month horizon. However, near-term rate volatility may persist, particularly if energy prices stay high. As rates normalise, we also expect the positive correlation between equities and bonds to hold. Equities will therefore likely outperform bonds, especially if earnings growth holds up. Only in the unlikely scenario of rising recessionary fears would we expect correlations to decline significantly, and so renew the diversification role for bonds against falling equities.

We maintain a neutral overall fixed income stance, with an underweight in sovereign bonds and an overweight in emerging market hard-currency debt. In government bonds, we prefer 5-to-7-year maturities in UK Gilts, German Bunds, as well as Swiss and Australian bonds, where growth risks appear greater than in the US. This underweight exposure helps portfolios absorb the risk that a supply shock drives yields higher. In parallel, an emerging market hard-currency bond overweight allows portfolios to earn attractive income. We stay neutral on corporate bonds, given little difference in spreads or the yields offered over equivalent maturity sovereign bonds.

What are the main risks to our outlook?

Middle East developments remain a key source of market sensitivity. We watch the resumption of flows through the Strait of Hormuz and energy production. These will determine whether the shock remains geopolitical, or becomes a macroeconomic risk.

For now, earnings remain the anchor for equity markets, and portfolios need to capitalise on this resilience

Beyond the conflict, we monitor energy price futures, food prices, the difference between yields on nominal and inflation-protected bonds, real interest rates, the trajectory of the US dollar, credit spreads, bank lending surveys, and corporate bond issuance. Together, these indicators provide a reading on inflation, growth, liquidity and corporate financing conditions. For example, if real rates rise, the US dollar strengthens and credit spreads widen, financial conditions are tightening. Markets are then pricing a broader macroeconomic and financial shock, not only geopolitical volatility.

Capital spending plans also deserve attention. The technology sector has been a key driver of both earnings growth and equity market gains. Any signs that companies are delaying or reducing AI-related investment would weigh on earnings expectations.

Stay invested

The market landscape remains constructive but given the risks, we remain selective. Earnings growth can drive further equity upside, but scope for a rise in valuations is more limited, in developed markets. Emerging markets are supported by better valuations and stronger earnings revisions.

Higher sovereign yields are a risk, but they do not threaten equities under our base scenario of a gradual resumption in oil flows and a stronger starting point for monetary policy than in 2022.

Bonds keep a useful role in portfolios, but their diversification properties are limited during supply shocks and inflation volatility. We therefore remain selective, and maintain an overweight in emerging market hard-currency debt to diversify sources of income. 

The key question is whether the conflict will remain contained, or evolve into a broader macroeconomic and financial shock. For now, earnings remain the anchor for equity markets, and portfolios need to capitalise on this resilience.

For a detailed analysis of our key convictions, see our Investment Strategy Monthly, Ten Investment Convictions. Our recent rethink investments paper sets out the details of our thematic equity convictions.