Chief Market Strategist, Asia Pacific
In Brief
- Fed tightening, persistent energy-driven inflation, and heavy bond issuance continue to push yields higher, but equities remain resilient.
- Rapid AI advancement is being met with growing security concerns and rising model competition, pushing investors to demand clearer answers on regulatory risk.
- Diversification is back in focus with opportunities in short-duration bonds, high-yield credit, and equities beyond U.S. tech into financials, industrials, Europe and Japan.
We are entering the final quarter of 2026 with strong fundamentals but a more challenging policy environment. Central banks, led by the U.S. Federal Reserve, are tightening monetary policy to bring inflation under control. Because governments want to appease voters, fiscal consolidation is often given low priority. Meanwhile, there is no clear endgame in the U.S.-Iran conflict, which is pushing up energy costs. Together, these factors are driving bond yields higher.
Meanwhile, the development of artificial intelligence (AI) models is advancing rapidly. At the same time, concerns about security are growing as AI agents gain unauthorised access to government and business databases. A reality check could raise further questions about the regulatory risks and commercial viability of these models, as well as the investment spending associated with them.
After equity returns dominated investors’ attention for much of this year, portfolio diversification and income generation should once again take their rightful place in asset allocation decisions.
Can equities still perform when bond yields rise?
Government bond yields continued to rise. The 10-year U.S. Treasury yield reached 5.2% in late September, its highest level since 2007, before the global financial crisis, and over 100bps since the start of the year. The lack of a clear path out of the U.S.-Iran conflict, together with rising prices for refined petroleum products such as diesel, is keeping inflation elevated. U.S. headline inflation is likely to remain between 3.5% and 4% for the rest of the year, even though core inflation has been relatively stable.
This inflation environment has prompted the Fed, led by its new chair, Kevin Warsh, to raise the policy rate for the first time since July 2023. He has made clear that inflation is the priority in his policy decisions and that more needs to be done to bring it back to target. This is facilitated by strong economic growth. The job market, with unemployment rate at 4.1%, which is generally considered full employment allows the Fed to concentrate on tackling price increases. Hence, even though energy prices have been the main contributor to inflation, and this is outside the Fed’s control, Chair Warsh is entitled to tighten monetary policy. Meanwhile, large fiscal deficits and a strong pipeline of bond issuance by technology companies are also helping to drive bond yields higher.
Our analysis shows that rising bond yields are not necessarily bad for risk assets, including equities. In fact, the S&P 500 and Nasdaq still recorded net gains in September, when the 10-year U.S. Treasury yield rose by 40 basis points. If yields are rising because of strong economic fundamentals and earnings growth, the broad market should remain resilient. However, if high borrowing costs begin to threaten the growth outlook, the market reaction could turn negative.
Is the AI investment story changing?
AI is at the forefront of investors’ minds and is likely to remain so over the medium term. The good news is that consumers and businesses continue to find promising new uses for the technology. However, investors are demanding a clearer outlook for financial returns, which is complicated by two factors. First, competition among frontier-model developers is increasing. Enterprise clients are looking to adopt open-weight models that they can bring in-house to protect their data. As we argued a few months ago, decisions about which model to deploy have shifted from chief technology officers (CTOs) to chief financial officers (CFOs), because token usage and cost per task must be carefully managed. These developments could complicate the revenue outlook for model developers. Indeed, AI laboratories are beginning to launch discounted models to protect market share.
Second, policymakers are increasingly focused on security. Several models have gained unauthorised access to government or corporate databases, with some incidents discovered only weeks later. International coordination and regulatory frameworks remain limited, but demand for oversight could increase at both national and international levels.
As we highlighted in our AI paper by the Strategic Investment Advisory Group, AI could pass through stages of development similar to those experienced by other technologies over the past century. We are probably approaching the “reality check” phase, in which technological designs and ambitions are tested in the real world. Investors’ exposure to AI—as both an opportunity and a risk—is not limited to the stock market. As we argued in the paper, it could extend from more defensive assets, such as fixed income, through infrastructure and real estate, to public equities. There are ways to invest in AI across different levels of risk appetite. However, this also means that the global financial market will be closely linked to the technology’s development in the years ahead.
How should investors position portfolios in today's market?
Many of the positive drivers behind strong returns from risk assets may be fading. Strong economic momentum remains an important source of support, but monetary policy and borrowing costs are becoming less accommodative. Investors may also become less forgiving of AI development, especially if governments take a more interventionist approach.
With yields higher, equities are no longer the only game in town. Despite persistent inflation, real yields have risen, giving fixed income better protection against the erosion of purchasing power. The relative valuations of stocks and bonds have also shifted in favour of bonds. The gap between the 10-year U.S. Treasury yield and the S&P 500 dividend yield is now at its widest since the early 2000s, at 400bps.
These are not reasons to shift completely from stocks to bonds. Instead, they provide a useful opportunity to review portfolio allocations and consider whether rebalancing is needed after equities have outperformed fixed income over the past two years.
Within fixed income, we continue to prefer short-duration government bonds, high-yield corporate debt, and U.S. dollar-denominated emerging-market fixed income. We see the futures market fully pricing in rate hikes in the months ahead, which helps to anchor the short end of the UST curve. The long end of the curve could still be influenced by fiscal concerns, election outcome and potential change in Fed’s communication with the market. For corporate bonds, solid economic backdrop is expected to keep default rates low, and hence corporate spreads tight.
We also see opportunities to diversify equity allocations away from U.S. technology. Other U.S. sectors, such as financials and industrials, are also benefiting from strong earnings momentum. Developed markets such as Europe and Japan have less direct exposure to AI and therefore offer diversification benefits. Some sectors in these markets have broad international exposure, allowing them to benefit from steady global growth while trading at less demanding valuations than their U.S. counterparts.
Global economy
- The Fed raised interest rates by 25 bps to 3.75%-4.00% at the September FOMC meeting, its first hike since July 2023, in a unanimous 12-0 vote that included Fed Chair Warsh. Fed projections showed that 16 of 18 policymakers anticipate at least one more 25 bps hike by year-end, with the median headline PCE inflation forecast at 3.7% for 2026 and the return to 2% inflation target not expected until 2029.
(GTMA P. 25, 26) - The European Central Bank (ECB) raised its deposit rate by 25 bps to 2.50% at the September meeting, its second hike this year, driven by energy-led inflation tied to the escalating Middle East conflict. The Governing Council lifted its 2026 growth forecast to 0.9% from 0.8% and maintained its inflation projection to 3.0%. ECB President Lagarde reiterated a meeting-by-meeting approach with no pre-commitment to further tightening.
(GTMA P. 17, 18) - China’s August CPI rose 0.8% y/y from 0.5% in July, while PPI accelerated to 3.8% y/y from 3.5%, both driven by elevated energy and commodity costs. Exports remained the bright spot, rising 25% y/y on strong high-tech and AI-related demand, even as underlying domestic demand remained subdued and core inflation held near 1% y/y. Policymakers responded by expanding loan-interest subsidies for consumers and small firms, and extending the maximum mortgage terms from 30 to 40 years to help stabilize the property market.
(GTMA P. 5, 6, 7, 9) - The Bank of Japan (BoJ) raised its policy rate to a 31-year-high of 1.25% at the September meeting, in a 7-2 vote with two Takaichi-appointed board members dissenting. The split vote and lack of explicit hawkish guidance weakened the Japanese yen (JPY) to around 157.55 and fueled a rally in Japanese equities led by chip-related stocks. With few explicit signals on the pace of future tightening, markets focused on Governor Ueda’s guidance ahead of October and December meetings.
(GTMA P. 14)
Equities
- U.S. equities delivered mixed returns in September, with the S&P 500 down 0.3% and Nasdaq up 1.9%. Despite rising yields, a hawkish Fed meeting and ongoing geopolitical uncertainty, AI remains a dominant tailwind for broad U.S. equity markets. Concerns over AI frontier model safety and potential development slowdowns were also short-lived, with markets promptly recovering on a marginal difference to AI capex plans. Among sectors, communication services and technology posted the largest gains, up 4.3% and 4.5% respectively, while all other sectors delivered negative returns in September.
(GTMA P. 28, 29, 35, 44) - Chinese equities were mixed in September, with the MSCI China down 5.0% and CSI 300 down 3.6%. Subdued August economic activity continued to highlight weak domestic demand, while momentum for property market remains modest since the ‘828’ policy introduction. Semiconductor firms also followed the decline later in the month on potential resumption of U.S. chip purchases.
(GTMA P. 28, 29, 35, 39) - Japanese equities nudged lower in September, with MSCI Japan down 0.8% and TOPIX down 1.1%. Expectation for a faster monetary tightening cycle by the Bank of Japan and a stronger currency both weighed on export-orientated sectors, in addition to higher energy prices, although AI remained a key tailwind with a rebound in related sectors by month-end.
(GTMA P. 28, 29, 35, 41) - For the rest of Asian equity, tech-heavy markets continued to benefit on ongoing AI optimism in September, with South Korea’s KOSPI up 0.3% and Taiwan’s TAIEX up 3.9%, while other regions detracted, with India’s BSE 100 down 6.0% and MSCI AC ASEAN down 2.9%.
(GTMA P. 28, 29)
Fixed income
- The U.S. Treasury (UST) yield curve bear-flattened in September, with 2-year yields rising 53 bps to 5.27%, while 30-year yields rose 38 bps to 5.62%. This was driven by stronger activity data, firm inflation prints and hawkish Fed pricing, while renewed Middle East tensions and Brent crude above USD 105 per barrel added further pressure. Strong September PMI data reinforced the move, with most tenors climbing above 5% and the Overnight Index Swap (OIS) market pricing a 37% implied probability of a rate hike at the October FOMC meeting.
(GTMA P. 54, 55, 59) - Credit spreads remained resilient in September, despite some intra-month volatility due to geopolitical uncertainty and elevated corporate issuance. Global investment grade spreads were broadly unchanged at around 85 bps, while high yield spreads widened to around 314 bps as investors became more selective amid heavy supply from AI-related issuers. Nonetheless, corporate fundamentals remained supported by earnings, with spreads staying near the tighter end of their historical ranges.
(GTMA P. 61, 62, 63)
Alternatives
- According to PitchBook data, the number of global private equity deals in 2Q26 is estimated to have increased to 5,672, up from 5,552 in the last quarter. Momentum on deal value stalled, however, with deal activity estimated to amount to USD 420billion in 2Q26, lower than USD 544billion in the last quarter. Exit activity in global private equity also slowed, with USD 275billion across 948 exits estimated in 2Q26, down from USD 343billion across 1,000 exits in the last quarter.
- As for the U.S. middle market, the J.P. Morgan Private Assets Index-Middle Market returned a total 11.1% on a trailing 12-month basis as of August, with revenue growth, net debt change and multiple expansion attributing to 10.5%, -2.4% and 3.1%, respectively.
(GTMA P. 73, 74) - Based on the KBRA DLD Direct Lending index on a par-weighted basis, the trailing 12-month default rate excluding non-accruals rose 20 bps over August to 2.3%. Consequently, the trailing 12-month default rate including non-accruals rose to 4.1%. Yield to maturity rose by 3 bps to 9.30% as of August.
(GTMA P. 75, 76)
Other financial assets
- Oil prices spiked on escalating tensions in the Middle East, with Brent reaching over USD 130 per barrel mid-month. Prices later eased on the updates that Saudi Arabia is working on restoring East-West pipeline flows and markets also reraised expectations for a U.S.-Iran negotiation entering a “technical phase”, with Brent closing at USD 98 per barrel by end September. Despite volatile geopolitics, rising U.S. yields and a hawkish Fed have pressure on gold, with prices declining to USD 4176 per troy ounce by month-end.
(GTMA P. 70, 71, 72) - The USD strengthened in September as markets reacted to a hawkish Fed meeting alongside elevated risk of sustained higher energy prices, with the USD index (DXY) up 2.0% over the month. OIS markets are now pricing in over three additional rate hikes by the summer of 2027. Most other DM currencies were broadly lower against the USD, with the AUD down 2.9%, the EUR down 2.2%, the GBP down 2.0%, and the CHF down 3.2%. The Japanese yen was a notable exception, which appreciated 1.6% relative to the USD as rate hikes from the Bank of Japan accelerated this month. The CNY also nudged higher by 0.2% vs the USD, as fixing continued in the direction of CNY appreciation.
(GTMA P. 67, 68, 69)