Climbing the wall of worry: why markets keep hitting new highs

Author: Janet Mui, Head of Market Analysis

War in Iran, energy prices under pressure and bond yields climbing. It’s a combination that gives investors plenty to weigh.

Yet key stock indices reached new highs in the third quarter of the year, propelled by strong corporate earnings and continued AI investment. Markets have been ‘climbing the wall of worry’, pushing higher even as investors remain anxious about what could go wrong.

The noise is real and relentless. Oil prices fluctuate with geopolitical news, bond yields respond to inflation concerns and stock prices react to changing borrowing costs. It’s easy to become distracted by the daily turbulence. For us, the more useful guide is whether the outlook for growth and company profits has genuinely changed.

AI investment underpins resilience

AI investment helps explain the resilience. Spending on chips, data centres, electrical equipment and power infrastructure is creating demand across industries and countries. Meanwhile, strong cloud revenues and substantial order backlogs suggest demand for computing capacity remains robust.

The opportunity extends beyond building infrastructure. Businesses can use AI to improve customer service, accelerate research and reduce routine administration. Helping employees produce more with their time could lower costs, improve margins and support economic growth. These gains will take time, but could benefit a much wider range of companies than those leading the investment boom.

Growing demand, uncertain returns

For investors, however, growing demand does not guarantee attractive returns from the companies who have invested heavily in this space. Competition among frontier laboratories developing the most advanced AI models is intensifying. Technology giants, independent developers and Chinese competitors are racing to improve performance and lower prices. Cheaper models encourage adoption but make it harder for providers to maintain pricing power.

The hyperscalers, the large technology companies building cloud and AI infrastructure, are committing enormous sums to expansion. This supports growth today but leaves less cash available to shareholders. Revenues and accounting profits can rise while free cash flow – the cash remaining after operating expenses and capital investment – comes under pressure.

Companies may feel they cannot afford to stop spending because falling behind would threaten their businesses. But investors still need to see that spending generates sustainable returns. We remain positive on AI’s productivity benefits, while paying close attention to profitability, cash generation and valuations.

The war in Iran and energy pressures

The war in Iran is another important influence on the outlook. Despite periodic optimism around negotiations, a swift and lasting resolution looks unlikely. Differences between the U.S. and Iran over sanctions relief and control of the Strait of Hormuz remain substantial, while damaged energy infrastructure will take time to repair. Even a diplomatic breakthrough would not immediately restore normal energy supplies, and any agreement could prove fragile, with the risk of renewed hostilities and disruption later on.

Energy pressures could therefore persist despite occasional falls in oil prices. Higher fuel and transport costs leave households with less money for other purchases and squeeze businesses that cannot pass those costs on.

However, the economy is less sensitive to oil than in previous decades. Producing a unit of output requires less oil, reflecting improved efficiency, alternative energy sources and the growing importance of services. Higher oil prices alone therefore need not trigger a recession.

The impact depends on how far prices rise, how long they stay high and what else is supporting demand. AI investment provides an important offset, particularly in the U.S. However, a prolonged, severe energy shock would still hurt growth, especially in economies dependent on imported fuel.

Inflation, bond yields and the debt burden

The more persistent concern is inflation. Energy disruption can keep headline inflation elevated and gradually feed into wider business costs. Central banks face pressure to respond, even though higher interest rates cannot restore oil supplies or reopen shipping routes.

Our expectation is for a relatively gentle profile of further rate increases. Slower wage growth reduces the risk of higher energy prices setting off a sustained cycle of rising wages and prices. These second-round effects appear more contained so far. But the longer energy stays expensive, the greater the risk that inflation spreads and requires a stronger policy response.

That same inflation uncertainty also pushes up bond yields. Longer-term bond yields could remain elevated even with modest central bank tightening. Uncertainty about inflation makes investors demand more compensation for lending over longer periods. This additional compensation is known as the term premium.

Government borrowing adds to the inflationary pressure. Large deficits, refinancing needs and spending commitments mean substantial amounts of debt must find buyers. Concerns about governments’ ability to manage those debts can push up the compensation investors require. Technology companies borrowing to fund AI infrastructure add to competition for money.

Higher yields then increase governments’ interest bills as debt is refinanced, leaving less room for other spending. This makes debt harder to stabilise and means fiscal concerns are likely to remain in the background.

Higher bond yields matter for stock prices too, but are only one of the many moving parts.

They increase the discount rate on future profits, particularly for growth stocks. But companies can grow revenues, improve productivity and develop new products, thanks increasingly to AI.

Shares represent claims on profits earned in nominal terms – that is, before adjusting for inflation. Businesses that increase sales and protect margins can grow earnings despite higher borrowing costs. That is why innovation, productivity and profit growth remain important, alongside the price paid for an investment.

Yet for investors, these same pressures also create opportunities.

Opportunities in bonds and gold

For bond investors, more attractive starting yields provide a cushion against some price volatility, although they cannot prevent losses if yields rise sharply. We expect returns to come mainly from income, with less reliance on capital gains from falling yields. Credit quality and the choice of maturities remain important.

Concerns about government finances also support holding some gold. It’s not another borrower’s promise to repay and may help when investors worry about monetary debasement – the erosion of a currency’s purchasing power. It can still be volatile and should be treated as one part of a portfolio.

We remain modestly optimistic, but strong performance in AI stocks and their dominance in market capitalisation can leave portfolios too dependent on one theme. European equities can help provide balance. Their relatively low technology exposure makes them a useful ‘anti-AI’ allocation, with earnings less dependent on AI spending. Quality bonds provide income, while gold offers another source of diversification.

Markets can continue climbing the wall of worry if earnings and growth hold up. We see reasons for that to happen, while recognising the risks along the way. That supports staying invested, with portfolios spread across different sources of return. 

If any of this raises questions for you, speak to your wealth manager.

---

The value of investments, and any income from them, can fall and you may get back less than you invested. Information is provided only as an example and is not a recommendation to pursue a particular strategy.

---

---