Article last updated 11 September 2025.
The 1982 Dire Straits song Industrial Disease paints a picture of social and economic problems that seem appropriate to the times in which we live. Included in the British band’s song is the thought-provoking line, “Two men say they’re Jesus, one of them must be wrong.”
Financial markets can also send out conflicting signals, just like the two rival seers in the Dire Straits track.
For example, many equity markets are climbing to new all-time highs, suggesting that all is well in the world. On the other hand, longer-term bond yields in many of the same countries (which move in the opposite direction to bond prices) are reaching their highest points of the present economic cycle, even though inflationary pressures are easing (figure 1.1). They’re even revisiting levels not seen since the 1990s. The existence of conflicting signals from two different markets is a troubling conundrum we need to solve when it comes to constructing client portfolios for the long term.
Figure 1: France feels the pressure
The gap between French and German 10-year government bond yields has begun to climb as investors weigh rising economic uncertainty in France.
Source: LSEG, Rathbones
First, let’s look at the key recent market developments. Equities have continued their recovery from the lows made on ‘Liberation Day’, when US President Donald Trump unveiled his ‘reciprocal tariffs’. The average global tariff rate for goods exports to the US will rise to 17.4%, up from 2.4% last year, according to the widely quoted Budget Lab at Yale (figure 1.2).
Figure 2: The rising cost of trade
The average effective tariff rate in the US (customs duty revenue as a percentage of goods imports) is still low compared with most of the nineteenth century but is projected to surge to 17.4%.
However, investors have come to terms with the reality – at least they now know what they’re dealing with. The second-quarter results season for US corporate earnings was quite good. This suggested that companies are finding a way to cope with the prospect of having to import more expensive materials and products, although cutting other costs to maintain profits could lead to weakness elsewhere in the economy. We’re certainly seeing some evidence of slower employment growth in the US. This is exacerbated by a more restrictive immigration policy that’s part of the same America First mentality that made Trump increase tariffs.
Being intelligent about artificial intelligence
Investment in artificial intelligence (AI), raising the prospect of future productivity gains for those employing it, has been the driving force behind equity returns since the launch of ChatGPT in late 2022.
But there have been occasional moments of uncertainty. The latest occurred in August, when a paper from MIT Nanda, an AI initiative started by the Massachusetts Institute of Technology, questioned the returns achieved by businesses that had implemented AI-based solutions.
However, a careful reading of the MIT report suggests that the problem lies not in the technology, but in the implementation. In other words, AI-based applications may well deliver better returns once management works out to use them better.
What does this mean for investors? They continue to give companies the benefit of the doubt over AI, when considering both the high investment in data centres and the effectiveness of corporate adoption of it. But we’re acutely aware that, as with other technological innovations in the past, there will be an increasing gap between the winners and the losers. Think of Google’s search engine, trouncing Yahoo’s; remember too Betamax’s beating at the hands of VHS video tapes. This tendency might have less influence on overall market levels, since the winners and losers in any market will to a degree counterbalance each other. However, the US is by far the most exposed to any disappointment, if its tech companies’ investment in AI bears only slow-growing fruit.
All things considered, though, because of this phenomenon of winners and losers, we will be reducing the threat of AI hype to our clients’ portfolios mainly through our individual stock selection rather than our relative investment in different financial markets.
The political dimension
Politics remains a factor for investors to consider. The policies with the most influence on global financial markets are those emanating from the White House.
We await the Supreme Court’s ruling on the legality of the tariffs imposed by Trump. This might hang on the interpretation of what constitutes a security threat. When announcing tariffs, the President cited the 1977 International Emergency Economic Powers Act, which allows the executive to take emergency action in response to threats. The 31 August to 1 September international summit, hosted by China, will have done nothing to reduce Maga Republicans’ belief that their country is under threat. It was attended by the leaders of (among others) Russia, North Korea, Pakistan, Iran and, perhaps most worryingly, India.
Meanwhile, the 8 September loss of a confidence vote by French Prime Minister François Bayrou highlights governments’ difficulties faced in controlling their fiscal deficits. It echoes the climbdown by the UK’s Labour government over welfare reforms, although that was the result of a revolt from its own backbenchers rather than a recalcitrant opposition. Higher spending in a world of higher interest rates leads to more tax revenue being spent on servicing the debt (figure 1.3). This is a problem that Chancellor Rachel Reeves will have to address in the Autumn Budget – most probably with higher taxes rather than spending cuts.
Figure 3: Governments are in the red
France and the UK have higher deficits than Germany.
Investors are demanding higher interest payments to account for such risks. This can generate a vicious spiral, where the debt becomes more unsustainable, leading to even higher interest rates because debt service costs are higher. Letting the economy run hot and allowing inflation to remain high is one tempting solution by governments to a high debt burden. This is a threat that steers us towards a preference for fixed income assets with shorter maturity dates. We believe they will be less volatile and could also benefit from any reductions in the Bank of England base rate.
We also believe that increased geopolitical tension and the effects of climate change could raise the rate of inflation. At the very least, they could make it more volatile. For example, particularly bad harvests, which are more likely because of climate change, could suddenly push up commodity prices.
While we’re comfortable being fully invested in equities, current valuations don’t justify being overweight relative to other asset classes.
Turning the European supertanker
This is particularly the case for US equities, which trade at levels consistent with past market peaks, judged on several measures. And yet, betting heavily against the US is a mug’s game over the long term. US companies remain the leaders in the current wave of technological innovation, backed by deep pools of capital and a never-say-die entrepreneurial spirit. We don’t subscribe to claims that the US equity market is in a bubble similar to the one that formed at the turn of the millennium. The leading companies are exceptionally profitable and generate strong cashflows from their operations, many of which are underpinned by regular subscriptions rather than unpredictable one-off purchases. Rather than relying on debt, as in the first internet boom, they’re using that cash to invest in the future.
We continue to see attractive prospects for European equities. This might be akin to turning round the proverbial supertanker, and some investors will become impatient with how long it takes. But there does seem to be, finally, a recognition by national governments that attitudes to regulation need to soften. There’s also a growing sense that innovation requires more support. Much of this change in thinking stemmed from a report last year by Mario Draghi, ex-President of the European Central Bank and former Italian premier. Germany is leading the way with a €1 trillion fiscal stimulus package, although it’s one of the few countries whose finances allow it to be so generous.
Japan has been through a similar phase of economic reflation, where state institutions boost GDP through fiscal and monetary policy. The Japanese stock market has also been supported by corporate governance reform. It’s been a source of reasonable returns for us, especially where our chosen fund managers have successfully applied their stock-picking skills to select companies where management attitudes are changing. However, much of this game has now played out, so we have less conviction in the merits of being overweight.
Our Diversifiers (the D in our LED investment approach) remain a way to offset risks in our core fixed income and equity portfolios. Gold has performed exceptionally this year, rising by 38% in dollar and 28% in sterling terms. The core buyers have been (non-US) central bank reserve managers, especially those outside the G7 group of leading developed economies, as they diversify their reserves away from dollars in response to White House policies. Institutional portfolio managers and retail investors see gold as a good foil against (geo)political risk. They also regard it as a hedge against the possibility of the devaluation of fiat currencies (currencies issued by governments) should governments decide to prioritise fiscal expansion over monetary rectitude. This is so-called ‘fiscal dominance’, a phrase with which we might become increasingly familiar in the years ahead. In other words, more on that later…
