‘Q3’ was just a few days’ old when the ceasefire between the US and Iran broke down. The oil price, which had dropped as low as $70 (£53) a barrel, leapt higher and the now-familiar pattern of inflationary pressure and rising bond yields resumed. The former endured for the remainder of the quarter and, by the end of September, bond market volatility had become a significant feature of the global financial landscape.
In spite of this inauspicious backdrop, stockmarkets managed to make progress. The MSCI World index rose 2% over the third quarter, with energy and technology companies leading the way. Despite some wobbles, investors remained focused on the AI trade, while interest-rate sensitive areas such as utilities and real estate lagged. Emerging economies trailed their developed counterparts, notwithstanding continued strong performance from tech-heavy markets such as South Korea and Taiwan.
The quarter saw increasingly insistent warnings from leading participants suggesting artificial intelligence had the potential to kill us all – or, at the very least, take our jobs. The news rogue AI agents had hacked into other websites, including computational tools company Hugging Face and the Australian Medicare database, did little to enhance trust. AI is becoming a salient issue in next month’s mid-term elections in the US, with many citizens rebelling against it.
None of this, however, did much to dent investor enthusiasm for AI companies, which continued to edge higher. The CNBC Mag 7 index rose more than 10% over the quarter – significantly ahead of the wider market. Indeed, as rising bond yields destabilised other parts of the stockmarket – and despite growing worries over their own debt levels – AI companies became something of a port in a storm.
For much of the quarter, investors sought to explain this apparent anomaly. After all, higher bond yields lift borrowing costs for corporations and could change the maths on the AI build-out. Why did equity investors not seem to care?
“Nvidia, TSMC and the memory giants of South Korea all saw strong growth and forecast resilient earnings into the future as the hyperscalers kept up their hyperspending.
It is because of the geopolitical upheaval and it is because of the rapid technological change that we are seeing markets do so well. Not ‘in spite of’ – ‘because of’.”
The one-word answer, for the most part, has been ‘earnings’. Factset earnings reports for the second quarter showed the blended earnings growth rate for the S&P500 at 50.4% – the highest such rate reported by the index since the 91.6% of 2021’s second quarter, when companies were emerging after Covid. Most businesses also guided higher for the upcoming quarter.
Nor did the AI spending spree show any signs of letting up. Nvidia, TSMC and the memory giants of South Korea all saw strong growth and forecast resilient earnings into the future as the hyperscalers kept up their hyperspending.
AI was not the only sector looking to borrow, though. Galvanised by the ongoing upheaval in global energy markets, there was also significant spending on the energy transition. Fidelity estimates some $2.3tn was spent on the global energy transition alone in 2025. That compares to $1.5tn spent on AI. Energy independence has taken on a new significance in the face of ongoing tensions in the Middle East – and, as the geopolitical climate worsens, there is also increased spending on defence.
“It is because of the geopolitical upheaval and it is because of the rapid technological change that we are seeing markets do so well,” says Karen Ward, EMEA chief market strategist at J.P. Morgan Asset Management. “Not ‘in spite of’ but ‘because of’.
“And the reason that is the case is because all of this chaos is creating more spending; and it is the spending that is generating growth; and that is generating corporate earnings; and it is those corporate earnings that keep pushing the equity market up – and that is going to continue as far as I see.”
Fixed income
Bond markets were at the heart of the third-quarter action. A combination of factors saw bond yields become unmoored from central bank interest rates, led by the US. The immediate problem appeared to be the prospect of higher inflation linked to the war in Iran – yet it soon became clear the problem was more complex than whether short-term interest rates would rise. Pressures appeared across long and short-dated bonds, which suggested something rather more serious was happening.
Concerns over central bank credibility persisted and, ahead of the Federal Reserve meeting in September, there were worries chair Kevin Warsh would cave to pressure from the White House for a rate cut. This did not come to pass, however, as the Fed elected to raise US interest rates and Warsh’s own credibility was – more or less – restored.
A further problem has been the sheer quantity of debt that bond markets are being asked to absorb. US national debt hit $40tn over the quarter, with most major developed nations also requiring significant funding. As already mentioned, the hyperscalers have also been issuing debt, which may be absorbing some of the natural buyers of government debt. This has created a supply glut that allows buyers to be more discerning than they otherwise might.
Then there is the question of fiscal discipline. Donald Trump’s promise of $5,000 per citizen if the Republicans won the mid-terms did little to suggest the US president wholly grasped the gravity of the situation in bond markets. Some governments in Europe are at least trying to make a good show of fiscal discipline – the UK included – but the US administration seems less bothered. It may be that, above all, that is scaring markets.
By the end of the quarter, there were few signs of a halt in rising bond yields. US treasury secretary Scott Bessent had attempted a ‘buyback’ mechanism – using treasury funds to buy long-dated bonds – though with little discernible effect on yields. The rest of the world is watching nervously, knowing any resolution is largely in the hands of the US and they must suffer higher borrowing costs in the meantime.
Three areas to watch in Q4
* Direction of bond yields: Developed market bond yields have ticked up to their highest levels in 20 years. It would be easy to pin this on higher energy prices but there appears to be more at work than inflation. After all, both oil prices and inflation have been higher in recent history and yields have not hit current levels. There are problems of central bank credibility, of oversupply and of fiscal policy.
“The market is telling us we definitely have higher-for-longer interest rates, much more unpredictability of inflation and much more volatility as a result of that,” says Marion Le Morhedec, chief investment officer of fixed income at Fidelity International. “That repricing is not necessarily a bad thing for fixed income investors but clearly it is a new paradigm.”
It is also likely to increase ‘fiscal dominance’ – where high public debt and large budget deficits trump all other concerns about a government. Le Morhedec expects a renewed focus on deficits, meaning bond markets will inevitably become more reactive to political shifts and likely to keep politicians on a tight leash. It may be that, as in the US, those politicians apparently do not care – but there could be rewards for more prudent nations.
The final factor to watch, believes Le Morhedec, is the influence of hedge funds. This has contributed to the volatility in French government bonds over recent weeks, she argues, and may become an increasingly influential factor in markets.
If bond yields do remain high, there is a further question around contagion. The equity markets have remained largely indifferent to the tumult in the bond markets, but – as we recently highlighted in our Monday Club focus ‘Debt toll’ – there are limits. Rate-sensitive sectors such as utilities and real estate have already sold off, but the real flashpoint is whether higher borrowing costs could bring AI spending to a halt.
* AI or bust: The AI trade has been remarkably resilient thus far – but a lot now depends on it. In the US, the top 10 stocks in the S&P500 – comprising around 39% of the index – all have their fortunes tied to the AI adoption curve. In the emerging markets, meanwhile, semiconductor giant TSMC is now 16% of the MSCI Emerging Markets index while AI-focused markets South Korea and Taiwan make up around half of the index between them.
Even corporate debt markets have become increasingly AI-focused as the technology giants have issued debt to fund their investments around artificial intelligence. Their share of corporate debt markets has moved from 2% in 2022, to almost 10% in 2026.
Not only are there concerns these businesses are overvalued, that AI spending will slow and that companies will not realise sufficient productivity gains to justify their investment, there is also a growing anti-AI movement. The Wall Street Journal reported last month that 63% of Americans support a pause in the development of AI, citing fears over job displacement, energy consumption and rapid, largely unregulated tech growth.
We need to break down this misconception that all AI companies are overvalued. Yes, there are some that are overvalued but, actually, there is a lot of the AI complex we like on a long-term view.”
Views are increasingly polarised – though John Lamb, investment specialist at Capital Group, steers a middle path. “There is definitely some froth out there in markets but it is a bit of myth that the whole AI complex is overvalued,” he says. If you look at companies such as Nvidia, they are trading on a forward multiple that is lower than the market overall.
“Or, if you look at a company such as SK Hynix, its free cashflow forecast over the next three years is equivalent to its entire market cap. So I think we need to break down this misconception that all AI companies are overvalued. Yes, there are some that are overvalued but, actually, there is a lot of the AI complex we like on a long-term view.”
One major short-term question is whether the Anthropic IPO goes ahead as planned in early November. If it does – and is deemed a success – it will be a significant endorsement of the strength of the AI trade and its resilience in the face of rising bond yields.
* Political upheaval: Last quarter, it was the UK’s political upheaval that was in the spotlight. Potentially a good deal more consequential than yet another UK prime minister, however, will be the US mid-terms and the run-up to the French presidential election over the final three months of 2026. The current polling suggests president Trump has a battle on his hands in the US mid-terms. “
The stakes in these elections extend far beyond domestic politics,” argues analysts at Edmond de Rothschild. “The outcome will determine not only the trajectory of tariffs but also that of the federal budget deficit, the direction of foreign policy and the Trump administration’s ability to pursue its deregulation agenda.
“To date, both the markets and political analysts agree on the same forecast: a divided Congress – meaning either a split Congress with a Democratic House and a Republican Senate, or both Houses under Democratic control.”
The analysts believe four factors are likely to influence the outcome of this year’s election: the inflationary impact of the war in Iran; the Federal Reserve’s interest rate path; the cycle of capital expenditure in the AI sector; and the US fiscal policy path. They suggest the equity market should be well-supported whatever happens in the elections, but the bond market looks more vulnerable.
France could also be a destabilising factor. Its budget deficit is vast and its citizens are already taking to the streets to protest against spending cuts. The government has an uphill battle to enforce fiscal discipline. In the meantime, French bond yields have been ticking higher, edging closer to 5% on 10-year government debt. In effect, markets are giving the incoming president – no matter their affiliations – a warning shot ahead of the elections in April next year.
Investors will need to tune out plenty of market ‘noise’ as the year draws to a close. It is difficult to see an end to geopolitical tensions, bond market volatility or AI worries. Nevertheless, both the global economy and financial markets have proved resilient so far and there appears no need to panic just yet.
