Bond yields climb as inflation refuses to fade

Looking back at October’s dataflow and what it may mean for portfolio positioning.

Introduction

October tested markets on two fronts. Long-term borrowing costs climbed to multi-decade highs across the US, Europe, the UK, Japan and Australia, while inflation came in hotter than expected in Australia, the US and the UK. Brent crude rose back above US$116 a barrel after Houthi strikes on Saudi energy sites.

Growth data was mixed rather than weak. US layoffs stayed near multi-decade lows and business surveys pointed to healthy expansion, China’s economy beat forecasts on surging exports, and AI investment showed no sign of slowing. Australia was the soft spot, with 39,300 jobs lost in September and unemployment at 4.7% as inflation rose to 4.3%.

The difficult mix we have been watching is now visible in Australia: a cooling economy alongside inflation that is still rising

What moved the dial

Supportive signals

• US layoffs stayed low. Weekly jobless claims fell to 194,000 in mid-October, the lowest since July and close to their lowest level in decades, and announced job cuts were the lowest for any September since 2022. Employers holding on to staff supports household spending.
• US wage growth cooled, with average hourly earnings up just 0.1% in September and 3.0% over the year. Slower pay growth reduces the risk of a wage-price spiral and takes some pressure off the Fed.
• US business activity stayed strong. The S&P Global flash composite PMI read 57.6 in October, well above the 50 level that separates growth from contraction, as both manufacturers and service businesses kept expanding.
• France avoided a credit rating downgrade. Moody’s held its Aa3 rating on 23 October, sparking a rally in French government bonds that helped pull global yields lower and eased one of the sharpest sources of stress in Europe.
• UK jobs data surprised on the upside, with unemployment edging down to 4.7%, more workers on payrolls and firms looking to hire more staff for the first time in two years.
• China’s economy grew 4.5% over the year to September, beating forecasts, with factory output and retail sales both firmer, helped by a “mini stimulus” of mortgage subsidies and targeted central bank support.
• China’s exports surged 36% over the year to a seven-month high of US$447 billion, driven by AI-related shipments, delivering its largest trade surplus in 20 months. It points to real global demand behind the AI build-out.
• Japan steadied its bond market. A 20-year government bond auction drew record demand after Prime Minister Takaichi moved to reassure investors on fiscal sustainability, reducing the risk of spillover into global interest rates.

Watch-outs

• Australian inflation jumped to 4.3%, with prices up 0.8% in September alone and the RBA’s preferred trimmed mean up 1.0% over the quarter, faster than the RBA expected. Governor Bullock called inflation “far too high”, and on 3 November the RBA delivered its fifth rise this year, lifting the cash rate to 4.85%, its highest since 2008, in a divided 6-3 vote.
• Australia’s economy showed strain. Employment fell by 39,300 in September against an expected 20,000 gain, unemployment rose to 4.7%, the Treasurer flagged growth likely below the 1.75% forecast in May, and the October PMI slipped into contraction.
• US rate expectations kept rising. The Fed held in October after September’s rise, but two officials voted for another increase and markets now price a December rise as highly likely. Higher energy prices, a stronger US dollar and rising bond yields have tightened financial conditions, with the Chicago Fed’s index tightening every week since late August.
• US inflation stayed high, with consumer prices up 3.7% over the year to September, above the 3.6% expected, and the ISM manufacturing prices gauge jumping to 77.9, its highest since May.
• US hiring slowed sharply. Employers added just 29,000 jobs in September against 90,000 expected, earlier months were revised down by 60,000 and unemployment rose to 4.2%.
• A global bond sell-off pushed borrowing costs to multi-decade highs. The US 10-year yield held above 5%, near its highest since 2002, France’s 10-year reached 5% for the first time since 2002, UK long-term borrowing costs hit a 28-year high, Japan’s 30-year yield set a record and Australian 10-year yields reached a 15-year high of 5.40%.
• Escalating conflict with Iran pushed oil to a six-month high, with Brent closing at US$116.72 on 23 October after Houthi strikes on Saudi energy sites. Shipping through the Strait of Hormuz remains a fraction of pre-war levels, and oil is up more than 80% this year.
• Low-quality borrowing kept expanding, with more of the AI build-out funded by debt and lending to weaker borrowers through private credit and speculative-grade loans still growing as defaults rise. The extra yield on the lowest-rated junk bonds jumped by more than 2 percentage points since late September to around 13.6%.
• UK inflation rose to 3.5% in September, hotter than expected, and Bank of England raised interest rates to 4% on 5 November.
• France’s political and social turmoil deepened, with more than 1,400 arrests in a single day of rioting, curfews in Paris, Lyon and other cities, unions calling a national strike for 5 November over budget cuts, and the euro sliding towards a 17-month low.
• China’s domestic economy stayed weak beneath the headline, with property investment down more than 20% on a year ago and consumer shares at their weakest in almost a decade.

Macro overview

October’s defining move was in bond markets. Long-term government borrowing costs reached multi-decade highs across the US, France, the UK, Japan and Australia as inflation surprised to the upside and oil climbed back above US$116. Higher long-term rates lift borrowing costs across the economy and lower the price investors will pay for each dollar of company profit.

Growth held up unevenly. US layoffs stayed low but September hiring slowed sharply, and China’s headline beat masked soft domestic demand. Australia is where the tension is clearest: inflation at 4.3% and a fifth rate rise this year on 3 November, alongside falling employment and consumer confidence near record lows. That is the combination of a cooling economy and stubborn inflation we watch most closely, because the usual fix for one worsens the other.

Asset class outlooks

Equities: Profits have held up and we expect them to keep growing into next year. AI investment shows no sign of a pullback, but more of it is now borrowed. We favour companies that can fund the build-out from profits and the businesses supplying the power, equipment and infrastructure it relies on. In Australia, we remain cautious on businesses that depend on discretionary spending such as retail and dining out.

Fixed income: The global sell-off is the key change, lifting borrowing costs everywhere and putting pressure on share valuations. France is the pressure point to watch: its 10-year yield rose above 5% and its gap over Germany reached the widest since 2011. Our base case is that this stays a French problem, with the ECB able to step in if needed. Lower down the credit spectrum, spreads on the lowest-rated bonds have widened sharply as lending to weaker borrowers keeps growing.

Alternatives and real assets: Oil remains the swing factor. Brent rose to a six-month high after Houthi strikes on Saudi energy sites, shipping through Hormuz is still a fraction of pre-war levels, and the conflict continues to disrupt supplies of essentials such as fertiliser and industrial chemicals.

FX: A stronger US dollar has added to tighter financial conditions, while the euro slid towards a 17-month low as France’s turmoil deepened.

Implications for asset allocation and portfolio positioning

Resilient profits, government spending and available credit give markets a reasonable foundation, but a constructive base case does not mean a smooth ride.

Practical implications:

• Keep the tilt toward businesses with strong, lasting growth that are less exposed to supply disruption.
• Favour companies funding AI investment from profits, and the suppliers of power, equipment and infrastructure.
• Stay cautious on Australian businesses that rely on discretionary household spending.
• Watch credit quality. Debt-funded AI investment and lending to weaker borrowers are where risk is building least visibly.
• Watch France as the pressure point for global bond markets.

Scenarios and probabilities

Scenario probabilities reflect our current assessment and are reviewed as new data emerges.

Base case: 75% probability

The global economy remains on solid ground. Company profits have held up well, governments are still spending and money remains relatively easy to borrow. We expect profits to keep growing into next year, which gives markets a firm base and is the main reason we stay broadly positive. Even so, risks are building. The Iran conflict has pushed energy prices higher and disrupted supplies of essentials such as fertiliser and industrial chemicals, while the war in Ukraine adds further strain to global supply chains, so we have tilted portfolios toward businesses with strong, lasting growth that are less exposed.

Inflation had been easing, but higher energy prices have pushed it back up, and rate rises are a blunt tool against supply-driven price pressure. Australia is a clear example of the cooling-economy, high-inflation mix we watch most closely: inflation rose to 4.3% and the RBA lifted rates for a fifth time this year on 3 November. With mortgage repayments climbing and consumer confidence near record lows, households are cutting back on non-essentials, and we remain cautious on businesses that depend on them. Fed Chair Kevin Warsh has signalled US rates will stay higher for longer as he gradually withdraws money from the financial system, and long-term borrowing costs are rising worldwide, lowering the price-to-earnings (P/E) ratio investors will pay. France is the pressure point, with 10-year borrowing costs above 5% and its gap over Germany the widest since the 2011 euro debt crisis. Our base case is that this stays a French problem.

AI spending remains the biggest driver of business investment and market gains, with the largest technology companies on track to spend close to US$800 billion this year. October results showed no sign of a pullback: Microsoft’s cloud business grew 48% and Alphabet flagged a significant rise in spending next year. What has changed is the funding. More is now borrowed, and the cost of insuring AI-linked debt against default, measured by credit default swaps, has hit record highs for companies including Oracle, Alphabet and Meta. We expect spending to continue, led by companies that can fund it from profits.

Democrats performed strongly in the 3 November US midterm elections. Democrats won control of both the Senate and the House. Markets may read the result as a negative for data centre construction and demand for AI infrastructure. We are taking a more balanced approach for now and prefer not to jump to conclusions on policy. A divided Washington most likely means two years of gridlock with President Trump: fewer new policies, but less room for large new spending or tax cuts, which could ease pressure on bond markets. More gridlock in Washington is generally seen as a positive by markets. We remain positive but hold a little extra cash, ready to act if volatility creates opportunities.

Bear case: 13% probability

The main risk is a real pullback in spending by households and businesses, especially in the United States, at a time when share prices are already high relative to profits. AI is the trigger to watch. If the rising cost of insuring AI-linked debt spreads from the most indebted players to the large technology companies, borrowing would become harder and spending plans could be cut quickly, hitting the economy and share prices at once. With market gains leaning on a few expensive technology companies, a sharp fall in those leaders could drag the whole market down.

Sustained oil price rises and worsening supply-chain disruption from the wars in Iran and Ukraine would add pressure, and with inflation largely supply-driven, central banks may be unable to cut while high government debt limits fiscal support. France’s debt troubles could also spread, lifting borrowing costs in other heavily indebted countries, including Italy, the UK, Japan and the US, and squeezing share prices even if earnings hold. A bitter stand-off between Congress and the White House leading to government shutdowns would add uncertainty.

Closer to home, the RBA may need to keep lifting rates, forcing stretched households to cut spending harder and tipping the economy toward recession. China adds risk too: if its property market weakens further and support fails to restore confidence, lower demand for our resource exports would hit national income and company profits directly. Here we would turn more defensive, with more cash, less exposure to shares and a tilt toward healthcare, consumer staples and utilities.

Bull case: 12% probability

In the bull case, tensions with Iran ease and the pressures on markets turn supportive. Falling energy prices, easing supply-chain strains and better diplomatic relations, including progress in Ukraine, would support stronger growth while keeping inflation in check. At best, ceasefires hold, the Strait of Hormuz reopens fully and recovery follows, and resolving trade disputes would lift profits as costs fall and consumers keep spending.

If markets trust that inflation is under control, long-term borrowing costs can fall even while the Fed holds rates steady, lifting the price investors pay for each dollar of profit. A credible French budget would narrow the gap over German borrowing costs, and gridlock in Washington after the midterms would limit new government borrowing. If AI spending keeps delivering profits like October’s rapid cloud growth, debt worries would ease, credit markets would calm and the benefits would spread to the many companies that use AI rather than the few that build it.

For Australia, if inflation peaks soon and the RBA can stop raising rates, pressure on household budgets would ease and spending would recover, while relatively low public debt gives policymakers room to do more. Here we would favour a growth-focused portfolio with less cash and more exposure to industrials, materials and financials.

Closing perspective

October’s message came from the bond market. Long-term borrowing costs rose to multi-decade highs as inflation surprised to the upside in Australia, the US and the UK, and oil climbed back above US$116. Growth is holding up unevenly, with Australia showing the clearest strain. We remain positive on the strength of company profits, tilted toward businesses with strong, lasting growth and companies that fund AI investment from profits, and are holding a little extra cash while volatility stays high.

This publication is prepared by Akambo Pty Ltd (ABN 16 123 078 900) AFSL 322056.

The information presented in this publication is general information only, and is not intended to be financial product advice. It has not been prepared taking into account your investment objectives, financial situation or needs, and should not be used as the basis for making an investment decision. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and financial circumstances.

Some numerical figures in this publication have been subject to rounding adjustments. Akambo Pty Ltd (including any of its directors, officers or employees) will not accept liability for any loss or damage as a result of any reliance on this information. The market commentary reflects Akambo Pty Ltd’s views and beliefs at the time of preparation, which are subject to change without notice.

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