Markets are presenting investors with a striking paradox. Inflation remains sticky, central banks are leaning against demand, government debt is mounting and bond markets are demanding a higher price for fiscal risk. Consumer confidence has weakened, while political uncertainty is increasingly shaping economic outcomes.
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Yet equity markets remain close to record highs, AI investment continues at speed, and earnings growth resembles the early phase of a recovery rather than the latter stages of a bull market.
For investors, the challenge is not necessarily deciding whether conditions are good or bad but understanding how both can be true at once.
The answer begins with an economy that is increasingly divided. Aggregate growth remains resilient, but its benefits are unevenly distributed. Higher-income households, owners of appreciating assets and businesses linked to technology investment, are still travelling relatively well. More interest-rate-sensitive households and smaller firms face a different reality. That helps explain why hard activity data can remain firm while confidence deteriorates. This also creates a more fragile form of growth. Headline resilience masks pressure beneath the surface, where small changes in employment, asset prices or borrowing costs can have an outsized effect on spending.
The labour market is illustrative of this. In the US, job openings fell below 7.1 million in August, while the ratio of vacancies to unemployed workers remained around one. Hiring, quitting and layoffs were broadly stable, consistent with a low-hiring/ low-firing market that is in balance but losing momentum. In Australia, Job Ads rose 2.2 per cent in September and remain well above their 2010s average, even as unemployment lifted to 4.6 per cent in August. Neither economy is displaying the labour-market deterioration normally associated with recession. But both are showing enough cooling to make households more cautious.
That caution is visible in consumer sentiment. US Conference Board consumer confidence declined sharply in September to its lowest level since early 2014.
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Perceptions of the labour market weakened, and inflation concerns remained prominent. Nevertheless, weak sentiment does not automatically translate into weak corporate earnings. Consumers can feel worse while continuing to spend, particularly when employment is still available and wealth is concentrated among households with a lower propensity to cut expenditure.
Moreover, equity markets are focused less on how consumers feel today than on the earnings stream they expect tomorrow. At the index level, expectations remain robust. The year-over-year change in 12-month forward earnings sits well above 30%, the type of growth that is typically associated with a recovery that has followed a recessionary trough.
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Pleasingly, the gap between sales growth and cost growth is at its highest level since the post Covid recovery period, providing some protection for margins even within this inflationary environment. Corporate fundamentals, in other words, are yet to display the more pessimistic message from confidence surveys and sovereign bond markets.
Of course, much of this is being amplified by the artificial intelligence boom. The investment cycle in computing, data centres, power and networks is large enough to support revenue and earnings well beyond the technology sector. If capital expenditure continues to expand, it can potentially offset weakness elsewhere and sustain the impression of a powerful aggregate economy. But the strength remains concentrated. A narrow group of companies exerts an unusually large influence on headline indices, allowing the market to appear stable even when the average stock is under greater pressure. Indeed, market breadth continues to weaken, with less than 50% of stocks in the S&P 500 trading above their 200-day moving average. The index can therefore look resilient at the same time parts of the underlying market are becoming cheaper.
This concentration makes the path of interest rates especially important. Previous tightening cycles suggest rates do not necessarily cause an immediate decline in earnings. Profits can continue to rise because monetary policy works with a lag and companies adjust financing, pricing and investment plans gradually.
Rates may not yet be prohibitive enough to stop the capital-spending cycle. Even so, monetary tightening starts a timer. The longer borrowing costs remain elevated, the greater the probability that refinancing, weaker demand and a higher discount rate begin to erode earnings and valuations.
While strong earnings growth has assisted equity valuations more recently, relative to the risk-free rate of return, rising yields have caused US equities to become the most expensive they have been since the turn of the century.
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Fiscal policy adds another layer of risk. A disorderly rise in sovereign yields can force difficult choices between spending restraint, higher taxes and greater issuance. It can also create feedback loops between markets and politics, especially around elections. France has offered a reminder that political decisions can quickly become market variables. Fiscal credibility was once a consideration reserved for emerging economies but is fast becoming a central input into the pricing of developed-market assets.
While continued and varying forms of market intervention may assist bond yields at the margin, it is arguable that the more straightforward path for yields is currently higher than lower. At very least, investors shouldn’t expect a sharp reversal, particularly from those countries where fiscal challenges are most acute, growth is robust and where more meaningful tightening is likely.
While that may sound confronting, it is not to suggest quality duration does not continue to have an important role in multi-asset portfolios, particularly when it provides strong carry and a hedge to increased equity risk. Rather, like the equity market, investors will need to be selective about how they add to duration.
While we expect the RBA to continue tightening, even as the economy faces downside risks to growth, it is the first among developed market peers to move the cash rate above its post-pandemic high. Moreover, Australia is not as sensitive to some of those fiscal risks developing offshore. Yet at the same time, the domestic equity market continues to face structural challenges and an earnings profile that is less attractive than US, Japanese and emerging markets peers.
Zooming out, the paradox is not necessarily a contradiction waiting to be resolved by one side being proven wrong. It is the market expression of a fragmented economy. Bond investors are pricing inflation persistence, fiscal uncertainty and the possibility that policy must remain restrictive. Equity investors are pricing nominal growth, strong balance sheets and a concentrated investment boom. Households are responding to living costs and job insecurity, while large companies are responding to strategic competition and the need to invest. Each group can be rational because each is exposed to a different part of the same system.
For investors, the appropriate response is not to make an all-or-nothing call on recession, inflation or the durability of the AI cycle. It is to build portfolios that can withstand a wider range of outcomes. That means retaining exposure to companies and regions with genuine earnings growth and pricing power while recognising the valuation and concentration risks embedded in market leaders. It means using high-quality fixed income for carry and diversification but carefully considering where and how to add duration. It also argues for adding to assets that may provide a hedge against geopolitical risk and fiscal debasement.
Most importantly, investors should remain anchored to their objectives rather than allowing contradictory headlines to dictate positioning. A paradoxical market rewards discipline because it creates plausible arguments for both excessive optimism and excessive caution. The strongest portfolios will not depend on every macroeconomic question being answered correctly. Markets can remain resilient while risks accumulate, and they can correct even when long-term fundamentals remain intact. Navigating that dynamic is not a temporary challenge; it’s the new norm.