Market Sense: The CIO View

Peter Fitzgerald, Scottish Widows Chief Investment Officer, reflects on investment markets in the third quarter of 2026 and shares his outlook for the months ahead.

At a glance

• Higher real yields are reshaping markets: Renewed energy inflation, tighter monetary policy and rising term premia have improved prospective bond returns while raising the hurdle rate for equities.
• Opportunities are becoming more selective: AI-enabling infrastructure remains attractive, alongside higher-quality bonds and selective exposure to non-US equities, energy, materials and real assets.
• Greater balance is needed: Inflation, fiscal instability and geopolitical disruption remain key risks, reinforcing the importance of diversification across return drivers.

A shift in the market regime

Q3 marked a decisive shift from tentative disinflation towards a more difficult regime of resilient activity, renewed energy inflation and structurally higher discount rates. July began with soft US inflation and labour data, briefly supporting bonds and weakening the dollar. Renewed Middle East disruption then lifted Brent above $100/bbl, with the shock broadening from crude into gas, refined products and transport bottlenecks.

By September, the Fed, ECB and BoJ had tightened, global sovereign yields had reached multi-year highs, and markets were reassessing both the neutral rate and the sustainability of elevated equity valuations.

The more significant change was not the frequent repricing of the next central-bank meeting, but the rise in real yields, term premia and capital demand associated with fiscal borrowing, energy security and the AI investment cycle. This materially improved prospective bond returns while creating a higher hurdle rate for equities.

US growth regained momentum

The US narrative whipsawed but finished stronger than the early-quarter slowdown suggested. July payrolls initially appeared exceptionally weak, with employment falling by 23,000 and previous months revised lower, driving a Treasury rally and weaker dollar.

August payrolls subsequently rebounded by 162,000, while September survey data indicated accelerating activity. The Fed responded with its first 25bp hike since 2023 and the dollar recovered.

Europe faced a tougher energy-growth mix

Europe faced a less favourable combination of renewed energy pressure and weak growth. The ECB tightened as energy risks returned.

In France, political and budget uncertainty weighed on assets, although risk pricing may have moved too far too quickly.

UK resilience met rising fiscal risk

The UK economy proved more resilient than expected. The BoE held rates at 3.75%, while warning that persistent energy inflation could eventually require tightening.

Gilts remained under pressure from rising global yields and concerns over public borrowing ahead of the Budget. For sterling and credit, the key tension was reasonable activity set against rising inflation and fiscal risk premia.

AI investment supported equities

Equities were supported by earnings upgrades and AI-related capital expenditure, but market leadership became more nuanced. The AI cycle remained earnings-led rather than purely valuation-led, with many beneficiaries among semiconductor, memory, power and equipment suppliers rather than AI-service providers themselves.

Hyperscaler capital expenditure also increased demand for capital and contributed to a higher real neutral-rate premium.

Higher yields challenged equity valuations

The vulnerability was duration. Higher real yields drove a derating even as earnings rose, challenging US exceptionalism and encouraging selective interest in non-US markets, value, energy, materials and infrastructure.

European opportunities were increasingly idiosyncratic rather than a broad index call, given energy exposure, positioning and French political risk.

Bonds regained portfolio utility

The global sell-off reflected a combination of higher term premia, expected policy rates, break-evens and real yields rather than developments in one isolated market. All else equal, higher yields should eventually result in lower commodity prices, weaker growth or tighter policy.

However, higher starting yields materially strengthened the medium-term case for duration. Treasuries returned to a more sustainable range, with the 10-year yield near 5¼% and inflation-linked yields close to 2.9%. Prospective Treasury returns now compare more favourably with expensive US equities.

Outlook

The opportunity set is broadening, but a more uncertain backdrop means diversification needs to work harder.

Higher starting yields have strengthened the outlook for higher-quality bonds, offering more attractive income and improving their potential contribution to diversified portfolios.

In equities, the AI investment cycle continues to create opportunities across the infrastructure required to support it, including semiconductors, memory, power and equipment. However, the focus is likely to shift increasingly towards whether elevated capital expenditure can generate sufficient earnings and productivity gains.

The higher hurdle rate for equities reinforces the case for regional diversification as economic conditions, policy paths and valuations diverge. Selective exposure to energy and materials could benefit from continued investment in energy security, electrification and digital capacity, while real assets and inflation-aware strategies may help portfolios navigate a more volatile inflation environment.

Risks remain closely connected

Prolonged disruption to the Strait of Hormuz could intensify pressure on energy and transport costs, keeping inflation elevated and prompting further monetary tightening.

High fiscal borrowing and instability in term premia could sustain volatility in sovereign bond markets, while disappointing returns from AI-related investment could put pressure on highly valued beneficiaries. China’s property slowdown remains a headwind to global demand, and renewed tariffs or political fragmentation could further disrupt trade, investment and supply chains.

Implications for pension investors

For a diversified pension investor, the strategic message is greater balance rather than wholesale risk reduction: bonds have regained portfolio utility, but inflation shocks can still make equity–bond correlations temporarily positive, while equity selection increasingly matters more than broad beta.