At the start of 2022, an investor buying a 10-year gilt (UK government bond) could expect to earn an annual yield of just over 1%. Today, the potential return exceeds 4%. The adjustment has been particularly brutal in the UK, as investors have reacted badly to the new government's approach to spending and borrowing. However, we have seen a similar trend in many bond markets around the world as an era of exceptionally low-interest rates comes to an end. It constitutes a definitive regime shift, with significant implications across asset classes.  

In developed markets, central banks are likely to continue tightening monetary policy until economies are either clearly in recession or inflation meaningfully falls. Neither condition has been met yet. As we move into the fourth quarter, we therefore expect central banks to maintain their hawkish stance and to see interest rates rise further. It will be difficult for stock and bond markets to begin a lasting rebound in this environment. 

Higher borrowing costs will have negative implications for economic activity and growth. Our base case at this stage is that a number of developed markets including the US, UK and Europe will fall into recession over the coming 12 months.

There will also be implications for corporate earnings and margins. So far this year, earnings have remained remarkably robust, with analysts still expecting profits to grow in 2022. However, with higher input costs and a more cautious consumer, we could see profit margins and earnings both fall. This economic reality could start to become apparent as third quarter earnings are announced over the coming weeks. We continue to closely monitor the earnings outlook to assess the implications for both equity valuations and market levels.

Against this uncertain backdrop, we expect equity market volatility to remain elevated. We took advantage of the rally in markets over the summer to further reduce our equity exposure and we are happy to remain underweight equities relative to our longer-term neutral allocation. Within our equity allocation, we maintain our preference for global, large-cap and high-quality companies.

Having endured a difficult year so far, government bonds are likely to remain under pressure in the near term in the face of rising interest rates. However, with the global economy moving closer to a recession and yields at the highest levels in over a decade, government bonds are starting to look relatively more attractive as a defensive asset.

Normally, government bonds help to protect portfolios from drawdowns in equity markets. That has not happened this year as both asset classes have fallen together. This has posed a challenge to multi-asset investors. Our overweight exposure to a broad range of alternative assets – including absolute return funds – has proven to be a better source of diversification and improved returns.

Commodities, in particular, have performed well since their introduction into portfolios late last year providing a good hedge against the disruption to energy markets following Russia's invasion of Ukraine. However, commodity markets are notoriously sensitive to the economic growth backdrop. In an environment of slowing growth, should we maintain our exposure to the asset class? For now, we think so.

The Russia-Ukraine conflict shows little sign of de-escalation. The disruption to European gas supplies could continue with broader implications for global energy markets, particularly as we start to see higher demand over winter. While weaker global growth could reduce demand for certain industrial metals, we continue to see value in maintaining some exposure to commodities as a hedge against rising energy prices. Taking a longer-term perspective, increasing demand for commodities as we transition to more renewable energy sources should also provide price support.

Our currency positioning in sterling-based models has also proven beneficial to returns, given the sizeable move we have seen in GBPUSD this year. We continue to see the merit in maintaining an overweight dollar position. But, given the extent of recent currency market moves, we may consider moderating our position and taking some profit.