Investment Strategy Focus October 2025

Fed, Long Bonds and Inflation 

Fed cuts rates. Two more cuts to come this year?

The combination of intense political pressure from President Trump and a weakening jobs market has forced the Fed’s hand, with a cut in the Fed Funds rates of 0.25%. The Fed recently cut the Fed Funds rate by 0.25% to 4%-4.25%. Further, in their dot plots forecasts, they suggest that two further rate cuts are likely on their way in November and December, bringing the Fed Funds rate down to 3.5%-3.75% by year-end.

By weighing up the risks to inflation and to employment, the Fed has clearly stated that it wants to support the labour market. In the short term, it is apparent that inflation (the Fed’s preferred measure is core PCE) sits well above the Fed’s 2% target, and that tariffs are likely to boost goods inflation further in the coming months as US companies attempt to pass on the increased cost of imports.

However, to counteract this inflationary impulse from imports we have lower gasoline prices, easing rents /house prices and lower wage growth. It is also unclear to what extent US consumers will accept higher goods prices - they may simply seek cheaper substitutes or even buy less or delay purchases.

There is an argument that tariffs may be initially inflationary but ultimately deflationary, if the result of tariffs (which are, after all, a tax on goods consumption) results in lower retail sales and thus lower growth.

All in all, this is no doubt an unusual and complicated macro environment for the Fed to navigate, without even accounting for the political pressure exerted by the Trump administration. 

A surprising reaction from long-term US Treasuries

Despite 5-year consumer expectations of inflation hovering close to 3% and US Treasury bond issuance expected in excess of USD 1bn over Q4 2025, both 10- and 30-year Treasury bond yields have eased to 4.1% and 4.6% respectively. This is good news for homebuyers in the US, as the 30-year fixed mortgage rate has fallen to its lowest in nearly a year, i.e. to 6.4%.

Ultimately, US Treasury bonds are not pricing in high long-term US inflation rates, with the current 10-year US Treasury bond inflation breakeven rate remaining at around 2.4%, close to its level at the start of this year.

Long-term bond yields in Germany and Japan have followed the US 30-year Treasury lower, providing some respite from the prevailing rising trend in yields.

In our view, clients are best served by not buying ultra long-term bonds even with the higher yields on offer today. There is still a high likelihood that the difference between 10-year and 20- or 30-year sovereign bond yields will widen further in the US, Europe and Japan in the medium term, given the high levels of government debt and wide budget deficits forecast for 2025 and 2026. We would thus rather wait before buying these very long-term maturities.

We continue to recommend medium-term duration for both sovereign and investment grade corporate bond investments, typically in the 5-7 year range. 

Credit risk considerations

Corporates safer than sovereigns?

The traditional method of pricing high quality corporate bonds is with reference to the underlying sovereign bond yield, and then adding a credit spread to reflect the higher risk of default. Today, investment grade corporate spreads have tightened to historic lows of under 1% for BBB-rated bonds over equivalent sovereigns in the US and eurozone.

Clearly, this tight spread reflects both i) the desperate hunt for additional yield by investors at a time when cash deposit rates have fallen, and ii) the strong balance sheet and cash flows of most large corporate borrowers. However, we should also perhaps consider that this tighter spread may also reflect the fact that the US and eurozone countries no longer look as “risk-free” as they once did, given today’s record-high levels of government debt compared to GDP. 

Consider that a 30-year Microsoft corporate bond (rated AAA) today offers a 4.8% yield, only 0.2% above a similar maturity US Treasury bond. Many investors may prefer to lend money over a long period to Microsoft than to the US Federal government, given Microsoft’s long record of profit growth, virtual monopoly of operating system and office suite and net cash position. Should we regard Microsoft as a safer long-term credit risk than the US government today? As governments strain to finance annual budgets against a backdrop of higher interest costs, could we be entering an era where high quality corporate bonds will trade consistently at tight spreads over sovereign bonds? 

ECB to remain at 2% despite well-behaved inflation

We do not see the European Central Bank reducing their deposit rate below 2%. In real terms (after deducting inflation), this is a real rate of around zero. A neutral rate would have the ECB’s real interest rate equivalent to the eurozone’s real GDP growth rate, which we estimate at 1.2%-1.3% for this year and next. In the ECB’s estimate, they have thus already reduced interest rates to below the neutral rate and are already supporting economic growth.

Compare the ECB’s 2% rate to the effective Fed Funds rate in the US of 4.1% or the Bank of England’s base rate of 4.0%. Even after subtracting inflation rates that are well above 2%, US and UK real rates are positive. By this measure, the ECB is doing more to stimulate growth than either the Fed or the Bank of England.

However, growth in the eurozone remains weak, a stronger euro is weighing on both growth and inflation, and inflation could fall below 2% in the next few months especially if energy prices continue to cool. On this basis, the ECB could conceivably cut their deposit rate further without risking higher inflation.

For now, we do not expect the ECB to lower interest rates further unless there is a material slowdown in growth. A good reason for the ECB to “wait and see” is in the long transmission time from interest rates to the real economy. The lag between a cut in rates and the positive impact on growth can be as long as 12-18 months. The ECB would argue that we have not seen the full effect of the interest rate cuts already implemented in boosting eurozone growth. 

Upgrading equities to Overweight

This is about momentum…

It is hard not to be impressed by the momentum with which global stock markets keep rising. The US is marking its 28th record high this year and, markets such as China, Japan, EM and even Europe are breaking out to the upside as well. The move is driven by a surprisingly resilient US economy, solid earnings and easy monetary positioning. It feels like the equity train has reached escape velocity. Hence, we upgrade our view on equities to overweight.

…..and not about (long-term) fundamentals

Does this mean our concerns regarding the potential impact on tariffs or AI overspending have disappeared? No, they have not. We remain sceptical and still wonder if AI can produce the expected productivity gains that will force the implementation rate required for these investments to yield enough return to justify the valuations. But we believe that these concerns are not for the near term, as it will take some time before the winners and losers from AI become apparent. Big Tech CEOs are likely to  keep spending on their AI dreams. This, in spite of concerns over the Return on Income that this heavy investment will ultimately earn. The spending trajectory is further boosted by the  impact of the OBBBA on corporate capex. It enables businesses to fully write down the costs of machinery, equipment and domestic R&D immediately.

Don´t fight the Fed!

What matters is an economy that seems (for now at least) to be denying the gravity of tariffs and a slowing labour market while the Fed embarked for further rate cuts. We have updated our expectation to two rate cuts in 2025 (versus one previously) and in 2026. This should add further fuel to a market that is already enjoying tailwinds of easy financial conditions (see Chart 2).  No matter where we look, history suggests that the current strength has room to run as rate cuts outside a recession has historically been a strong force pulling equities higher (see Chart 3). Moreover, our FX strategists have upgraded their 12m EUR/USD target to 1.24, which should support earnings growth for US large caps in general and US mega cap tech companies in particular.

We upgrade US equites to Neutral. Due to our dollar view, adding FX-hedged exposure might be worth considering. 

Keep course in Europe but a little less aggressively

After a stellar start to the year, European equities went into a consolidation phase during the summer. In our view, this was driven by two major impacts. Firstly, the ongoing euro strength weighed on consensus earnings expectations which was revised to -1% EPS growth for 2025 (vs. +8% in January). This didn’t  impact all companies equally as the earnings of US-exposed stocks were been revised down 10–15%, while the earnings of domestic exposed stocks managed to grow. Secondly, the market seems to have entered a “show me” phase in respect to increased spending.

Looking ahead to 2026, stronger European GDP growth should support earnings while FX headwinds will persist. We thus think that the current consensus expectation of ~12% earnings growth is too high which makes earnings downgrades likely. Since we don´t think Europe can outperform going forward, we downgrade Europe to Neutral. Within Europe, however,  we retain our current preferences and continue to prefer exposure to the European autonomy theme, domestic exposure (especially SMIDs) and certain sectors like banks.

Emerging Markets enjoy healthy tailwinds

We reiterate our overweight call on emerging markets. Looking forward, we think the EM equity rally can extend until year-end as macro tailwinds from Fed rate cuts and a weak dollar continue. Positioning and flow trends remain supportive amid ongoing strong demand for diversification and positive Q4 performance seasonality.

Big in Japan

We also reiterate our Overweight call on Japanese equities. We see the following factors to continue supporting the market: a constructive global economy, a recovery in the Japanese economy driven by external and internal forces (e.g. wage growth), solid corporate earnings and ongoing corporate reforms.

There is one key message

There is a real risk that we will see echoes of the last bullish phase of the dot.com bull market. We don´t want to fight that trend and so we increase our equity allocation to Overweight. Hence, we focus on the main message which is that the bull market is alive and strong. A more nuanced view will be provided in the upcoming Equity Focus.

Everyone is underweight commodities...

According to the latest Goldman Sachs survey of global family offices, these family offices only hold a 1% total allocation to commodities in their portfolios. This compares to an average allocation of 12% in cash and near-cash, and another 11% in listed bonds and corporate credit.

…despite a strong 2025 performance, so far

This strong performance is somewhat surprising for two reasons: the Commodities asset class has performed strongly over 2025, and indeed over the last 5 years. The S&P GSCI equal-weight commodities index has risen 15% in US dollars this year and has doubled in value over the last 5 years (15% annual average return).

Precious metals (gold, silver, platinum) have been the star performers with 44%-80% returns this year, but strategic industrial metals, such as copper (+20%) and tin (+26%), have also benefited from a combination of solid technology-related demand growth and restricted supply. Other commodities, such as cattle and coffee, have also risen sharply this year.

Commodities can play an important role in a well-diversified portfolio

Achieving true diversification in investment portfolios today has become a lot harder.

Global stock indices are more concentrated than ever, following the long-term outperformance of US mega-cap technology stocks, such as Nvidia. Any reversal in fortune of these technology stocks would have a heavy impact on overall performance of the 1350-stock MSCI World index, given the 22%+ weighting of the Magnificent 7 in this index.

What makes portfolio diversification even more difficult today is the positive correlation between stock and bond markets. According to Amundi, the 5-year correlation (2020-2024) between stock and bond markets varied from +0.44 for the UK to +0.62 for the US, with only China offering a negative correlation over this time span between local stocks and bonds. This is very important to know when constructing multi-asset portfolios, as it suggests that stocks and bonds now tend to go up and down together. Most importantly, it suggests that bonds will no longer act as a cushion for portfolio performance when stock markets correct or enter a bear market, as was generally the case from 2000 to 2019.

Take the recent example of 2022, notable for the Russian invasion of Ukraine. Over calendar 2022, global bonds returned -16% in US dollars, while global stocks returned -18%. Not much diversification of performance evident there. In contrast, the Bloomberg commodity index offered a +16% return over this same period. 

Commodities have diverse drivers

The Commodities asset class is, by its nature, well diversified among the various subclasses such as precious metals, energy, industrial metals and soft commodities (foodstuffs, cotton).

Soft commodities are often affected by climate and crop yield, while energy and industrial metals are, by nature, closely tied to the ups and downs of the global economic cycle. Precious metals are largely considered as a store of value (gold in particular) and so tend to perform well in times of crisis and geopolitical stress.

Commodities suffered post the last 1999-2008 super cycle

Commodities as an asset class have historically enjoyed long bull and bear markets. The last commodity super cycle was driven by the boom in Chinese manufacturing capacity over 1999-2008, when the S&P  GSCI commodities index rose 580% from trough to peak (23% annualised). Following the 2008 Global Financial Crisis, commodities suffered a prolonged bear market, falling 72% to March 2020.

Since early 2020, the combination of i) a post-COVID reopening economic boom and ii) the 2022 invasion of Ukraine has resulted in a 144% gain in the S&P GSCI equal-weight commodities index (+18% annualised to date). 

Preferred ways to introduce commodities into a diversified portfolio

Today, there are several “intelligent” ways to add commodity exposure easily to a diversified multi-asset portfolio. We particularly like commodity strategies and indices that capture the roll yield in commodity futures that are in backwardation. This is where the far-dated future price is lower than the spot price, potentially capturing extra returns over time as the lower futures prices converges on the higher spot price.

One such strategy is the BNP Paribas Energy & Metals Enhanced Roll index, which has delivered a 15% return (hedged) in euros and 18% in US dollars over the last 12 months. This index only holds exposure to commodities in backwardation, and is currently exposed to gold, silver, natural gas, oil and copper.

A second simpler diversified commodities strategy to follow is embodied in the Bloomberg equal-weight commodity ex-Agriculture index, which holds a basket of 12 different commodities split between energy, industrial metals and precious metals. This has returned 9% over the last 12 months in euros and 15% in USD.

Finally; there are several funds and ETFs that give exposure to single commodities, such as gold, silver, platinum, copper, aluminium, and tin.