The bull market can survive higher rates

As oil prices return to pre-Iran war levels, we expect continued resilience in the US and global economy. Lower oil prices should help reduce headline inflation and support real consumer spending. Still, we expect underlying inflation in the US to remain sticky and elevated, keeping the risk of Fed rate hikes alive.

The key investment implication is that higher US rates may create volatility, but we do not think a somewhat higher Fed Funds rate is likely to derail the equity bull market as long as earnings growth remains strong and continues to broaden beyond artificial intelligence (AI). We believe that corporate earnings will remain robust, supported by the ongoing boom in AI spending as well as continued profitability across non-tech companies.

We have conviction that earnings growth will power global equities higher over the second half of the year, even if gains are accompanied by increased volatility from monetary policy uncertainty.

In fixed income, we expect increasing divergence. We see upward pressure on US rates, while rates should remain steadier in other markets where underlying inflation is less sticky and growth cooler. These moves in relative rates can keep the US dollar supported versus other major currencies. We also see opportunities in selective EM FX, but prefer to fund those positions via the lower yielding Swiss franc. 

The US labor market has accelerated this year after near-zero employment growth in 2025. The three-month moving average of job growth reached a very strong 188,000 through May. While employment growth is unlikely to remain quite that robust, even a step down would still be healthy, given that the breakeven pace needed to keep the unemployment rate steady is estimated to be closer to 60,000. We believe the improvement in the labor market should support consumer spending, which has remained solid despite the oil shock.

Much has been made of the K-shaped economy, where overall economic health and spending are driven far more by higher-income than lower-income consumers. However, there is incremental evidence that the “bottom of the K” is inflecting higher, with banks and credit card companies recently reporting improving spending among lower-income consumers.

Exhibit 1: US nominal spending is picking up

Johnson Redbook Index Same Store Sales Weekly YoY, 4 week moving average

Resilience extends beyond the US. Global manufacturing. PMIs have moved well into expansionary territory, with increasing breadth across regions and sectors. The AI capital expenditure (capex) boom supporting the US and EM Asia is well established, but we increasingly see non-tech capex inflecting higher as well. This reflects both a cyclical rebuilding of inventories and a structural trend toward investment in national resilience, including defense spending and the reorientation of supply chains.

Exhibit 2: Global Manufacturing PMI is at a multi-year high

On inflation, the decline in oil prices below pre-conflict levels should put downward pressure on headline inflation and limit pass-through to some core measures. That said, we continue to view underlying inflation as sticky and above the Federal Reserve’s (Fed) 2% target. Core services inflation excluding housing has rebounded to above 3%. In addition, more than half of the components of core PCE are running above 3%. In short, inflation is not just an oil story.

Exhibit 3: Underlying US inflation has been broadening out

United States, % of Core PCE Line items >3% (Level 5 of 9:50 items)

The rebound in the labor market and the persistence of inflation have shifted the Fed in a hawkish direction. Nearly all FOMC members now view risks to price stability as skewed to the upside, while labor market risks have shifted to a more balanced assessment. An increasing number of FOMC members are signaling a willingness to hike rates this year.

Moreover, new FOMC Chair Kevin Warsh has gone out of his way to stress the importance of delivering price stability, as defined by an unchanged 2% inflation target, after five years of missing that target to the upside. Our conversations with clients suggest there is underlying skepticism that the Fed will hike rates this year because of political considerations. We think a Warsh-led Fed will be more willing to deliver rate hikes if labor market strength and core inflation justify action, which looks increasingly likely.

In our view, the increasing potential for Fed tightening is a manageable headwind rather than a reason to abandon risk assets. With US household and corporate leverage still near multi-decade lows, we do not view a few hikes as a meaningful risk to the economy. A few rate hikes could cool very strong nominal GDP growth and create some market volatility, but we doubt they would spell the end of this bull market.

The reason is straightforward: equities are ultimately driven by earnings growth, and earnings growth remains very robust. The blistering earnings growth seen in the US and emerging markets is driven in large part by the surge in demand for AI hardware. But beneath the surface, earnings growth is fairly broad. The median S&P 500 stock delivered 14% earnings growth in Q1, one of the strongest quarters in a decade. Given that capex spending is increasingly broadening into non-tech areas and that consumer spending should remain resilient, we see room for non-tech cyclicals to play a greater role in driving market performance in the second half of 2026.

There is also increasing attention on the rising supply of equities, both from mega IPOs and secondary issuance. Goldman Sachs estimates a potential increase in issuance of USD 700 billion this year. As with rate hikes, we view this as a modest headwind rather than a major risk to the market. Buybacks are expected to remain strong at USD 1 trillion, meaning net issuance should still be negative, though less negative than in recent years. Looking historically, we do not see convincing evidence that major IPO activity is a major driver of forward equity market performance.

The primary risk we see to the market is a meaningful downward shift in expectations for AI capex spending. The AI capex cycle has been a boon to markets and household wealth, so a change in the narrative could undermine markets and potentially weigh on consumer confidence. We are also aware that the AI narrative can shift well before earnings expectations. As a result, we are tracking several indicators that we think will be central to sustaining optimism around AI capex spending. These include adoption rates, token spending, GPU prices, and memory prices. At the moment, these indicators are generally still pointing in a positive direction, but they merit close monitoring.

We remain overweight equities and prefer emerging markets and Japan, where our leading indicators point to the strongest earnings growth. Maintaining exposure to AI-linked stocks makes sense given surging earnings growth, but increased crowdedness and growing participation in leveraged single-stock ETFs highlight the need for diversification. Indeed, increased concentration in tech across both US and EM equities strengthens the case for more active selection.

The macro backdrop also supports a more differentiated approach across asset classes. Sticky US inflation and a more hawkish Fed leave us cautious on US duration, and we expect US Treasuries to underperform equities as the rates market increasingly skews toward rate hikes. However, we do see value in UK and Australia duration as those economies cool.

Similarly, we expect the US dollar to remain strong as the Fed stays hawkish while other central banks slow their tightening cycles, reflecting more energy-driven inflation indexes and slower growth. We selectively like EM carry, particularly the South African rand, but prefer to fund those positions in Swiss francs rather than US dollars.

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness for global equities, rates and credit as of 30 June 2026. The rest of the ratings pertain to the relative attractiveness of certain regions within the asset classes of equities, bonds, credit and currencies. Because the Asset Class Views table does not include all asset classes, the net overall signal may be somewhat negative or positive.