Unstable world
Financial markets are sending mixed signals. Many equity indices have reached new highs over the past year, while bonds are under pressure, with borrowing costs rising to their highest levels since the mid-2000s. The US-Iran conflict, the AI investment boom and surging government debt are all contributing to an unstable world, albeit one that still presents opportunities as well as risks.
These forces are influencing not only markets but also politics, with the UK's new Prime Minister and Chancellor constrained by the nation's large and increasingly expensive debt burden.
Understanding the interplay between these developments is important for investors navigating today's market environment.
Equity strength
The simplest explanation for the strength of equity markets over the past year is that the economy continues to grow at a reasonable pace. The International Monetary Fund projects global growth of around 3% in 2026. While not exceptional, this is certainly not weak.
The AI boom has also contributed to market returns, with the huge sums being invested in data centres providing a meaningful stimulus to economic activity.
Prior to 2026, much of the strongest stock market performance had been concentrated among the largest US technology companies, the so-called "hyperscalers", which are building the infrastructure required to support AI. More recently, however, the beneficiaries have broadened to include semiconductor manufacturers, such as those in South Korea and Taiwan.
The equity optimism has developed wider still, with evidence of AI-driven productivity improvements beginning to emerge across the wider economy, rather than remaining confined to the technology sector.
Bond weakness
While these factors help explain the bullish mood in equity markets, investors focused on bonds have been more concerned. The yield on the 10-year gilt, a key measure of the UK government's borrowing costs, has risen from approximately 4.25% in late February to around 5.4% at the end of September. Similar trends have occurred across Europe and the United States.
Iran
Prior to the outbreak of war between the United States and Iran, oil prices were around $70 per barrel and markets expected central banks to cut interest rates this year. However, with the blockage of the Strait of Hormuz, oil prices had risen to around $100 by the end of September and markets are now projecting multiple interest rate increases.
This inflationary impulse, and the expected policy response, is unwelcome news for bond investors and is likely to persist while energy exports from Gulf nations remain disrupted.
AI and debt
The rapid growth in AI spending is supporting equity markets, but questions over funding are becoming increasingly important. The hyperscalers' capital expenditure programmes have expanded to the point where free cash flows alone are often insufficient to fund investment. As a result, many are now raising capital through the bond markets by issuing more debt.
Government debt
This dynamic adds to the already significant borrowing taking place in the public sector. UK public debt stands at around 100% of GDP. Many European countries have debt levels approaching similar levels, while the United States has an even larger burden. Persistent fiscal deficits remain commonplace, with government spending continuing to exceed tax revenues.
As debt levels continue to rise, investors are increasingly questioning the long-term sustainability of both corporate and government finances.
Political choices
The political significance of these market developments should not be underestimated.
Rising borrowing increasingly constrains a government’s tax and spending plans. While equity investors remain focused on growth and the opportunities presented by AI, bond investors are asking a different question: who will pay for today's spending commitments?
While this is a global challenge, it is especially pressing in the UK, where the experience of the 2022 Liz Truss mini-budget crash has left politicians acutely aware of the pain that bond markets can impose. Investors have become highly sensitive to signs of fiscal imprudence, leaving governments with less room to make unfunded spending commitments.
For Andy Burnham and John Healey, this means the Budget on October 28 will likely be judged as much on fiscal credibility as on economic ambition, and plans such as a National Care Service must be seen to be properly funded or further gilt losses would likely occur.
The global forces driving bond markets may be beyond Britain's control, but whether the UK is viewed as part of the problem or merely an unfortunate victim remains a domestic political choice.