We continue to be more optimistic than consensus about the global economy and expect growth across both developed and developing economies to be higher in 2026 than this year.

We also expect marginally higher inflation as wages growth reflects tighter labour markets. If we are correct, it is likely that central banks are close to the end of their easing cycle and interest rates are at their cycle lows. With the US government shutdown, hard data on the US economy is scarce, but consumers are still spending, and the AI capex boom continues, putting a floor for economic growth of around 2%.

US inflation data for September was marginally lower than expectations, mostly due to the housing components and rent, which remains the main weak spot in the economy. The US Federal Reserve cut rates as expected to 3.85%, but at the post-meeting press conference, Fed Chair Powell guided the market away from expecting another cut in December.

At the time of writing, market pricing for a December cut has shifted from 100% certainty down to a 65% probability. Further cuts are also priced for next year with a terminal rate of 3% by the end of 2026. We continue to view this as too aggressive, particularly given our strong growth and higher inflation outlook.

In Australia, the September quarter CPI was much worse than feared, following the August monthly CPI’s upside surprise. A broad-based increase in inflation pushed the year-over-year CPI back to 3% and will keep the RBA firmly on hold. The market is tentatively pricing in another rate cut for the first half of 2026, mostly in expectation of further weakness in the labour market.

If our view is correct and economic growth is on an upswing, then the risk is further tightness in the labour market and more pressure on wages.

The European Central Bank (ECB) kept rates on hold in September as expected and markets are priced for them to be on hold for an extended period. The ECB seems more confident on European growth prospects as looser European fiscal policy and financial conditions support the economy.

Last month, we started positioning for a turn in the monetary policy cycle, mostly by reducing interest rate risk and credit risk at the margin. We reduced duration to below 0.50 years and have maintained that position as we expected inflation to be above the RBA’s forecast and result in a repricing higher in short term yields. While correct, this meant the portfolio didn’t benefit from the post-employment data rally. However, we did benefit from the Australian yield curve flattening significantly following the CPI data.

Within credit, spreads remain historically tight, and we have continued to reduce risk, mostly by moving up in quality in the banking sector. We reduced exposure to subordinated bank debt by 7%, reduced senior bank debt by 5% and added 5% in semi-government securities. Subordinated bank debt spreads are extremely tight and moved wider over the month. We continue to hold credit default protection where spreads remain very tight – specifically across US and European high yield and US investment grade sectors – adding 3% protection over the month.

It was a busy month in Australian residential mortgage-backed securities. Several new issues came to market in our favoured mutual sector (mostly non-profit credit unions) where spreads are wider than major bank issues and credit standards are high. We sold 8% exposure from older bank issues where spreads had moved below 60bps and replaced them with the new mutual issues at spreads closer to 90bps, lifting total RMBS to 27% of the portfolio.

Foreign currency exposures had a negative impact on monthly returns. We have benefited from being short US dollars (USD) since March, and although we reduced the size of the short position, we gave back some gains due to a rebound in the USD in October as markets priced out the size of policy easings.

We continue to keep the Australian dollar (AUD) short position to a minimum as we expect the AUD to benefit from the RBA being on hold and have preferred using the USD to fund emerging market currency exposures.

The USD gained the most against the Japanese yen (JPY) where we continue to maintain a long position. We view the JPY as the best risk-off hedge in currency, providing downside protection from potential credit market dislocations. We expect the Bank of Japan (BOJ) to restart their policy tightening cycle in the face of persistently higher inflation and wages growth, and this should support the yen over the medium term.

With a more optimistic growth outlook for 2026, we view current yields at their cycle lows. As such, we expect to maintain interest rate risk towards the lower end of our range. Credit markets are fully discounting good times ahead and the extra premium investors receive for lending to corporates over governments is historically narrow, reducing the margin of safety.

As a result, we have shifted up in quality in the bank sector and added some semi-government exposures. Some cracks are appearing in the lower quality US syndicated loans and ABS sector, with recent defaults linked to fraud, but it remains contained for now. If spreads widen, the portfolio is highly liquid and well positioned to add credit risk as value is restored.