Investments

16 October 20026

By Alexandra Campbell, Chief Investment Officer, NAB Private Wealth & JBWere 

After a decade of low inflation that paved the way for low interest rates, the outlook has become less straightforward. Growth is continuing, but the rapid rise in inflation following COVID-19 remains stubborn, governments are spending heavily while productivity is stalling in key economies. Central banks in a number of key economies, including the United States, have tightened monetary policy and will need to tighten further if inflation does not ease.

This is further complicated by the huge capital raisings required to fund the build out of artificial intelligence. While this investment has supported strong growth in corporate earnings, the productivity gains required to justify the investment are yet to be realised, with questions as whether the growth required to support prevailing valuations is sustainable.

The result is a mixed economic picture. Surveys of private-sector supply chain and business executives (PMIs) suggest the global economy is still expanding, and the US remains more resilient than many expected. Yet there are also signs normally associated with a mature economic cycle: elevated share market valuations, full but weakening labour markets, weakening consumer confidence, pressure in housing markets and the prospect of further rate rises.

Inflation is proving difficult to defeat

Inflation sits at the centre of the uncertainty. In the US, price growth has remained above the Federal Reserve's target for an extended period. Strong employment, large government deficits and buoyant share markets have helped sustain demand while supply is constrained. Rising energy prices add further pressure as major supply shocks flow through to transport, manufacturing and households.

Australia is particularly challenged. The cost of housing, energy, healthcare, insurance and other essential services continue to become more expensive, while wages have risen faster than productivity as a result of a full labour market.

NAB Economics expects the RBA’s September rate rise, which lifted the cash rate to 4.60%, may be enough to slow demand and keep rates on hold. Avoiding another rise would likely require clearer labour-market weakness, however, such as rising unemployment.

Other major central banks are confronting similar choices. A small number of rate increases may simply slow demand around the edges. A longer tightening cycle would have broader consequences, increasing borrowing costs for households, businesses and governments while weighing on economic growth. This is looking more likely.

Government spending complicates the picture

Central banks are also working against a powerful tide of public spending. Around the world, governments continue to run sizeable budget deficits as they fund defence commitments, energy security projects, ageing populations and efforts to strengthen domestic industries.

The US is running particularly large deficits, while China has also significantly increased government-related borrowing. Australia remains in a comparatively stronger position at the federal level, although state borrowing and high household debt leave the economy sensitive to higher interest rates.

The combination creates a difficult balance. Government spending can keep economies growing, yet persistent deficits can also sustain demand and such that inflation remains elevated, forcing central banks to keep rates higher for longer. That may make recessions harder to trigger, but simultaneously increase financing costs across the economy, impacting productivity and growth … stagflation.

Bond markets are resetting the price of capital

The economic pressures have been most visible in long-dated government bonds. During September, the Australian 10-year government bond yield moved above 5% and reached its highest level in more than 15 years, while US, UK, German and Japanese yields also tested multi-year highs. This reflects elevated macro risks, with investors seeking greater compensation for persistent inflation, heavy government borrowing and the risk that interest rates remain higher for longer.

Higher long-term yields raise the cost of capital and reduce the present value of future earnings, placing particular pressure on growth assets. As investors adopt a more defensive stance, high-quality bonds are expected to attract greater demand for their relatively stable income and traditional role in diversifying equity risk.

Higher yields also flow into government deficits, as maturing government bonds are refinanced at higher cost, such that interest costs rise and absorb a larger share of public revenue. That can narrow the room available for tax relief, infrastructure, defence, energy support and other policy priorities.

Despite the higher cost of debt, corporates are issuing large quantities of debt. SIFMA reports US corporate bond issuance reached about US$2.2 trillion through September, roughly 25% higher than a year earlier, as borrowers funded capital expenditure, refinanced existing obligations and, in some cases, financed the expansion of artificial intelligence and data-centre infrastructure.

Strong demand and tight credit spreads show that markets remain receptive to high-quality issuers. However, heavy supply increases competition for capital and widens the gap between stronger and weaker borrowers, reflected in credit spreads. For investors, this creates attractive income opportunities in parts of the credit market, reinforcing the importance of careful issuer selection.

Share markets reliant on strong earnings growth

Despite these concerns, US equities have continued to rise, supported by strong growth in earnings and market expectations that technology will deliver meaningful productivity gains with the benefit to be realised by corporates in the form of future earnings growth. Recent corporate earnings have supported valuations that appeared stretched in prior years. While valuations appear high based on historical earnings, valuations appear cheap if earnings growth is sustained into the future, but this leaves little room for disappointment.

The critical question is whether the extraordinary sums being invested in data centres, semiconductors, electricity infrastructure and software development will generate sustainable earnings. If so, today's spending could underpin another period of economic expansion and profit growth. However, if the expected return is not fully realised or is delayed, corporates may face weaker cash flows, heavier debt burdens and increasing pressure from investors. Market volatility reflects investor uncertainty.

In contrast, Australia's share market has been less exuberant. Resource companies have benefited from solid earnings, but banks and businesses reliant on consumer discretion are dealing with softer housing conditions and more cautious household spending in the face of rising energy and housing costs. Australian corporates are also exposed to higher cost of debt, exposing weak balance sheets.

Markets remain vulnerable to surprises

Investor positioning adds another layer of risk. Share allocations remain high and market optimism is concentrated in a relatively small number of large companies. Those conditions do not imply a correction, but they may amplify market moves if expectations change.

A renewed inflation shock, a faster pace of interest-rate increases, weaker corporate earnings or disruption to global energy supplies could all prompt investors to reassess risk more aggressively and pivot their portfolios to be more defensive.

For diversified investors, the reset in yields is both a risk and an opportunity. Further increases could place more pressure on equities, property and leveraged borrowers. At the same time, higher starting yields provide more income and a greater potential cushion against volatility than bonds offered during the era of near-zero interest rates. The outcome will depend not only on fiscal responsibility, inflation and central-bank policy, but also the market’s capacity to absorb sustained government and corporate issuance to fund deficits and technology investment.

The broader message is not that a downturn is inevitable. The global economy continues to grow, corporate profits remain healthy and artificial intelligence are expected to [DW1] deliver transformational productivity gains, but the timeframe is crucial. The margin for error is narrowing.

Inflation has not fully returned to target, public spending remains high and financial markets have already priced in a great deal of optimism. For businesses and investors alike, the next phase of the economic cycle is likely to reward resilience, sound financial management and the ability to adapt quickly as conditions evolve.

To discover more call 1300 683 106 or email us on NAB Private Wealth Investor Desk

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Important information:

The information contained in this article is believed to be reliable as at October 2026 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, financial and taxation advice before acting on any information in this article. Any forecasts or views about future events are not guaranteed and may change. Past performance is not a reliable indicator of future performance. The views expressed are those of the author and are current as at the date of publication.

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