The third-quarter move in interest rates has been a global phenomenon, driven by higher “real” rates (bond yields excluding inflation) and, depending on the model used, additional risk compensation for inflation and real-rate risks. Higher real rates make sense given the historic physical investment boom occurring in the global economy (primarily within AI-related areas but also with regard to military and other infrastructure expenditures) that has been accompanied by persistent government budget deficits. The resulting demands for financial capital have been intense, marking a sharp departure from the so-called global savings glut of the prior two decades.

This is evident in the total amount of global debt outstanding (Exhibit 1), which has been running ahead of global economic output in recent years.

In response to the upward pressure on bond yields—and out of precaution over inflation (given AI-buildout demands and higher energy and related prices arising from wars in the Middle East and Eastern Europe)—numerous central banks have raised policy rates in recent months.

However, by almost any measure, financial conditions are still quite accommodative, as shown in Exhibit 2.

Taken together, these dynamics point to ongoing upward pressure on interest rates. Admittedly, the growth dynamic is still somewhat narrow as it is heavily dependent on the AI buildout and central-government expenditures. And some areas—such as residential real estate, consumer borrowing, lower-quality debt, and industries that tend to fare better in falling-rate environments—have faced headwinds this year, as shown in Exhibit 3.i But, in the aggregate, the global economy appears strong enough to absorb the regime shift in interest rates, unless monetary or fiscal policies become far more restrictive.

These dynamics have created a very different economic and financial environment than the one that prevailed for most of the 21st century. As we’ve previously pointed out, investors need to be selective and remain attuned to likely winners and losers.

As hockey great Wayne Gretzky wrote in his autobiography, it’s important to skate to where the puck is going, not where it’s been.ⁱⁱ And in the current environment, that includes watching inflation risks closely.

Despite tariffs, wars, stubbornly high energy prices, and AI-driven demands for materials and electricity, we have yet to see significant knock-on effects on broader measures of inflation. Somewhat encouragingly, as shown in Exhibit 4, most inflation measures have cooled over the past year. But as Exhibit 4 also shows, using the U.S. as an example, that’s not true across the board, and inflation is still well above where central bankers would prefer to see it. Making an assumption that recent improvements will continue unabated would require quite a leap of faith (never a good basis for investment strategy). Importantly, we have seen second-order effects of the energy shock in various measures of transport prices, the AI buildout in manufacturing prices, and tariff impacts on the prices of some goods. Fertilizer-supply disruptions arising from energy shortages and weather risks related to an extreme El Nino pattern are also likely to continue pushing the prices of certain agricultural goods higher.iii And of course, the potential for additional tariffs from the U.S. administration and countermeasures from its trade partners add yet another near-term risk to the outlook for prices.

However, the more important (and largely underappreciated, in our view) story for the longer-term inflation outlook is labor demand and supply. This might surprise some investors given the exceptionally quiet state of many countries’ labor markets, where workers are experiencing a “low-hire, low-fire” environment. Some economists view this as a risky situation for worker employment and incomes. Researchers at the Kansas City Federal Reserve, for example, recently opined that the U.S. labor market was currently “stable but fragile” and that an economic downturn could cause the unemployment rate to roughly double. That caution is understandable. However, in our view, labor market risks run both ways, with shifting population dynamics as a key factor. As we noted in our second-quarter outlook, workforces in numerous countries are expected to shrink significantly in the coming years and decades as Baby Boomers leave the workforce and fertility rates continue to decline. Taken together with drastically lower immigration rates, there appears to be a meaningful and widespread labor-market supply crunch ahead.

Meanwhile, labor-force participation rates in many advanced economies (with the exception of the U.S.) have already reached or are approaching all-time highs, as shown in Exhibit 5. Outside the U.S., there appears to be limited scope for workers reentering the labor force to help ease supply pressures.

At the same time, the number of people aged 15 to 64 in high-income countries has already started what’s projected to be a long, steady decline, as shown in Exhibit 6.

A maxed-out participation rate with a declining number of working-age people is likely to create serious labor-supply pressures in the years and decades ahead. Of course, it’s important to note that demographics, while slow-moving, aren’t set in stone. For example, while Japan and South Korea are seeing early signs of success incentivizing higher marriage and fertility rates, it’s taken some serious financial incentives.^iv We expect policy measures aimed at slowing these trends will receive consideration in other countries as well, if not in this decade, then perhaps the next. But slowing, much less reversing, this trend will take political will, well-designed incentives, and time. And of course, these types of measures could put additional pressure on government budget deficits if enacted.

As long as economic activity remains robust (even if somewhat narrow), supply pressures (including within the labor market) pose important risks to the inflation outlook. The underlying dynamics can be complex, but the investment upshots are straightforward. We maintain our focus on taking advantage of diversification benefits but also remain attuned to the economic environment (including inflation!) and its likely winners and losers. We also believe that investors should be appropriately selective in an environment that looks notably different from the one that has prevailed for most of this century.

GLOSSARY AND INDEX DEFINITIONS

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