Markets without a margin for error
John Abernethy | Clime Investment Management Limited
The world economy is not yet sliding into recession, but the outlook has become more difficult. Growth through 2026 will be challenged by the Iran war, the associated oil shock, rising inflation, and weakening confidence in the USD and US bond market. A rebound in 2027 remains plausible, but only if the energy shock resolves in the coming months.
This matters because asset markets are still priced as though the post-GFC world of suppressed real yields remains intact. The ‘risk-free’ rate has been redefined by investors over the past decade, and that redefinition has supported a major expansion in equity valuations. The key question is whether that reset is sustainable.
After the GFC, and again through COVID, central banks drove bond yields toward zero. In Europe and Japan, negative real yields became normal. In the US and Australia, the use of QE (quantitative easing) compressed yields and encouraged investors to move further out the risk curve. That supported higher PERs (price-to-earnings ratios) and lower earnings yields.
Although real bond yields had begun to normalise before the current oil shock, equity valuations did not adjust in the way history might have suggested. US PERs have remained elevated even as bond yields rose. More recently, as the Iran war pushed energy prices higher, bond markets barely moved. Real yields declined, and the US equity market recovered to record highs.
This is the defining issue for investors. If the US 10-year Treasury yield is higher than the earnings yield on the S&P 500, investors are accepting a lower implied return from equities than from government bonds. That can persist for a time, particularly where earnings growth is strong, but it is not a comfortable long-term foundation.
The US market’s valuation has been supported by the extraordinary profitability of the major technology companies. The so-called Magnificent Seven now account for around one-third of the S&P 500’s market capitalisation. Their operating margins, ROEs (returns on equity) and investment capacity are unlike anything available in Australia. The four major hyperscalers alone are expected to spend hundreds of billions of dollars on capex in 2026, much of it directed toward AI infrastructure.
This is not simply a market concentration issue. It is an economic power issue. Only the Chinese state can plausibly match that scale of investment. That is why trade policy, IP protection and technology restrictions will remain central to the global outlook.
Australia sits in a more difficult position. The average ROE across the Australian share market is materially below the US. Outside a small number of high-quality companies, many Australian large caps generate returns that are only modestly above, or in some cases below, a reasonable cost of equity. The causes are structural: weak productivity, high energy costs, elevated labour costs, regulation, tax complexity, and an index dominated by banks and miners. Banks sell largely undifferentiated products, and miners are price-takers in global commodity markets. Neither sector has the same earnings power as the dominant US technology platforms.
The 2025 calendar year highlighted how unstable asset-class leadership can become in this environment. Precious metals performed strongly, the USD weakened, and Australian equities lagged most major markets. The weakness in the USD should not be dismissed as a short-term move. It reflects growing concern about US fiscal sustainability and the long-term role of the dollar in global settlement.
The US remains the world’s financial anchor, but its fiscal position is deteriorating. Net interest on federal debt is now a major expenditure item, and the deficit remains large despite reasonably strong nominal GDP. Public debt is moving toward levels last seen after WWII. This has been manageable because global trade and reserves still rely heavily on the USD. Any credible challenge to that position — whether through BRICS trade settlement, digital currencies or reduced foreign Treasury demand — would have major consequences for bond markets and global liquidity.
The tariff war adds another complication. The US objective is to pressure China, but China has shown considerable resilience. Exports to the US have fallen, yet China has redirected trade toward ASEAN (Association of Southeast Asian Nations), Africa, Latin America and Europe. Its trade surplus remains substantial. Tariffs may therefore do less to weaken China than to accelerate the development of a more independent trading bloc outside US influence.
For Australia, China’s economic evolution is critical. The old model of steel-intensive growth has matured. Recycled steel is rising, and demand for iron ore is likely to be capped over time. Australia’s resource base must therefore pivot toward the next phase of Asian industrialisation: India, Indonesia, copper, lithium, rare earths and energy security. Relying indefinitely on iron ore royalties and company tax is not a strategy.
Domestically, Australia faces a stagflationary risk. Growth is below trend, productivity is weak, real wages remain pressured, housing affordability is unresolved, and energy policy remains incoherent. Inflation, which had appeared to stabilise near 3%, is vulnerable to a renewed push above 4% as fuel, freight and food costs rise. Unlike the US, where debt risk sits primarily with the government, Australia’s debt burden sits with households. That makes further rate increases more painful.
The implication for investors is straightforward. Equity indices are priced for a favourable outcome, while the macro environment has become less forgiving. Sustaining current valuations will require strong earnings growth, stable bond markets, contained inflation and ongoing liquidity support. That is a demanding combination.
Investors should focus less on chasing index momentum and more on quality, cashflow and sustainable yield. In equities, that means businesses with pricing power, sensible balance sheets and credible returns on capital. In credit, it means transparent structures, secured exposures and lenders with clear governance. Yield without visibility is not yield; it is speculation.
The coming period is unlikely to reward complacency. Slower growth, persistent inflation, geopolitical disruption and inflated asset prices are a difficult mix. Portfolios should be built around assets that can withstand that environment rather than assets that depend on the risk-free rate remaining permanently suppressed.
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First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.
All prices and analysis at 27 May 2026. This document was originally published on firstlinks.com.au on 27 May 2026 and has been prepared by prepared by Firstlinks, a Morningstar publication (Morningstar Australasia Pty Limited (“Morningstar”) ABN: 95 090 665 544 AFSL: 240 892). The content is distributed by WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer. This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. Past performance is not a reliable indicator of future performance. Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB. Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.