How is the war in Iran impacting financial markets?

The war in Iran certainly introduces a new risk or uncertainty into our base case assumptions for the economy, the outlook over the year ahead. I would say, if anything, it widens the range of potential outcomes, both the negative and the positive, around our central scenario. And the key reason for that is that Iran is just such a key supplier of energy to the globe.

And so, if the conflict in Iran extends for a long period of time, and has important implications for the price of oil, which then affects inflation and perhaps consumer spending, and ultimately could weigh on economic growth more broadly. Of course, at the time of this filming, a lot of questions remain unclear. We don't know whether or not this conflict will escalate even further, or whether it will be short-lived or extended for a long period of time.

And so what I like to do is look back at history and ask ourself the question: what have financial markets done in instances in the past where we've had sort of an intensification of geopolitical conflict?  And what we find is that, typically, the market response to these kinds of events or military action tends to be fairly muted and often short-lived.

So we've looked at events all the way back to World War II. For our data set, we've got 42 events in that data set. And on median, the S&P 500 (Index) has declined just around 3% over the course of five days, and has fully recovered within 12 days from the event. So, most of the time, the impact is is actually not all that significant. In the current experience, at least so far, is not all of that atypical relative to that median experience. And so of course, headlines will dominate the news flow in the near term, and perhaps cause a lot more financial market volatility and will potentially stoke fear among investors. But I think it's also important not to lose sight of the fact that ultimately, this situation will likely come to a conclusion.

Of course, we don't know when that will be or what that might look like. But at some point, this situation will diminish, perhaps conclude, perhaps end, and then at that point, investors will likely shift their attention to things that are more important for the long-term outlook for the macro economy, which at the moment, appear fairly constructive.

We've got tailwinds from artificial intelligence; we've got central banks that have been easing monetary policy and governments that have been expanding fiscal stimulus. So all of those things combined, aside from the situation in Iran, paint a pretty favourable or constructive macroeconomic backdrop.

What is your outlook on interest rates?

Our outlook on interest rates over the year ahead is that central banks are likely to be on pause, at least for the foreseeable future. But for the Fed in particular, we think that they can resume interest rate cuts in the second half of the year. Complicating the picture a little bit in the near term is the fact that the conflict in the Middle East has boosted oil prices here in the short term.

So to the extent that energy prices remain elevated for an extended period of time, perhaps that limits how low inflation pressures will subside. And it could affect whether or not the Fed will cut in any sort of imminent fashion. But we still think, and the market agrees, that at some point later in the year, inflation pressures will subside enough to allow the Fed to resume interest rate cuts. The market's pricing in anywhere from 25 to 50 basis points in rate cuts over the next 12 months. Our forecasts are in line with that.

And so that's sort of what we see for the Fed. For Canada and Europe, though, we think that those central banks are likely at the end of their rate-cutting journeys, and we don't see any interest rate change in those regions over the next 12 months.

What is your view on fixed income?

So within the fixed income market, particularly the government fixed income market, we've seen quite a bit of fluctuation in yields as investors digest a variety of investment implications as it relates to global growth as well as fiscal policy. And then in terms of elevated government debt levels around the world. And also more recently, the flare up in geopolitical risk.

On that note, with the conflict in Iran, we've seen a little bit of a back up in yields in the last couple of weeks, as investors price in a little bit higher inflation premium attributed to the fact that energy prices have spiked and could remain higher if the conflict is prolonged. So in our view, and according to our models, we can expect something like low- to mid-single digit returns for government bond yields over the year ahead.

Importantly, we think valuation within the sovereign fixed income market, or, valuation risk within the sovereign fixed income market is relatively limited. So, we don't see an environment where yields were to rise aggressively on a sustained basis over a one-year forecast horizon. At the same time, there's a lot of pressures that limit or that might restrict the ability for yields to fall meaningfully lower in the short term, just because there's so much fiscal stimulus in the system, elevated government debt burdens. That's causing yields to stay a little bit higher.

So we expect sovereign bond yields to remain perhaps flat to slightly higher over the year ahead, which translates to something like low to mid-single digit returns on sovereign fixed income. Now, investors could get a little bit higher return potential if they move into the corporate bond market, investment grade or high yield bonds. But there, I would stress that spreads are historically narrow at the moment, offering very little extra return for that risk that companies could default on their financial obligation. At the moment there is a little bit of stress perking up in some parts of the credit space, primarily in private credit. Also, as it relates to the software sector, we're seeing a little bit more stress in that part of the market. Not necessarily signs of systemic, broad-based stress within the credit market. And so, as a result, you still see those spreads within corporate investment grade bonds really near their historic tights.

And so, in our view, even though investors could get a little bit higher return in the corporate bond market, the risk/reward is not super appealing. And so, in terms of our asset allocation, we would recommend slightly lower exposure to credit markets in this environment.

What is your view on equities?

The conflict in the Middle East certainly complicates the outlook for equity markets in the very short term. But I think if you step away from that conflict, I don't want to minimize the risk associated with it. But at least if we if we just step aside from that for a moment, and look at the long-term picture for equity markets, I think what you'll find is a pretty constructive view.

Corporate profits are expected to still continue growing at a very rapid pace. If you look in the U.S., analyst estimates are still for around 15% earnings growth in 2026, and another 15% earnings growth expected for 2027. That's a very strong backdrop for economic growth. A lot of that is being fueled by all the investment that's being made in artificial intelligence. Not just the investment, but also the productivity benefits that arise from that investment. And so, what we're seeing within the equity markets, actually some very interesting things happening as it relates to AI. We were seeing a lot of rotation within the markets, as investors are starting to tease out the winners and losers from this theme. So, it's not one of these situations where everybody is going to win.

Of course, there's some companies making significant investments to the tune of hundreds of billions of dollars. But every dollar that those companies spend is another company's revenue. So, what we're seeing happening within equity markets is that the companies that are part of the AI build out — so the ones providing the hardware chips or the infrastructure that relates to data center buildout, or the energy used to power these data centers — those companies are benefiting tremendously in this environment.

But there are also some losers. So particularly in the software space, there's companies that are being heavily disrupted by the AI technology. Think of a business that one of the core competencies is providing some software solution that, overnight, gets automated by AI. Of course, that company’s revenue is that significant at risk.

So you're seeing a big difference in the performance between winners and losers within the equity market. I think that's a key theme that's likely to play out over the next several months and quarters. But overall, we see this as being a pretty positive story for the overall corporate, profit-growth backdrop. Not just for the technology companies, but all the companies that will be adopters of those AI tools within their businesses.

When we look at the pricing, or what's priced into the market to try to tease out where the opportunities exist, particularly from an asset allocation perspective, what we find is that stock markets have gotten quite a bit more expensive. Not just in the U.S., but also around the world. So we're seeing stock markets priced at the upper end of their historic ranges in the U.S., also in Canada and Japan.

And so in those regions, return potential would be a little bit lower. Whereas we see in other parts of the world - UK, Europe, in emerging markets in particular — we still see valuations trading at a discount relative to where our models would suggest that they should be. So in our view, we would expect over the year ahead, mid- to high-single digit returns across the global stock markets. Importantly, with the higher single digit returns being available in regions outside of North America.

How have you positioned your asset mix in the current environment?

The way we position our asset allocation in any given environment is considering all the risks and potential opportunities available to us, or the challenges on the horizon. Of course at the moment, there's a lot of uncertainty for a variety of reasons. But particularly, with respect to the war in Iran. And so, we like to construct a portfolio that we feel has the ability to withstand all sorts of scenarios.

Of course, at the moment, our base-case scenario is that the conflict in the Middle East will have minimal impact on the longer-term economic prospects for growth, interest rates and inflation. But in the near term, of course, that is a significant risk. In our base-case scenario, we expect the economy to continue to grow.

We expect that the Fed will be able to resume interest rate cuts in the second half of 2026. And in that environment, we feel that government fixed income offers something like low- to mid-single digit return potential. So fairly low return expectations in the fixed income side of the equation. If we turn to equities, we can get a little bit better return potential, maybe in the mid- to high-single digits.

That gap between fixed income and equities is not unusually large at the moment, and so that equity risk premium is not super appealing. We don't think that, in this environment, it makes sense to have significant risk exposures within our asset mix. We're happy to have a little bit of risk exposure. So, we have a 1% overweight allocation to stocks. We're at 61% relative to our 60% neutral.

And our recommended allocation for fixed income is 37% versus a 38% neutral. Where we have made a change over the past quarter, though, where we see more opportunity is within the regional allocation within the different equity markets. And so, the return potential or the risk premium between stocks and bonds at the overall level might be narrow, but we see more opportunity for the difference in returns between regions.

So at the moment we're less constructive on the U.S. equity market, just because it's so expensive and more constructive on other parts of the market, namely international equities. This past quarter — and we were already tilted in this direction a quarter ago — but this quarter we decided to expand our underweight in U.S. equities and direct those proceeds to international markets. Canada, Japan, Europe and emerging markets, where we've expanded or boosted our overweight exposure in those regions.