The local story this week was inflation, but the interesting part is how local and global influences are being blamed depending on one’s perspective. Deputy RBA Governor Andrew Hauser intimated that inflation is getting worse and that this week's print would likely land on the higher side of expectations,. a domestic problem, framed principally domestically with a focus on the structure of the economy. However, the Government thinks this is much more to do with the Strait of Hormuz. Similarly the week's biggest corporate headline locally, NextDC's data-centre rollout being held up by planning, is the Australian face of a thoroughly global story about how much debt is being used to build AI infrastructure. As Tolstoy opened Anna Karenina “Happy families are all alike; every unhappy family is unhappy in its own way” and every nation from China to the UK to the US and France seem to be grappling with ostensibly local imbalances in their economies. 

Our Sydney Manager Walking Tour produced two distinct readings of the local inflation problem, from two people who have both worked at the RBA. The first was essentially arithmetic: rates are roughly where they have to be. Take inflation back to 2.5%, add a real rate of 1 to 1.5% and a term premium of about 1%, and 5% is simply not a bad long-term number and what’s required to rein in inflation. The second was behavioural, and it was the one that landed with advisers in the room. Inflation expectations are embedding; on that speaker's calculation the cumulative cost to the average household is already around $14,000, and people are responding below the surface. They cannot put a number on it, but they have a sense that things are getting more expensive and that they should act accordingly.

Which of those you believe determines almost everything downstream. Households and businesses are getting used to three or four per cent and building it in, and this has now been running for five years. If you trust market pricing and treat the current episode as a cycle, and we have all heard the word transitory before, then policy is already tight and there is little to worry about. If inflation instead settles at 4%, policy is actually loose, and the case for moving before it is too late becomes urgent. That is the argument central banks are having with themselves. Global PMIs point to building inflationary pressure, some of it supply-side and tied to the Strait of Hormuz, though few expect the Fed to act immediately before the midterms.

There is a credit dimension that is not being discussed much yet. Spreads are widening at the riskier end, AI-related borrowing is crowding out other issuers, and US bankruptcies are rising below the surface, with the middle ground so far largely untouched. We are seeing comparable dynamics locally in private credit, different in kind, similar in shape.

The week before last one explanation for big tech's weakness was that rates were rising and multiples were compressing. This week undermines that: rates fell, with US 10-years back around 5% and Australian 10-years near 5.2%, and the selling continued anyway. So it was about the stocks. Chips in Korea drove emerging markets down another three to four per cent, taking them to roughly 8% for the month against almost 6% for the Nasdaq. Meta's earnings came in a little below expectations, but what the market took a dim view of was the spending plan and the debt required to fund it while preserving Mark Zuckerberg's voting control. With heavily indebted CoreWeave front and centre, the market is now separating the AI infrastructure names that lean on debt from those funded with equity, and asking whether the monetisation arrives quickly enough to make those debt levels sustainable. That looks set to be the organising question of reporting season but it is all what happens when the credit cycle begins to turn which may be worth watching out for.

On the numbers so far, roughly a quarter of the S&P 500 has reported and earnings have narrowly beaten what was a high hurdle — companies are clearing estimates by about 2.1% against a five-year average of 7.5%. With the bar set that high, any disappointment should attract a reasonable reaction. The more encouraging detail for the broadening-out thesis is that the other 493 are keeping pace, and expectations for them are accelerating while those for the Magnificent 7 decelerate. On current estimates the fourth quarter would be the first since 2022 in which the 493 outgrow the Mag 7. That rests on relatively few results, and there is a good deal to look at under the hood, so we intend to work through the Goldman Sachs ex-AI index next week if we can obtain the holdings.

The rotation we flagged last week is becoming more entrenched. Australia, global small caps and emerging markets excluding Korea and Taiwan have all been close to level pegging, and the global small-cap quality managers that were badly out of favour earlier in the year continued to outperform, with divergences of around 10% against the index. Emerging market strategies without Korean and Taiwanese chip exposure did not fall either.

For a diversified portfolio this leaves the financial year to date around flat on average, and modestly positive — plus one or two per cent depending on risk profile, where these exposures have been held. The market remains range-bound, trading in a band of roughly 10% over the past four to six months. More reassuring is that the hedges have started to work again: duration has provided genuine downside protection, a softer Australian dollar has cushioned returns, and the Swiss franc has been notably strong. After a topsy-turvy year, portfolios are behaving the way they are supposed to.

On France, Andrew Hunt's view remains that the politics and the fiscal arithmetic do not fully explain the move, and that something else is at work, specifically the relationship between the West and what has become its principal financier. His equation is a simple one. Government borrowing has to be funded by household savings or by capital inflows, and with limited domestic capacity it has increasingly been the latter for the past decade and a half. What is notable is that this no longer runs mainly through the People's Bank of China but through large state-owned corporations, with proxy accounts and custody arrangements surfacing in Canada, and in Belgium last year. Both Washington and Beijing appear well aware of the mutual dependency, and a muddle-through remains the highest-probability path, with some sabre-rattling along the way. The tell to watch is currency volatility, which is subdued for now; were currencies to become as unsettled as they were earlier in the year, that would be the signal to think harder about left-tail risk.

Diversification is doing its job, and duration is again earning its place in a 70/30 or 60/40 portfolio. Underneath that, the cost pressures in the system are real and worth acknowledging. The Fed and the ECB will be widely watched this week, but we expect to learn more from the US earnings season: Microsoft, Alphabet and Amazon all report, and 179 S&P 500 companies in total.