At the crossroads of geopolitics, monetary policy and structural change

Key points

• Major central banks are adopting a more hawkish stance, reflecting the inflation-growth trade-off.
  
  
• Despite near-term dollar strength, policy uncertainty and fiscal dynamics support the case for diversification away from the dollar over time.
  
  
• Navigating the interplay between geopolitics, monetary policy and structural shifts has become increasingly important for active managers.

After several months dominated by geopolitics, the macro narrative is broadening. While developments in the Middle East remain influential, central banks have reasserted themselves. Policy divergence is becoming more pronounced, and regional dynamics are creating a more complex and opportunity-rich investment landscape.

Central banks back in focus

Recent meetings have delivered a more hawkish tone than anticipated, with both the European Central Bank (ECB) and the Bank of Japan (BoJ) moving to tighten policy.

This reflects a broader recalibration. Central banks are increasingly taking ownership of inflation, seeking to determine what level they can tolerate while balancing the risks to growth.

The challenge is to tighten policy sufficiently to prevent inflation from becoming entrenched but avoid tipping economies into recession. However, different economies are facing different trade-offs, leading to a wide range of policy outcomes.

Geopolitics: still relevant, but no longer dominant

Geopolitical risk has not disappeared, but it has evolved. The memorandum of understanding between the US and Iran has been interpreted by markets in a broadly positive way.

However, the substance of the agreement highlights its tentative nature. For markets, the key issue is implementation. Traffic through the Strait of Hormuz, a critical global energy artery, remains far below pre-conflict levels. While there has been some reopening, volumes are still insufficient to eliminate the risk of shortages, particularly in energy-dependent regions such as Asia.

The US: growth resilience meets inflation persistence

Growth in the US continues to be underpinned by a powerful investment cycle, particularly in artificial intelligence (AI). The projected capital expenditure boom of next year suggests that the AI theme is not a short-lived phenomenon but a more structural driver of economic activity.

This has helped sustain economic momentum, even as earlier concerns around labour market weakness have faded. However, the strength of growth is accompanied by persistent inflation.

Even after adjusting for one-off factors such as the impact of tariffs and demand linked to AI, underlying inflation remains above target. This presents a challenge for the US Federal Reserve (Fed), which is now facing a shift in expectations.

Markets that were previously debating whether rates would be cut are increasingly considering the possibility of further hikes. This recalibration has implications across asset classes, particularly those underpinning the strength of the US dollar.

Dollar positioning: cyclical strength, structural questions

The combination of stronger growth, resilient employment and a more hawkish Fed supports a near-term case for dollar strength. This has been reflected in portfolio positioning, with exposure tilted towards the dollar against other currencies, particularly in Asia.

However, the longer-term outlook is more nuanced. Structural concerns, including policy uncertainty and fiscal dynamics, continue to support the case for diversification away from the dollar over time.

Europe and the UK: stability with underlying risks

In Europe, the ECB’s June tightening reflects a determination to anchor inflation expectations. Growth has held up better than anticipated, providing policymakers with room to act. While downside risks remain, particularly if energy prices rise again, the baseline outlook supports a measured continuation of policy tightening.

In the UK, developments have been more politically driven. The resignation of the Prime Minister has introduced a new layer of uncertainty, but market reaction has been relatively subdued. Gilts and UK assets have performed reasonably well, suggesting that investors are focusing more on the potential for reduced uncertainty and more market-friendly views.

We anticipate a period of uncertainty, with muted moves in UK markets likely to persist through to September or October. By then, we expect greater clarity on the incoming Labour leadership’s policy direction, with any fiscal implications likely to be outlined in the budget.

Asia: policy lag and structural opacity

Japan moved to raise rates in June, but the pace of tightening suggests that policy remains behind the curve. The persistence of yen weakness reflects this, with the currency acting as an adjustment mechanism in the absence of more aggressive action.

China, meanwhile, continues to present a more complex picture. Official data suggest stability, but the underlying dynamics are less transparent. Many observers increasingly believe that policy support may be operating through less visible channels, raising questions about how long that can persist.

Dispersion and the search for alpha

The combination of geopolitical risk, central bank uncertainty and structural shifts such as the AI investment boom creates a backdrop where the next market-moving headline is difficult to predict.

For active investors, this demands a more agile approach, with the ability to capture relative value opportunities. In a world where no single narrative dominates, success will depend on navigating the intersection between geopolitics, monetary policy and structural change.