Shifting contours of the West Asia conflict

In the past couple of weeks, the shape of the latest conflict in West Asia has changed materially. What began in February with a US-Israel attack on Iran has widened into something closer to a regional war. Saudi Arabia is now in direct combat with Yemen’s Houthi rebels, and Iran itself is leaning more on its regional proxies than on any direct exchange with the US.

Sitting at a distance from the region, here is how I read these developments.

The US is stepping back, at a cost it is choosing not to bear again

The US is genuinely reducing its footprint in the region. It is going ahead with a complete troop withdrawal from Iraq by the end of this month, and it has been pulling back the air-defence assets stationed near Iraqi Kurdistan rather than replacing what Iranian strikes destroyed earlier this year. American bases and radar systems took real damage during the opening months of the war, and the retreat reads as much like a costly re-think forced by Iran’s missile reach as it does a deliberate strategic choice. Either way, the direction is the same: a smaller American footprint, and no urgency to rebuild the old one.

Saudi Arabia is buying insurance, but the policy has no fine print yet

Saudi Arabia’s answer has been the Mecca Joint Defence Agreement, signed in August with Turkey and Pakistan, which promises that an attack on one signatory is an attack on all — an Article 5 for the region, at least on paper. The trouble is that the pact has no joint command, no standing force, and no publicly disclosed trigger mechanism. That gap is precisely why the Houthis have felt free to keep striking Saudi oil facilities through August and September, even after the agreement was signed. Until Riyadh, Ankara and Islamabad fill in the operational detail, the alliance is more of a signal than a shield — and every GCC state now has to think seriously about its own defence, because the American umbrella is visibly folding.

A regional war, not (yet) a world war

For a few weeks earlier this year, this conflict looked capable of pulling in the whole world — China and Russia lending Iran diplomatic and material cover, Turkey drawn in as a NATO member, and America’s own NATO allies under pressure to show up. That risk has receded. The BRICS summit that just wrapped up in New Delhi is as good a marker as any: the bloc’s joint declaration called for restraint in West Asia and protection of trade and energy flows, with China, Russia and Iran all at the same table making conciliatory noises.

What is left looks less like a great-power stand-off and more like an old-fashioned regional contest — Persians, Arabs, Turks, Kurds and Jews working out, the hard way, who controls the trade routes and the oil beneath them. Each of these carries a pride of lineage and ancestry that a shared religion. Yemen alone has seen tens of thousands displaced in the past month, and Saudi Arabia is reportedly readying a full-scale offensive. The conflict is narrowing in its cast of characters, not in its intensity. If the American buffer keeps thinning at this pace, I would not be surprised if we are talking about redrawn maps within a year or two — Houthi forces have already taken Perim Island and the port of Mocha, and those are real territorial changes, not symbolic ones.

Pakistan: indispensable card, weak hand

Pakistan’s position in the Mecca agreement is genuinely a case of the game not being playable without its bat and ball. Saudi Arabia brings the money, Turkey brings the hardware, and Pakistan brings manpower and its status as the only nuclear-armed country in the Muslim world — a card no amount of Gulf capital or Turkish drones can substitute for. That makes it indispensable to the alliance on that one dimension. It does not make Pakistan a strong player overall. Its own foreign exchange reserves needed a $3 billion emergency infusion from Saudi Arabia as recently as April this year to stay stable, and its economy remains structurally dependent on the same Gulf patron it is now committed to defend. And for all the shared faith, Pakistan is ethnically and historically apart from the Arab, Persian and Turkic core of the region — its seat at this table has been bought with deterrence and troops, not kinship, and that distinction tends to matter once real decisions about sacrifice have to be made rather than treaty text signed. Holding the one card that makes the alliance possible, while remaining fragile and an outsider on every other count, is not a contradiction. It is exactly the position Pakistan is in.

India’s hedge is intact — the mediator role is not yet earned

India has played this well so far, prioritizing energy security and the safety of its diaspora over taking sides in a war that does not clearly serve its interests either way. I expect that posture to hold. Where I would be more cautious is the idea that this naturally earns India a mediator’s seat at the table. India’s diplomatic capital in this conflict is real, but as a peacemaker it has not yet been tested.

What this means for the portfolio

Crude and freight remain the transmission channel into India. Watch Bab-el-Mandeb and Hormuz transit data as closely as Brent itself — a route disruption moves faster than a price chart.

A shrinking US security umbrella raises the medium-term risk premium on Gulf-exposed remittances, contracts and diaspora employment — not a near-term shock, but a slow bleed worth pricing in.

Defence and energy-security themes in India (domestic defence manufacturing, refining diversification, strategic reserves) get a structural tailwind from a world where regional powers, not the US, underwrite their own security.

Resist the “peace trade.” A narrower conflict is not a resolving one, and positioning for a quick de-escalation in oil or Gulf-linked equities has been a repeated mistake through this war.

A closing thought

Kautilya’s Arthashastra laid out the mandala theory of statecraft some 2,300 years ago: your immediate neighbor is your natural rival, and your neighbor’s neighbor is your natural friend. That is more or less the geometry Iran, Saudi Arabia, Turkey and Pakistan are redrawing in real time, ring by ring. India sits outside that immediate circle — not by accident, but by a policy choice made and held since independence — and that distance is precisely what gives it the luxury of choosing when, and whether, to step in.

 

Mr. Bond stirring the markets

Mr. Bond has been misbehaving again, and this time he means it.

Earlier this week, the yield on the US 10-year treasury note strolled past 5%. That is the highest this benchmark has traded since October 2023, and on a closing basis, the highest since 2007 — before the world had heard of Lehman Brothers. Even at the worst of that bond rout, the 10-year peaked closer to 4.3%. The last time yields genuinely lived at these levels was when George W. Bush was still in the White House.

The move has not happened in isolation. The 2-year yield, which tracks the Fed's own rate path far more closely than the 10-year does, is sitting near 4.7%, its highest since mid-2024. That leaves the 10-2 spread — the gap between long and short paper — at roughly 32-33 basis points. This number gets thrown around a lot as a recession signal, so it is worth being precise about what it says and does not say.

A negative 10-2 spread has come before every US recession since the mid-1950s. That much is fair to say. But the lead time between inversion and the actual downturn has varied enormously — anywhere from under a year to well over two — so it is a warning bell, not a countdown clock. And right now, the spread is not negative. It is positive, and has been widening out from the deep inversion we lived through in 2022-24. That widening is not automatically good news either. It can mean two very different things: investors betting on strong future growth (a “bull steepening” driven by rate cuts), or investors demanding more compensation to hold long-dated paper because they are worried about deficits, debt supply, and inflation that will not go away (a “bear steepening”). What we have today looks far more like the second kind.

It is interesting to note that in 2018 10-2 spread were around 30bps, but through 2018, this spread was not widening toward this level — it was narrowing toward zero, compressing from the high-50s in early 2018 to just over 10 basis points by December, as the Fed pushed through the last hike of a long, well-telegraphed cycle. Today's setup is the opposite in an important way. The Fed had already been cutting rates through the back half of 2025, brought the funds rate down to 3.50%–3.75%, and then paused. What is rattling the market now is the real prospect — priced at somewhere near 85–90% odds going into tomorrow's meeting — that the Fed reverses course and hikes, its first increase since 2023. That would not be the tail end of a mature tightening cycle, the way 2018 was. It would be a fresh, oil-shock-driven restart, with the disruption in the Gulf and crude prices near $100 a barrel doing much of the work of keeping core inflation uncomfortably close to 3.5%, well above the Fed's target. The mechanism rhymes with 2018. The stage of the cycle does not.

Either way, the transmission into the real economy is fairly mechanical. The 30-year fixed mortgage rate has already climbed into the high-6% range, its highest in about a year, and continued pressure on the 10-year could push it further toward, and perhaps past, 7% — a slower grind than an overnight jump to 7.5–8%, but a real drag on housing activity all the same. Corporate borrowers rolling over debt face steeper coupons, which eats into margins and dampens the appetite for fresh capital expenditure. And the fiscal arithmetic gets less forgiving by the day. With the stock of US federal debt as large as it now is, every extra 25–50 basis points on the long end translates into a meaningfully larger annual interest bill, competing for the same budget as everything else Washington wants to spend on.

For Indian investors, none of this happens in a vacuum. Two channels matter most. First, when US treasuries pay close to 5% risk-free, the relative appeal of Indian equities and debt for foreign portfolio investors takes a hit — capital that might otherwise chase emerging-market returns has a much easier, safer alternative at home. Second, Indian companies that lean on external commercial borrowings to fund growth now face a higher cost of capital, since global benchmark rates set the floor on what they pay, regardless of where India's own monetary policy stands. There is a third, less discussed link too: the same conflict that is pushing up oil prices and stoking US inflation is also pushing up India's import bill and leaning on the rupee — a thread I have been following separately, and one that ties directly back into this bond story.

My own base case is that Indian markets stay under pressure as long as developed-market yields hold near these levels, and that a great deal now hinges on what the Fed actually does tonight rather than on what it has already done. A hike would confirm the market's fear that this is a genuine reacceleration in the tightening cycle. A hold, even a reluctant one, would at least buy some room.

Investor takeaways

Watch tonight’s Fed decision, not just the bond move that has already happened; the market has moved from a coin-flip to pricing a hike as the favorite, and the reaction to either outcome will matter more than today's headline yield

Rate-sensitive Indian sectors — real estate, NBFCs, and companies with meaningful external commercial borrowings — deserve closer scrutiny on funding costs in this environment

Treat the positive, widening 10-2 spread as a signal of fiscal and inflation risk, not as an all-clear on recession; a steepening curve driven by term premium is a different animal from one driven by genuine growth optimism

Stay selective on FII-dependent segments of the market until developed-market yields show signs of stabilizing.

 

Q1FY27: Earnings are better, but the easy part may be over

The June quarter has turned out better than what the market was expecting. Corporate earnings were mostly stronger, financials remained healthy, metals made a sharp comeback, and several consumer-facing businesses showed that demand has not completely disappeared. At the same time, the quarter also tells us why the earnings recovery should not be taken at face value.

A large part of the improvement came from a handful of sectors and companies. Oil marketing companies, aviation, parts of pharmaceuticals, staples and infrastructure remained weak. Commodity-linked earnings also played a disproportionately large role in the improvement. Therefore, the headline number is much better than the underlying economy may suggest.

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The most useful number is not the headline 18% growth. It is the fact that earnings beat expectations across a broad spectrum of the market. In the large-cap universe, the proportion of companies beating expectations was materially higher than in mid- and small-caps. This is important because it suggests that the recovery is not merely a small-cap phenomenon.

Where did the growth come from?

Financials remain the backbone of the earnings cycle. Bank credit growth has been strong, asset quality is benign and lower provisioning has helped profits. NBFCs have also continued to grow their loan books, particularly in secured retail, gold loans and vehicle finance. The important change is that growth is increasingly coming with better asset quality.

Metals were another major contributor. The sector moved from being a relatively small contributor to incremental earnings to one of the largest. This is good for aggregate profits, but it is also a reminder that commodity earnings are cyclical. A strong quarter does not automatically mean a durable structural improvement.

Consumer discretionary was a pleasant surprise. Paints, jewelry, quick-service restaurants and premium alcoholic beverages showed resilience. Real estate also continued to report healthy collections and profitability, even though the absence of large launches affected quarterly presales.

Technology was better than the headline commentary might suggest, but not strong enough to become an earnings leader. Revenue growth remained modest, decision-making cycles were long and deal sizes were under pressure. AI-related work, vendor consolidation, utilization and currency helped margins.

And where was the weakness?

Oil marketing companies were a major drag. Revenue was strong, but marketing losses and LPG under-recoveries hurt profitability. Aviation was another conspicuous weak spot. Pharmaceuticals delivered healthy domestic volumes, but US pricing pressure and lower contribution from key products kept profits subdued.

Infrastructure remains the weakest link in the investment story. Project awards, particularly in roads, were weak and delays in appointed dates affected execution. At the same time, elevated costs and working-capital pressure hurt margins. Capital goods had better order flows, but commodity costs, freight and execution expenses continued to prevent a clean margin recovery.

Automobiles sit somewhere in the middle. Demand is healthy, helped by affordability, exports and a favorable product mix, but commodity inflation has squeezed margins. The second half of FY27 will be important because the benefit of GST rationalization will have to be measured against a higher base.

What do the FY27 and FY28 estimates say?

The broad market consensus after the 1QFY27 earnings is remarkably similar: FY27 and FY 28 are expected to be decent years with 14-15% earnings growth for Nifty 50. The Nifty 50 EPS is estimated to be in the range of 1230-1240 for FY27e and 1415-1450 for FY28e.

There is therefore no earnings recession in sight. The more conservative sector work also points to healthy earnings growth in lenders, metals and telecom, while consumer discretionary, real estate and capital markets retain strong medium-term growth characteristics.

But there is an important qualification. One set of estimates implies that the Nifty needs about 16–17% earnings growth in the remaining nine months of FY27 to deliver the full-year forecast. That is possible, but it is not a low hurdle.​

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The catch: quality of earnings

This is where I would be slightly careful with the celebration. The earnings recovery is real, but the quality of the incremental earnings is not uniformly high.

Commodity sectors are doing a lot of the heavy lifting. Metals, non-OMC energy and some chemical businesses have benefited from favorable prices, inventory effects or a low base. These can make the aggregate Nifty number look better without necessarily telling us that the domestic economy has entered a powerful earning upcycle.

The second issue is the gap between revenue growth and profit growth. In several sectors, companies are still fighting input-cost inflation, freight costs, wage costs or weak pricing power. A good part of the improvement is therefore coming from operating efficiency, lower provisions, currency benefits or a favorable base rather than a broad-based expansion in pricing power.

The third issue is that the market already knows about the earnings recovery. The forecasts of roughly ₹1,230–1,240 Nifty EPS for FY27 and ₹1,420–1,450 for FY28 are no longer a surprise. If earnings merely meet these numbers, investors will still have to contend with the valuation they are paying for them.

What I take away from Q1

The June quarter has materially reduced the fear of an earnings slowdown. That is important. The financial sector is healthy, domestic consumption has not collapsed, metals have recovered, telecom earnings are improving and several investment-linked businesses continue to have strong order visibility.

However, I would not read the quarter as confirmation of a broad-based economic boom. Infrastructure execution is still weak. IT demand is not yet robust. Staples remain soft. Pharma has issues in the US market. And commodity-linked profits are doing more work than one would ideally like.

My reading is therefore simple. FY27 is likely to be a better earnings year than FY26. FY28 could be better still. The estimates of 14–16% earnings growth are credible, but they leave less room for disappointment than the headline Q1 numbers might suggest.

For investors, the important question is no longer whether earnings will grow. They probably will. The more difficult question is whether earnings will grow fast enough to justify the prices being paid for them. 

The missing philosophy

India has long worn the title of a land of philosophers, and worn it honestly. Where much of Western philosophy busied itself with metaphysics — the nature of being, the structure of reality — Indian philosophy, for the most part, stayed close to the ground. It asked a narrower, more urgent question: how does a human being get free of sorrow? Buddha, Mahavir Swami, Guru Nanak and others who worked out answers to that question have, over time, been elevated by their followers to a status close to divine — the Buddha is counted as an incarnation of Vishnu in several Hindu traditions, and popular devotion to all three has often gone further than the founders themselves ever claimed for their own teaching. Whether or not that elevation was the intent, it tells you how completely these men solved something real: people concluded nothing less than God could have done it.

What strikes me, though, is how long it has been since India produced anyone in that lineage. It has been decades since a philosopher of any real originality emerged. We have reached a point where even people who genuinely understand the old texts are scarce, while people who repackage folklore as philosophy — pulp versions of a deep tradition — get celebrated as saints and scholars. The vessel survives; what it was built to carry has mostly drained out.

The same drift, in science

I see a parallel drift in science and technology globally, and it is worth sitting with even though it is easy to overemphasize. Consumer hardware — the appliances that define daily life — has not seen a genuinely new category since roughly the 1960s. The washing machine, the fridge, the fan, the air conditioner, the telephone, the motor car, the aeroplane: all invented before then. Everything since has been refinement — smaller, faster, more integrated, more connected.

Medicine shows a similar, narrower pattern worth naming carefully. Smallpox, tuberculosis, plague and leprosy did get real answers — a vaccine, antibiotics, multidrug therapy — and those are genuine cures, not something to understate. But look at where research money and attention have gone since, and the balance has visibly tilted toward managing chronic, lifestyle-linked disease — the kind plausibly worsened by the food, air and pace of life that industrial science itself produced — rather than toward the kind of outright cure that ended smallpox. Managing a problem indefinitely is also, conveniently, a much better business model than solving it once.

One reason for this, in my view, is that science has drifted loose from philosophy and is now steered almost entirely by market economics. Profit, not human welfare, decides what gets built next. That is not a criticism of any single company or scientist — it is closer to a structural observation about incentives, and it sets up the point I actually want to make, which is about how we in investing use the word “philosophy” ourselves.

A slide, not a philosophy

Every investment manager’s sales presentation carries a slide titled “Investment Philosophy.” I went through more than fifty of these over the past couple of weeks, and noticed something: the slide is almost never about philosophy. It is a list of boundaries and methods — what the fund will do, what it would not do, what process it follows. Useful information, certainly. But philosophy, properly understood, is not a list of rules. It is a willingness to question the premise underneath the rules.

Two of the most crowded trades in Indian markets today are precision engineering and defence manufacturing. Analysts and fund managers are underwriting multiple decades of uninterrupted growth for both, and pricing companies as if that growth is close to guaranteed. What I have not come across, in any of the research I have read on either theme, is even a footnote asking whether the underlying technology, product, or need could itself fade. It is not an unreasonable question. A decade from now, a meaningful share of conflict could be waged in cyberspace rather than on physical terrain, which would make a slice of conventional hardware less central than the market currently prices it to be. Fibre and composite parts are already displacing metal in engineering applications that used to be metal by default — metal injection moulding is one example — and that substitution has room to run further. I raise this as a live possibility to be underwritten against, not as a forecast; the point is that the possibility is being priced at zero.

What philosophy should actually do

To my mind, an investment philosophy worth the name has to do three uncomfortable things. First, it must question the growth and existence assumptions baked into a valuation — not just accept the multi-decade growth story a management team or a sell-side note hands you, but ask what has to remain true for that story to hold. Second, it has to be honest about the assumptions and limitations of the investor putting up the capital — most of us are not equipped to independently verify a decade-out technology thesis, and a philosophy that pretends otherwise is not being honest. Third, and perhaps most important, it has to hold the fund manager to the commitment actually made to the investor, rather than to the commitment implied by a glossy slide.

None of this is an argument against precision engineering or defence as businesses, and it isn’t a comment on any specific company or fund — plenty of these businesses will keep growing for good reasons. It is an argument for treating “philosophy” as a genuine discipline of doubt rather than a marketing slide, in the same way India once treated it as a genuine discipline for getting free of sorrow. We have let the word survive while quietly hollowing out what it was supposed to do. That, more than any single stock or sector, is the gap worth noticing.

Cash, Patience and the Apocalypse Trade

I’m watching one date on the calendar more closely than anything else right now: August 27–29, when Fed Chair Kevin Warsh delivers his first Jackson Hole address since taking over from Jerome Powell in May. A slight hint of hawkishness there could force a serious rethink for a lot of investors who, in my view, are still positioned for continuity — an accommodative Fed and an unbroken AI/data-center trade. It’s worth remembering that Warsh has already made a point of withholding forward guidance and that his committee has flagged the possibility of a hike, not a cut, to counter the inflation spike coming out of the West Asia conflict. That is not the backdrop a market priced for calm usually gets.

One data point that sums up how one-sided this positioning has become: the most recent round of large-fund portfolio disclosures showed a decisive pivot deeper into AI infrastructure — data-center operators, cloud capex plays, and chip-adjacent names — even as some of last cycle’s semiconductor favorites were being sold down. When funds of that size are still adding to a single theme this late in the cycle, it tells me positioning risk, not conviction, is doing a lot of the buying.

Zoom out, and the bond market is telling a simpler story: something has to give. Either asset prices crash and deflation sets in, or a large, coordinated QE program gets launched to buy bonds back down. It’s worth remembering that as recently as five years ago, close to $18 trillion of developed-market long-dated government debt traded at a negative yield. We have travelled a very long way from that world.

​The 30-year US Treasury yield touched 5.31% this month — its highest level since June 2003. Japan’s 30-year is at a historical high of its own. A huge cohort of fund managers across the US, Europe, and Japan have simply never operated in a 4.0–5.5% long-yield world, and by my base case, they will not like what the history books tell them about what happens next. Savers, endowments, pension funds, and insurers are all searching for a light at the end of the tunnel. The argument that high inflation lowers the real cost of that debt offers savers little comfort — though fiscal policymakers will certainly take what relief they can get. Financing the fiscal profligacy unleashed since Covid was always going to get harder from here; it is now becoming a genuine strain.

The global financial crisis was met by a coordinated G-20 response that helped prevent a repeat of 1929. I don’t see that same coordination available today. The current state of US relations with the rest of the G-20 is not exactly fertile ground for a joint monetary-and-fiscal rescue, should markets freeze up again.

The optimist’s scenario

By my read, a genuinely benign outcome from here would require all five of the following — and that’s a demanding list:

·         an immediate cessation of hostilities in West Asia, with a full US withdrawal from the Strait of Hormuz and a resulting fall in energy prices;

·         an end to the recurring tariff uncertainty out of the US, freeing up global trade;

·         a meaningful, coordinated bond-buying program (QE) from the Fed, ECB, and BoJ together to bring yields down;

·         a negotiated settlement between Russia and Ukraine, easing the tension in Europe; and

·         an orderly, controlled unwind of the overheated AI/data-center trade.

My base case

A more realistic outcome, in my view, looks like this:

·         a material correction in asset prices, led by a disorderly unwind in the AI/data-center trade, followed by a fragmented (not coordinated) QE response once the damage is done;

·         continued stalemate in both West Asia and Ukraine; and

·         elevated energy prices — Brent averaging around $85/bbl — for at least the next couple of quarters, before demand destruction and alternative shipping routes ease the supply constraint. That figure isn’t a contrarian call on my part; it’s roughly where the EIA’s own outlook already sits, which only adds to my conviction here.

Notice the sequencing in my base case: I’m not expecting central banks to ease into live, war-driven inflation out of choice. I expect them to be forced into it — a crisis-triggered QE that follows a disorderly correction, not one that pre-empts it. That’s an important distinction, because it means the path to easier money likely runs through a genuine drawdown first, not around one.

How to navigate through this

A disorderly correction in US/global AI names would hit Indian equities too. My preference into this kind of setup remains a larger allocation to cash and short-duration debt.

My best trade for the next six months is unglamorous: hold cash, be patient, and go all-in only when the sharp correction actually arrives and the world around you looks and feels like the apocalypse.

The balloon could pop faster than the market expects

A few weeks ago, I wrote about a group of people standing in a dark room, each holding a pin, none of them knowing whose hand would find the balloon first. I think I can now name one of the pins. It is called a rate hike.

This is not a small, one-line risk. It sits at the intersection of everything I have been tracking this month: India’s stickier-than-expected inflation, America’s own hawkish undertone, a US political calendar that could remove the last source of pressure on the Fed to go easy, and an AI investment cycle that has been priced for perfection. Put these together, and I think the probability of a rate-hike-triggered correction is higher than most portfolios are prepared for — even though I continue to believe that the longer-run destination for global monetary policy is easier money, not tighter.

Inflation is not cooling the way we hoped

India: a stall, not a reversal

July’s CPI print came in at 4.45% year-on-year, above where most estimates had it pegged, and above June’s 4.38%. Food inflation is running hot at 5.5%, durable food inflation has climbed to 5.1%, and even core inflation — stripping out food and fuel — is holding near 3.9%, with the ‘super-core’ reading (core excluding gold and silver) creeping up to 2.5%. None of these numbers is alarming in isolation. Together, they tell me the disinflation trend of the past year has stalled, not reversed, but stalled at a level still uncomfortably close to the upper end of the RBI’s comfort zone.

My own base case is FY27 CPI inflation averaging around 5%, with a genuine risk of topping 5.5% if the monsoon turns uneven in its closing weeks or crude prices find a bid again. On that math, it would not be unreasonable to expect ~50bps of cumulative tightening in 2HFY27 — a meaningful shift from a market that has spent most of this year debating rate cuts, not hikes.

The US: a hawkish Fed the market isn’t pricing in

The view that the Federal Reserve may hike interest rates by 50-75bps points before this year is out is strengthening gradually, against a Fed Funds futures market that is currently pricing in barely 25 basis points of hikes. That is a large gap between what I think is coming and what the market has actually priced in — and gaps of that size tend to close abruptly, not gradually, once the data forces the market to catch up.

In my view, successful policy needs many conditions to align at once — growth, inflation, credibility, fiscal discipline — while failure can come from any single one going wrong. Right now, resilient growth and sticky inflation are both arguing against the rate cuts the market has been hoping for, which is why my own reading of US rates and the dollar stays firmly on the hawkish side for the next two to three quarters, not the dovish one.

The political overlay nobody wants to say out loud

If the Republicans lose ground in this year’s US midterm elections, the Trump administration effectively becomes a lame-duck presidency for its remaining term. A weakened White House has historically had less leverage — political or otherwise — to lean on the Federal Reserve to keep money cheap. Whatever informal pressure exists today to ease policy in an election-conscious environment would diminish sharply once the electoral calculus behind such pressure disappears.

That matters because a Fed chair with a hawkish reputation, freed from midterm-related political pressure, has every incentive to hold the line on rates for longer than the market currently expects — partly on principle, partly to protect their own legacy. The direction of travel over the medium term may still be lower rates, for reasons I laid out a few weeks ago, but the road between here and there could run through more tightening first, not less.

Why a hike could pop the AI balloon faster than anyone expects

This is where the rate-hike story stops being an isolated macro debate and starts becoming a market-structure problem. Ruchir Sharma and Michael Burry, among others, have separately warned that if US rates move higher from here, the unwind of AI-linked positioning could be sharper and faster than currently priced. I think the underlying numbers explain why that warning has teeth. The RIC report by BoFA strategist digs deeper:

●    Capex without proof of productivity. AI capital expenditure is sitting at record highs relative to sales, while economy-wide productivity growth is running at just about 2.2% — barely above the roughly 2% average this economy has managed since 1987. By my own read, AI’s actual contribution to that number is only about 0.1 percentage point a year, a fraction of what the dot-com capex cycle delivered relative to its own spending. That is a very large bet resting on a very thin evidence base.

●    A crowded, one-way trade. Fund manager surveys consistently show semiconductors as the single most crowded trade in the market, cited by well over three-quarters of respondents, even after brief rotations toward defensives. Crowded trades unwind violently precisely because everyone is trying to exit through the same door at the same time.

●    Concentration risk in the index itself. The ten largest companies in the US market now represent more than $24 trillion, or roughly a third of the broad index. When an index is this concentrated, a reversal in mega-cap leadership does not stay contained to a sector — it drags the benchmark, and every fund benchmarked to it, down with it.

●    A discount-rate problem. AI and other long-duration growth stocks are priced on cash flows expected many years out. Higher rates mechanically shrink the present value of those distant cash flows more than they shrink the value of a bank or an energy company earning cash today. A rate hike does not just raise the cost of capital for AI companies — it re-prices the entire long-duration growth complex at once.

None of this means AI itself is a mirage. There are real, if narrow, productivity gains showing up in areas like software development, and history shows that transformative technologies — railroads, fibre-optic cable, shale — usually do create genuine value eventually, even when the first wave of capital that funds them is destroyed along the way. The risk is not that AI fails as a technology. The risk is that AI-linked equity valuations are pricing in a smooth, uninterrupted path to that value creation, and a rate shock is exactly the kind of event that interrupts smooth paths.

Reconciling this with my ‘more QE eventually’ view

Regular readers will remember that I have also argued the opposite-sounding case: that America’s over-levered household sector, its habit of rolling short-dated Treasury debt, and a banking system running low on reserves all point toward more monetary easing eventually — potentially a ‘super QE’ larger than 2008 or 2020. I still believe that. The two views are not actually in conflict; they describe two different points on the same timeline.

“What’s much less certain is what happens in the interval between ‘everyone knows QE is coming’ and ‘QE actually arrives.’ That gap is where currency stress, bond-market air pockets, and credit events tend to live.”

A rate hike in late 2026 or early 2027 would not contradict the eventual-easing thesis — it would be the disorderly middle chapter that forces the eventual easing to happen.

Higher rates now would be deflationary in their immediate effect: they would raise the cost of AI-related capex, slow the investment momentum that has been propping up GDP growth, and puncture the wealth effect that has kept US consumption resilient even as real household finances have deteriorated. That combination — weaker growth, a wounded wealth effect, and credit stress already visible in pockets of leveraged loans and private credit — is precisely the kind of shock that eventually forces a central bank’s hand toward emergency easing. The path there, though, could be considerably more painful.

Strategy

Indian Equity: Cut to underweight; trim froth. Nifty offers only moderate upside on my own math, and valuations are rich, so macro risk (rate hike + global AI shakeout) argues for buying dips, not chasing rallies. Reduce high-beta, high-PE, story-driven names; favor quality, cash-generative large-caps and domestic-demand plays over globally-linked cyclicals.

Global Equity: Cut exposure. Reduce concentration. Prefer diversified international and value-tilted funds over concentrated AI-themed funds.

Debt/Fixed Income: Rising rates hurt long-dated bonds first and hardest. Prefer accrual, short duration and high-quality corporate paper over long gilts.

Cash/Liquid Funds:  Overweight. Keep dry powder to redeploy if the ‘gap’ between hawkish talk and eventual policy easing turns disorderly. Liquid and ultra-short funds, not idle savings accounts.

(Note: I am not considering gold and cryptocurrencies in my strategy as my understanding of these assets is extremely poor. Each investor may consider these as per his\her understanding.)

The bottom line

The probability of a rate hike — in India, and more importantly in the US — is higher today than the market’s own pricing suggests. If that hike arrives while AI-linked valuations remain this stretched and this concentrated, the resulting correction could be faster and sharper than the consensus ‘soft landing, gentle AI cooldown’ narrative currently assumes. I do not think this changes the eventual destination — a more accommodative monetary regime once the strain becomes visible enough to force policymakers’ hands. But the road between here and there is the part investors actually have to live through, and it is worth positioning your portfolio for a bumpier middle chapter: equity that leans toward quality and away from crowded themes, debt that stays short in duration; and adequate dry powder (cash).

As always, I could be wrong about the timing, the trigger, or the severity — markets have a way of staying irrational for longer than any single argument accounts for. But positioning for a plausible, non-trivial risk is not the same as predicting it, and that distinction is the whole point of risk management.

The Balloon in the Dark Room

Yesterday’s post drew a wider response than I expected, and I am grateful for it. Most readers found the argument thought-provoking and timely; a smaller number found it unnecessarily alarming and short on substance. Both reactions are fair, and I want to address the second group directly rather than let the disagreement sit unanswered.

When the numbers stop explaining themselves

Every investing career eventually runs into a stretch where the spreadsheet stops being a reliable guide. Valuation models still produce an output, but the confidence behind the output erodes, because the inputs themselves — growth rates, discount rates, terminal assumptions — are being asked to do work they were never designed for. In those stretches, experienced investors tend to fall back on something closer to pattern recognition than arithmetic: a sense, built from having sat through a few cycles, that the character of the market has shifted even before the numbers confirm it.

My sense is that we are in exactly that kind of stretch. It is not a single data point driving that view; it is the accumulation of several stress signals appearing at the same time, each individually explainable, but collectively unusual.

The signals worth naming

Fiscal sustainability. In several major economies, government deficits and debt-servicing costs have reached levels that would once have triggered a sharp market response. Instead, they have been absorbed with surprising calm, largely because interest rate cycles and demand for sovereign debt have so far cooperated. That cooperation is not guaranteed to continue indefinitely.

Sticky inflation. Headline inflation has come off its post-pandemic peaks, but the underlying components — services, wages, shelter — have proven far stickier than central banks initially projected. This matters because it narrows the room policymakers have to cut rates aggressively if growth weakens, which is precisely the tool that has rescued markets in past downturns.

Stagnating growth. Several developed economies are showing growth rates that are positive on paper but weak beneath the surface — propped up by government spending, a handful of mega-cap companies, or one-off factors, rather than broad-based private investment.

Stretched growth valuations. A narrow set of companies, heavily concentrated in AI-linked infrastructure, is being priced as though its current growth trajectory extends cleanly for a decade or more. Multiples of this kind have historically required near-perfect execution to be justified, and near-perfect execution is a high bar over a long horizon.

Rising credit stress. Pockets of the credit market — leveraged loans, private credit, and select corporate sectors — are showing early signs of strain: widening spreads, downgrades, and refinancing difficulty. Credit stress is usually a leading indicator rather than a lagging one; it tends to show up before equity markets acknowledge a problem.

Geopolitics and trade. Tariff uncertainty, shifting alliances, and logistics disruption are adding a layer of unpredictability to corporate planning that did not exist to the same degree a decade ago. Supply chains built for efficiency are being rebuilt for resilience, and that transition is expensive and slow.

Volatility across unrelated assets. Semiconductor equities, silver, bitcoin, and the SpaceX IPO have each delivered sharp, painful drawdowns in recent months. What is notable is not any single move, but that the losses have appeared across asset classes that are not normally correlated — a sign that liquidity and risk appetite, not asset-specific fundamentals, may be the common thread.

AI’s unresolved business model. Artificial intelligence has genuinely disrupted several legacy industries, and that part of the story is real. What remains unproven is whether the AI buildout itself — the capital expenditure, the compute, the infrastructure — will generate a return that justifies its cost on any reasonable timeline. Disruption of others’ business models is not the same as having a durable one of your own.

The balloon in the Dark Room

None of these signals, on its own, is a crisis. That is exactly what makes the moment harder to read, not easier. It feels like a group of persons standing in a dark room holding pins in their hands, knowing there is a balloon somewhere above, without knowing which pin — or whose hand — will find it first. The probability that no pin ever finds the balloon is not zero. But it is not the base case either, and treating it as the base case is where I think the complacent reading of this market goes wrong.

Why this could be a combination, not a repeat

Markets rarely repeat a crisis exactly; they tend to borrow ingredients from more than one. My working view is that if a serious correction unfolds from here, it is more likely to resemble a blend of three earlier episodes than a clean replay of any single one.

2008 and 2000, combined. The 2008 crisis was fundamentally a credit crisis — leverage built on assets whose value was assumed rather than tested. The 2000 crisis was a story of capital pouring into business models that had not yet proven they could generate durable cash flow. The current AI investment cycle carries elements of both: enormous capital expenditure, increasingly financed with debt and vendor-financing arrangements, directed at business models that remain commercially unproven at scale.

1997 and 1998, revisited. The Asian financial crisis and the collapse of Long-Term Capital Management were both, at their core, stories of a strengthening US dollar exposing leverage and mispricing elsewhere in the system. A materially stronger dollar today would put similar pressure on precious metals and crypto assets, both of which have attracted significant speculative positioning over the past two years.

1987, echoed. Black Monday was less about a single fundamental trigger and more about mechanics: rising rates, unresolved trade and currency disputes, stretched valuations, and — critically — automated trading systems that amplified a decline rather than cushioning it. The scale and speed of algorithmic execution in markets today is far greater than it was in 1987, which means the mechanical amplification risk, if anything, is larger, not smaller.

A downturn that borrows credit stress from 2008, unproven business models from 2000, dollar-driven deleveraging from 1997, and mechanical amplification from 1987 would not look identical to any one of those events. It could plausibly be sharper and more disorienting than any of them individually, precisely because it would be arriving from several directions at once rather than one.

What the twelve months before every crash have in common

It is worth revisiting how each of these episodes felt in the twelve months before they began, because the emotional texture tends to rhyme even when the underlying causes differ. In 1996, 1999, and 2007, the dominant mood was not fear — it was irritation with anyone who raised the possibility of a top. Alan Greenspan’s irrational exuberance remark in December 1996 was widely dismissed at the time, and the market ran for several more years before the reckoning arrived. The same pattern held in 1999, and again in 2007, when concerns about housing and credit quality were treated as the fringe view rather than the mainstream one.

I do not think 2026 sounds meaningfully different from those years. The specific worry differs each cycle, but the response to the worry — dismissal, followed by irritation, followed eventually by recognition — has been remarkably consistent. That consistency is itself part of the argument, not a footnote to it.

A closing note

None of this is a prediction with a date attached, and it should not be read as one. It is a personal, opinion-based on reading of conditions that I believe warrant more caution than the current mood in markets reflects. Markets can, and often do, remain irrational for longer than any individual view accounts for, and I could simply be wrong. Regardless, I would like to be cautious and brace myself for the “reset”. Also, I completely respect the disagreement.

 

Getting ready for the “reset”

Shravan has just begun. In the Hindu calendar it is the month dedicated to Shiva, the ascetic among the gods, and across northern India devotees mark it by giving up ordinary comforts, keeping fasts, and walking long distances to fetch water from the Ganga to offer at their local Shiva shrine. Poets have long used the same month as a backdrop for separation and longing between lovers — a season built, in one way or another, around waiting for something to end so something else can begin.

That idea of an ending that clears the way for a beginning is what keeps pulling me back to one particular story from Hindu mythology. I have told it before, and I want to tell it again, because I think we are approaching another one of those endings — a serious reset in asset prices.

The Churning of the Ocean

The devas and the asuras — the gods and the demons — had been at war for so long that both sides were spent. Neither could win, and neither had anything left to fight with. Exhausted, they turned to Vishnu for a way out. His advice was unusual: stop fighting each other and churn the cosmic ocean together instead, using Mount Mandara as the churning rod and the serpent Vasuki as the rope. Whatever the ocean gave up, they would share.

The churning was long and violent, and the ocean did not give up its treasures gently. The first thing to surface was Halahala, a poison so potent it threatened to destroy everything before the churning had even produced anything of value. Shiva volunteered and swallowed it, holding it in his throat rather than letting it pass further. Only after the poison was contained did the ocean release what everyone had actually been hoping for: wealth, wish-fulfilling treasures, and finally Amrita, the nectar that grants immortality.

Vishnu made sure the nectar went to the gods alone, tricking the demons out of their share so the balance of power would not tip too far. The gods grew stronger — but the story doesn’t end there. In Puranic literature, whenever the gods grew careless or forgot the common good, they were beaten back and had to be rescued again, usually after a long stretch of humility, by Vishnu, Shiva, or the Mother Goddess. Power gained is never kept automatically; it has to be re-earned.

Why this isn’t just a story

I don’t think this is a tale meant only for a festival evening and then forgotten. It maps unusually well onto how societies actually respond to shared crises — a prolonged war, a pandemic, a depression. Faced with a problem too big for any one side to solve alone, people are forced into collaboration: vaccines get developed, institutions like the UN get built, deterrents and safety nets and global markets get put in place. That collaboration is the churning.

In economic terms, the churning shows up as the stretch that follows a downturn — the period of loose money, aggressive investment, and heavy borrowing that policymakers and businesses turn to once they’ve run out of other options. Everyone involved does things they would never do in calmer times. Capacity gets built at a scale that looks absurd in hindsight, and asset prices climb to levels no conventional model can justify. Markets call this a “bubble”. And exactly like the myth, a bubble produces both nectar and poison at once — except the poison, this time, isn’t shared equally. It’s the financial investors who tend to drink it, while the productive capacity that got built along the way — the factories, the roads, the networks — usually survives the bust and keeps paying dividends to society long after the investors who financed it have been wiped out.

India’s own growth is a good illustration. It’s hard to picture the country’s IT and services industry reaching global scale without the late-1990s technology bubble that funded it. The 2000s housing, road, power, and cement capacity built across the country owes a lot to the subprime credit boom in the West. And the cheap capital that has since flowed to Indian entrepreneurs traces back, in no small part, to years of quantitative easing after the global financial crisis. In every case, the capacity outlasted the bubble that financed it — even as many of the entrepreneurs and financiers who built it ended up considerably poorer.

AI as the current churning

The years since the global financial crisis have been marked by weak growth, low inflation, aging populations, and stretched government budgets — a problem the Covid-19 pandemic made considerably worse. The scale of research and, especially, debt-financed capital that has since gone into building out artificial intelligence looks to me like the same kind of churning: an attempt to force a solution to a problem no single company or government could solve alone.

If the pattern holds, both the nectar and the poison of this churning are close to the surface now. The nectar is real productivity gains — the AI applications that genuinely make businesses more efficient and profitable, and that will go on rewarding the companies and investors behind them for years. The poison is what tends to follow an investment cycle like this one: debt that several AI developers won’t be able to service, business models that turn out not to be financially viable, and job losses at the legacy companies AI displaces.

My own reading is that financial investors, in particular, should brace for the poison stage — the point where asset prices reset and the excesses built up over this cycle get worked out of the system. Putting a date on that is guesswork by nature, but if I had to name one, I’d say from the second quarter of 2027.

Also read

Progress, Peril and Robustness – 1

Progress, Peril and Robustness - 2

Progress, Peril and Robustness - 2

Continuing from yesterday (see Progress, Peril and Robustness – 1)

Investment implications

A BIS report provides a clear map of where systemic risk is building, and reading it is a useful discipline before you decide how much risk to carry and where. Here is how I would prefer to incorporate the four pressure points highlighted in the BIS 2026 annual report in my investment strategy.

Not assuming the disinflation trade is safe

Markets have priced in resumption of the disinflation path that was underway before the Hormuz shock. The BIS’s own work suggests otherwise — energy shocks of this size have historically produced inflation effects that outlast the shock itself by a year or more, and the mitigating factors this time (anchored expectations, looser labour markets) are real but not guaranteed to hold if the shock persists. My own view: don’t fully unwind inflation hedges just because oil has pulled back from its peak. Real assets, select commodity exposure and inflation-linked instruments may still be relevant in a diversified book.

Separate the technology story from the financing story

I remain a believer in AI as a genuine productivity technology — the BIS’s own task-level studies show real efficiency gains. What worries me is not the technology; it is the financing structure around it. Circular financing arrangements — where the same dollar of capital seems to be creating revenue for multiple related entities — are exactly the kind of opacity that precedes a repricing. The practical takeaway: be diversified within your AI exposure rather than concentrated in the handful of hyperscalers and their closest financing partners, and treat any single-stock AI position as a venture-style bet, sized accordingly.

Private credit is not free lunch

The report flags that direct lending funds have quadrupled their exposure to AI and IT borrowers over five years, often with similar pricing and tenor despite growing concentration risk. Retail investors who have moved into private credit funds chasing yield should understand that liquidity terms in these vehicles can become binding constraints exactly when you need liquidity most. This is a reminder to price illiquidity properly rather than treat the extra yield as a free lunch.

Expect more volatile sovereign bond markets, not fewer

The BIS’s description of a fragile fiscal-financial nexus, where bond market liquidity can evaporate quickly, is a structural reason to expect higher volatility in developed market sovereign bonds over the coming years — not a one-off event, but a recurring feature. For fixed income allocations, this argues for staying closer to the shorter and intermediate end of the curve, and being selective about duration bets even when yields look attractive, since the BIS itself flags that governments may increasingly need central bank backstops to keep these markets functioning smoothly.

Reading the global report through a domestic lens

None of the four pressure points above originate in India, but all of them touch us, and in ways worth spelling out separately.

·         Energy dependence is our biggest transmission channel. India imports the overwhelming majority of its crude, and the BIS’s own exposure analysis places India among the emerging economies most affected by Hormuz-related disruption scenarios. A sustained oil price premium — even a modest one, well short of the panic peak — shows up quickly in our import bill, the rupee and the fiscal arithmetic. This is not a new theme for readers of this blog; it is the same fiscal-currency link I have written about before, just now driven by a fresh external trigger rather than a domestic one. (Read here and here)

·         Our macro buffers are genuinely better than in past crisis episodes, but they are buffers, not immunity. Strong bank balance sheets, healthy capital ratios and steady domestic institutional flows into equities have absorbed shocks well so far. That is a real strength. But a BIS report that flags global inflation persistence and fiscal fragility as base-case risks, not tail risks, argues for treating our own resilience as a cushion to lean on, not a reason for complacency about valuations.

·         India’s IT services sector sits directly in the AI capex cycle’s crosswinds. A continuation of the hyperscaler spending boom is a tailwind for the sector through cloud migration and AI-enabled services demand. But the BIS’s own warning about the sustainability of that capex — debt-funded, concentrated, partly circular — means a sharp AI capex slowdown, should it materialize, would hit sentiment toward Indian IT stocks even though our companies are several steps removed from the actual financing risk. Worth distinguishing between the operating exposure (mostly indirect and manageable) and the sentiment exposure (which can move faster than fundamentals).

·         The dollarization risk the BIS discusses is low for India today, given capital account management, but it is worth watching over a longer horizon as stablecoin regulation evolves globally and domestic crypto/stablecoin adoption picks up at the margins. This is more a five-year theme than a this-year theme.

·         On fixed income, the domestic story is somewhat more comfortable than the global one — our own fiscal consolidation path has been more disciplined than many advanced economies’, and RBI’s recent Financial Stability Report corroborates that domestic financial stress remains low by historical standards. But global yield volatility, if it persists, will still spill into our markets through FPI flows and benchmark repricing, so treat domestic bond market calm as conditional on the external environment staying orderly, not as a given.

To conclude: India’s relative position within this report is a source of comfort, not complacency. The buffers are real, but the report is fundamentally about a world where shocks have become more frequent and financial systems have become more interconnected in ways that are hard to see until they matter. Being well-diversified, avoiding concentrated bets on any single global narrative — AI, energy, or otherwise — and keeping some genuinely defensive assets in the mix remains the right posture, regardless of how sound our own banking system looks on paper.

There is a line from the Gita that I keep returning to in years like this one: योगस्थः कुरु कर्माणि सङ्गं त्यक्त्वा धनंजय — perform your actions established in yoga, having abandoned attachment. The BIS report, at its core, is a document about attachment: to easy financial conditions, to a single technology narrative, to the assumption that resilience shown once will hold indefinitely. The investor’s job, as always, is to keep doing the work — reading, rebalancing, staying diversified — without becoming attached to any one story about how the world must unfold.

Also Read

Progress, Peril and Robustness - 1