When the chips are down, bonds step up
Since 2022, many market strategists have questioned the diversification potential of bonds - to what extent can they be relied upon to cushion equities during a drawdown? For most of the preceding forty years, multi-asset investors could simply count on a consistent, negative stock-bond correlation as a structural feature of balanced portfolios. Since 2022, however, inflation has induced a more dynamic and persistently positive stock-bond correlation. In short, bonds have repeatedly failed to diversify equity risk - and many strategists even wrote the obituary of the 60/40 portfolio.
We have increasingly viewed the rise in yields as an opportunity, particularly over recent months, as the move higher has been concentrated in real yields rather than inflation expectations. Bond yields can be decomposed into two components: expected inflation and the real yield - the additional return investors demand above that inflation expectation. In the US, it is the real yield component that has expanded materially, with 10-year real yields approaching 20-year highs near 3.0%, while inflation expectations have remained contained.
Rising real yields reflect an economy competing intensely for capital, consistent with our view that surging AI-driven spending demand from hyperscalers has been an important force pushing real rates higher, rather than a renewed rise in inflation fears. Hedge fund Citadel made a similar observation, noting that all of September's increase in 10-year yields came from real yields, with inflation expectations remaining stable. For bond investors, this is a more constructive backdrop than a generalised inflation shock - real yields at these levels offer genuine compensation.
The sharp sell-off in AI-related stocks towards the end of last week saw the traditional diversification return in striking fashion. Even as Wednesday's hotter-than-expected CPI print sent two-year yields surging more than 15 basis points (bps) to 4.95%, Treasuries subsequently reversed sharply. The 10-year yield closed the week at 5.07%, a full 25bps below Wednesday’s post inflation peak as the AI growth scare overwhelmed the inflation signal.
This dynamic presents a meaningful shift in risk sentiment: last week it was equities, not inflation, driving bond markets. Bonds acted as a genuine hedge to the week's equity volatility - precisely the role they have struggled to play since 2022.
Whether this marks a temporary reprieve will depend on whether the next leg of market stress is driven by growth or inflation fears. For now, the evidence suggests bonds have earned back their place in the diversifier's toolkit.
United States
US markets are balancing strong profit expectations against growing scrutiny of the amount being spent on artificial intelligence. After eight consecutive sessions of semiconductor weakness, technology shares recovered some ground on Monday as investors looked ahead to major company results. Those earnings will be important in showing whether large investments in computing capacity are beginning to produce sustainable revenue and cash flow. At the same time, higher interest rates and volatile energy prices remain challenges for businesses and households. The recent strength in government bonds during the technology sell-off is encouraging for diversified portfolios, even though the relationship between bonds and equities can change as inflation expectations move. Overall, the US economy and corporate sector still offer meaningful long-term opportunities, but investors are likely to be more selective about valuations and the quality of earnings.
Europe
European markets have faced renewed pressure from political uncertainty, particularly in France, where unrest and concerns about public finances have pushed government borrowing costs higher. Higher energy prices add a further challenge for businesses and consumers, while investors are watching whether inflation remains contained and whether activity surveys continue to show growth. European companies are not all exposed to these risks in the same way: many earn revenues across the world and operate in a wide variety of industries. This provides scope for selective opportunities even when regional headlines are difficult. The forthcoming UK inflation figures and October business surveys should help clarify the outlook for monetary policy and economic activity. For long-term investors, Europe remains an important part of a globally diversified portfolio, although fiscal credibility and energy security will remain key themes.
Global Markets
Global markets continue to be influenced by three powerful forces: the investment cycle around artificial intelligence, shifting expectations for interest rates and geopolitical disruption to energy supplies. The sharp decline in chip-related shares showed how quickly sentiment can change when valuations are demanding, while the response in government bonds illustrated that different asset classes can still provide useful balance. Oil-market uncertainty adds to inflation risks, especially for countries dependent on imported energy, and upcoming purchasing managers’ surveys will help indicate whether businesses are continuing to expand. There are also reasons for a constructive long-term view: innovation, business investment and opportunities across different regions remain important sources of growth. In this environment, spreading investments across countries, sectors and asset classes is particularly valuable because it avoids relying on any single theme to deliver returns.
