For the past few years, I have encouraged everyone to ignore the headlines and focus on medium-term trends. Looser fiscal policy, the AI boom, higher defence spending and a focus on securing supply chains in a geopolitically uncertain world all pointed to stronger nominal growth, which is good for equities. From a cyclical perspective, the environment for growth remains very strong. However, the risks are rising, and these are the indicators I am watching closely.
First, the conflict in Iran has lasted longer than anyone expected. We cannot predict the outcome, but we know the supply buffers in energy markets, namely floating storage and strategic reserves, have largely been exhausted. We must therefore remain alert to the possibility of persistently high energy prices, which in turn complicate the outlook for central banks. Keep an eye on oil, gasoline, diesel, jet fuel and gas prices.
Which brings me to bonds. I have always said bond yields would be the ultimate constraint on this equity bull market. In an environment of inflationary, rather than deflationary, shocks and profligate fiscal policy, equity markets can be sustained by higher nominal growth as long as bond investors are willing to fund the borrowing.
Bond yields have been highly volatile in recent months and, with the AI boom increasingly debt-financed, well-functioning bond markets matter even more. The recent US rate rise showed Kevin Warsh, chair of the Federal Reserve, understands the importance of maintaining the Fed's credibility, which should keep yields under control for now.
However, I expect these concerns to resurface, given our expectations for strong growth and the inflationary risks posed by the Middle East conflict.
At what point do bond yields become a major risk for equities? I would break this into two phases.
We are in phase one, where rising bond yields raise the bar for equity performance. Bonds are a competing source of return, and the level of corporate bond yields sets the hurdle for corporate performance, particularly in AI, where data-centre financing deals now yield 10%.
Our equity-bond valuation models are not yet flashing and, despite huge capex requirements, hyperscaler balance sheets remain exceptionally strong from a credit perspective. Our equity investors still believe the scale of the AI opportunity is underestimated, adoption continues and the revenues of the hyperscalers and frontier labs are surging.
Phase two would come when bonds sell off on concerns about debt sustainability. We are not there yet. In the US, strong growth is keeping the show on the road, and bond markets are already imposing some fiscal discipline on European governments. The rise in bond yields over the summer was driven by rate expectations rather than volatility at the long end of the yield curve.
However, with an ageing population, the medium-term trend is for government spending to keep rising. The trigger for these concerns to come to the fore could be a bigger rate shock caused by higher-than-expected inflation, or a meaningful slowdown in growth that exposes the underlying debt dynamics.
For now, the benefit of higher nominal growth for equities outweighs the risks from bonds. We therefore favour equities over bonds, but as yields rise, the burden of proof is increasing.
Johanna Kyrklund is chief investment officer at Schroders. The views expressed above should not be taken as investment advice.