INVESTORS WARN OF "CORRECTION" RISKS AS HIGH-FLYING STOCKS DEFY BOND GLOOM / THE FINANCIAL TIMES

Investors warn of ‘correction’ risk as high-flying stocks defy bond gloom

Wall Street indices have surged to a string of record highs despite anxiety over economic fallout from Iran war

Harriet Clarfelt and Kate Duguid in New York and Emily Herbert in London

Wall Street’s rally has highlighted the growing dependence on just a few technology and semiconductor stocks linked to AI © Angela Weiss/AFP/Getty Images

Soaring borrowing costs could trigger a “correction” in the stock market, big investors have warned, highlighting a growing disconnect between exuberant equities and bonds battered by worries over high inflation.

Wall Street’s S&P 500 stock index has punched through a series of record highs in a tech-powered rebound that began at the start of April, when news of a temporary ceasefire in the Middle East war prompted traders to pile back into the market.

By contrast, a sell-off in government bonds has pushed US long-term bond yields to their highest level since 2007 on Tuesday, as investors bet that oil prices stuck above $100 a barrel will fan inflation and spur central banks — including the Federal Reserve — to lift interest rates.

The divergence has prompted some big fund managers to doubt whether equities can continue to shrug off the gloom enveloping fixed income, particularly if rising borrowing costs trigger alarm over sky-high valuations of AI stocks.

“We will see a correction — the question is more when than if, in my opinion,” said Vincent Mortier, chief investment officer of Amundi. 

Mortier said that the equity market had “seen a total change of narratives, views and positioning in a matter of six weeks” in contrast to bond investors’ focus on the surge in prices for everything from diesel to petrol and jet fuel triggered by Iran’s closure of the Strait of Hormuz.

The yield on the 10-year Treasury has climbed more than 0.3 percentage points since the initial ceasefire as a global bond sell-off gathers pace. 

Thirty-year yields, which are sensitive to concerns about the vast scale of US government borrowing, climbed to a 19-year high of 5.2 per cent on Tuesday.

A market measure of inflation expectations for the 12-month period a year from now — the one-year, one-year inflation swap — on Monday rose above 4 per cent for the first time since early 2025.

The S&P 500, however, has gained more than 12 per cent since the ceasefire, and is showing little indication that the conflict in the Middle East will do lasting economic damage.

“There’s an incompatibility between having equities at all-time highs, [credit] spreads at tights, high bullishness . . . and at the same time, interest rates and energy [markets] pricing in a lasting impact on the economy,” said Raphaël Thuin, head of capital markets strategies at Tikehau Capital.

“Short-term, there are good reasons to be nervous,” Thuin added. 

“It does feel like the rally is very stretched [and] the market is due a pause.”

Bank of America’s closely watched poll of fund managers on Tuesday showed a record monthly surge in the proportion of investors that are overweight equities — from a net 13 per cent overweight to a net 50 per cent, the highest level for more than four years — with earnings optimism driving the boost.

At the same time, a net 44 per cent of allocators said they were underweight bonds — the biggest proportion since June 2022. 

The survey’s authors said the results suggest early June is “ripe for profit-taking” and the degree of the bond market sell-off would determine the size of the stock market pullback.

Wall Street stocks have also powered ahead of their European counterparts, highlighting the rally’s growing dependence on just a few technology and semiconductor stocks linked to AI.

Mandy Xu, head of derivatives market intelligence at Cboe Global Markets, said activity in the single stock options market suggests that “higher rates have not dampened extreme bullish positioning”, with some indicators of exuberant sentiment approaching the same levels as the 2021 “meme stock” era.

The greater dependence of Europe on energy imports has punctured traders’ bullishness about the region, leaving the Stoxx Europe 600 struggling to return to its prewar level.

“There is this dichotomy in the [US] markets where [they] are looking to other things than geopolitics right now,” said Kamal Bhatia, chief executive of Principal Asset Management. 

“It’s very perplexing.”

For some investors, the exceptional first-quarter earnings season did more than enough to outweigh the geopolitical uncertainty for the stock market. 

Giles Parkinson, head of equities at Trinity Bridge, said the recent rally in stocks is in fact “underdone” while “earnings are exploding”.

For now, “bonds are saying ‘yellow flag here’ about inflation and the risk of chronic inflation and high oil prices causing the economy to eventually slow”, said one asset management executive. 

“Equities are saying, ‘we’re going to keep partying until that happens’.”