Financial advisors are sounding alarms that elevated U.S. stock markets haven’t adequately factored in inflation risks and remain exposed to sudden increases in bond yields.
Stock markets have been driven higher by strong first-quarter corporate results and optimism surrounding artificial intelligence developments, overshadowing concerns about elevated energy costs and the ongoing conflict with Iran.
However, a recent surge in bond market yields over the past week — pushing 30-year Treasury bonds beyond 5% and benchmark 10-year bonds past 4.5% — may alter the investment landscape. This development led to stock market hesitation on Friday.
Paul Karger, co-founder and managing partner of TwinFocus, who oversees investments for ultra-high net worth families, reported that his clients are constantly questioning him about the apparent market contradiction during their meetings.
“Breakfast, lunch and dinner: the question is always about how to make sense of the fact that this is such a divided outlook,” with earnings telling a positive story but oil prices and inflation emerging as a negative for companies, Karger said.
Karger employs what he describes as a “barbell” strategy for the assets he oversees: building substantial overweight positions in cash, gold and other commodities, while keeping positions in the market-leading mega-cap growth stocks.
Following an initial decline after the beginning of the U.S.-Israeli conflict with Iran in late February, U.S. stock indices have staged a significant recovery. The benchmark S&P 500 was recently up more than 17% from its yearly low in late March, providing a year-to-date increase of over 8% — despite Friday’s nearly 1% decline.
Increasing benchmark yields typically pressure equity valuations, as businesses and consumers face elevated borrowing costs. This can also impact economic expansion and corporate earnings, while potentially making bond returns more attractive compared to stocks.
This situation may be particularly relevant now with the stock market at high levels. The benchmark S&P 500 as of Thursday was valued at 21.3 times earnings projections for the next 12 months, according to LSEG Datastream. This exceeds the index’s historical average forward P/E ratio of 16, though it remains below the 23.5 level reached in October, as improving U.S. earnings prospects have helped maintain valuations somewhat in check.
“I do think there is a real fear that inflation is kind of embedded in the economy going forward,” said Peter Tuz, president, Chase Investment Counsel, in Charlottesville, Virginia. “You don’t see any signs of it going down right now, and that is a real fear, and it will drive the market down if it continues.”
Jack Ablin, chief market strategist at Cresset Capital, warned that if there’s a delay of even several months in reopening the Strait of Hormuz to both oil and liquefied natural gas (LNG) tankers as well as other commercial shipping, the outcome could be “a brand new inflation regime for which investors just aren’t prepared.”
The factor keeping equity markets strong, portfolio managers explain, is corporate earnings. U.S. publicly traded companies are producing first-quarter profits that significantly exceed expectations and are on pace to be approximately 28% higher than the previous year, representing the largest increase since late 2021.
“We’re seeing the impact of the AI spending boom and (a related) increase in productivity,” said Jeremiah Buckley, a portfolio manager at Janus Henderson, which could continue into 2027, he added.
The recent wave of artificial-intelligence market excitement has lifted stocks including semiconductors. Extensive capital investment in data centers and other AI-related infrastructure increased chip demand. Nevertheless, high valuations in AI-related sectors are also prompting some to predict a correction.
Also supporting equity markets is concern about missing opportunities.
“Traders don’t want to turn bearish if there is a possibility — as many think — that the Strait of Hormuz situation could be cleared up in just a few weeks’ time,” said Tim Murray, capital markets strategist at T. Rowe Price.
Nevertheless, investors are growing more conscious of the dangers — and the potential impact on equities. The jump in crude oil prices, still trading above $100 as uncertainty surrounds the temporary ceasefire between Iran and the United States, has fueled inflation concerns. Producer prices experienced their biggest increase in four years in April.
“Markets aren’t braced for an ‘extreme’ scenario in the Iran war” of an extended Hormuz shutdown, John Higgins, chief economic adviser, financial markets at consultancy Capital Economics, cautioned his clients in a report released on Thursday. While Treasury markets are accounting for the inflation risk, equity markets are not similarly considering the possibility that a prolonged shutdown may impact the growth that has supported profits.
The geopolitical crisis in the Persian Gulf and the inflation it may be generating has the potential for lasting consequences.
“The Iran crisis has the potential to reshape the trajectory of the markets” for the remainder of the year, said Matthew Gertken, chief geopolitical strategist at BCA, a market analysis firm.
