Can shares live with rising bond yields?

It’s a quiet, holiday week in many markets around the world. So, a handful of inflation announcements will be watched closely. The key question is how robust the equity bull market can be if rising prices lead to higher interest rates and increasingly attractive bond yields.

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Inflation spotlight

From the US to Europe and Japan, there’s just one economic story this week. Inflation.

In America, new Fed chair Kevin Warsh will receive an early test of his stated preference for lower interest rates when the central bank’s preferred measure of inflation - the personal consumption expenditures index - is unveiled.

Economists expect a 3.4% year-on-year rise, which would be the biggest jump since the middle of 2023. If inflation pressures are broad-based, it becomes hard for the Fed to dismiss them as transitory. If they push inflation expectations higher too, then the call for higher interest rates becomes hard to resist.

Market have already put to one side the optimistic view from earlier in the year that rates would fall two or three times this year. ‘No change’ or even a hike from here now looks more likely.

That’s the case in Japan, too, where a 1.9% rise in core inflation - excluding energy and food costs - suggests that price hikes there are not just about the country’s well-known dependence on imported oil.

And in Europe, also, the next move looks likely to be up for the ECB, with inflation data at the end of the week likely to make a case for the first hike since September 2023.

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Rising correlation

Higher interest rates naturally feed through into higher bond yields. And on both sides of the Atlantic these are firmly in the 4.5-5% range in which they start to make bonds look increasingly competitive versus shares.

A key question this week is how robust the equity bull market can remain in the face of rising bond yields.

So far, equity investors have preferred to focus on rising corporate earnings. And the recent first quarter earnings season delivered another quarter of strongly rising profits. So, a second key question today is how well earnings can withstand the yet-to-materialise energy shock from the now 13-week-long US-Iran conflict that has kept the Strait of Hormuz effectively shut for three months.

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IPOs and bullish sentiment

Few of us expected oil supplies to remain constrained for so long. And anyone who did will have been surprised at the apparent lack of economic impact. A third unanswered question, therefore, is how long the global economy can withstand a shortage of the world’s most important commodity.

For shares to continue dismissing this concern will require sentiment to remain bullish. Which is where the ongoing AI narrative, and in particular excitement about the upcoming flotations of SpaceX, Anthropic and OpenAI, come in.

With SpaceX, the IPO of which was confirmed last week, looking to be the biggest flotation ever, there is plenty of interest from investors. A key feature of the upcoming IPOs will be the impact they have on demand for other investments.

New ‘fast entry’ rules could put the stocks straight into the indices tracked by passive funds. That would ensure billions of dollars being automatically allocated to these stocks, potentially pulling money away from other listed companies.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.