Markets are pulled in two directions

Investors continue to be buffeted by the headwind of rising bond yields and the tailwind of booming company earnings. How this two-way pull resolves itself will be key to the final three months of another strong year in the markets.

• Refer a friend and you’ll both receive a £100 Amazon.co.uk gift card when they invest £5,000 or more in a qualifying account. T&Cs and exclusions apply. Find out more

Narrow gains

The market as a whole has edged higher over the summer, but with flagging momentum. Look beneath the surface and the cracks are starting to show. The gap between the performance of the broad equal-weighted S&P 500 index and the market leaders has widened significantly over the past couple of months, a worrying reminder of how markets can narrow as they approach a cyclical peak.

Just 25% of the US’s biggest stocks are now ahead of their 50-day moving average, and less than half are doing better than their 200-day average. Behind the scenes, a stealth correction seems to be underway.

That is showing up in valuations, which have fallen below 20 times expected earnings. Investors are indicating clearly that they are concerned about paying up for profits which may be close to peaking.

That would not be surprising, with earnings running 30% ahead of a year ago and with another 20% gain pencilled in for the next 12 months. Investors are rightly questioning how sustainable that can be.

• Looking for personalised financial advice? Our advisory service can help you plan for your next step.

Rising yields

The reason why earnings may be rolling over is not hard to identify. The 10-year government bond yield in the US is now 5.3%, up from about 4% at the start of the year. Yields have entered the restrictive zone in which they threaten growth.

And the reasons why yields are rising are also easy to see. High debt levels, inflation, concerns about fiscal policy and an absence of the traditional buyers of last resort in the bond market.

The big challenge for governments today is not so much the level of debt as the cost of servicing it. Funding costs have doubled to 4% of GDP just since the pandemic. That in turn pushes the premium investors demand yet higher in a worrying fiscal loop.

So, it is hard to see the upward pressure on bond yields easing soon in the absence of an economic slowdown. The question which then arises is: how high is too high for bond yields from a stock market perspective?

• Read: How high can bond yields go before stocks suffer?

The week ahead

Waiting for earnings season to arrive in a couple of weeks, investors will peruse a few key market moves and economic data for signs of what might stabilise the bond market.

The oil price will be top of the agenda. The price of Brent crude dipped back below $100 at the end of last week as leading developed countries agreed to release crude and diesel reserves, but it later bounced back to $102 with no sign of peace breaking out in the Gulf.

Elsewhere, jobs data last week were weaker than expected, with just 29,000 new jobs created in September. That eased pressure on bond yields as fewer jobs weaken the case for further interest rate rises. Futures markets are pricing in just a 20% chance of a rate hike at the Fed’s next meeting on 28 October.

Also of interest will be the University of Michigan’s sentiment survey. Last month, it showed weaker consumer sentiment but higher inflation expectations. More inflation fears this week could spark another bout of bond market volatility in anticipation of further monetary tightening.

That is already having an impact on this side of the pond. Higher mortgage rates, as financial markets price in a 90% chance of an interest rate increase in early November, have lowered the Nationwide house price index in four of the past five months. This week, the Lloyds index is expected to confirm the weakness in the property market.

Autumn angst

The next Bank of England meeting comes just a few days after the first Budget of the Burnham era on 28 October. It’s a fiscal event that everyone, including the government itself, expects to be challenging, as the Treasury’s wriggle room is squeezed by the rising cost of borrowing.

• Read: What can we expect in the Autumn Budget?

Also arriving soon after our Budget will be an arguably much more consequential event, the US mid-term elections in early November. This is the opportunity for increasingly restive American voters to deliver their verdict on a cost-living-crisis and economic boom that many believe is disproportionately favouring only the country’s richest people.

For the stock market to hold its nerve through a nervous autumn will require it to continue climbing a steep wall of worry.

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

• Read: How high can bond yields go before stocks suffer?
• Read: How to create a retirement salary
• Read: 5 stocks to watch in October

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. 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.