Rate fears, high share valuations and surging bond yields - the week ahead

The equity market glass was decidedly half full in the wake of the US Presidential election. Today it looks distinctly half empty as investors ask whether, in the run up to Donald Trump’s inauguration, it has been better to travel than to arrive.

Storm clouds on the horizon

In the wake of Donald Trump’s unexpected clean sweep victory in November’s Presidential election, investors took the view that tax cuts, tariffs, deregulation and immigration curbs would be a positive combination for the US economy and Wall Street.

Just two months on, the mood is more downbeat. As the new President prepares to return to the White House next week, the focus is now on high stock market valuations, persistent inflation, and the prospect of higher for longer interest rates.

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What looked like tailwinds for the market just a few weeks ago feel more like headwinds as we move into 2025. In particular, rising bond yields threaten a re-run of 2022 when equity markets adjusted to the likelihood of higher borrowing costs after a long period of rock-bottom interest rates.

If investors are turning a bit more cautious, that will bring them more into line with economists who have taken a more pessimistic view of the impact of Donald Trump’s proposed policies. They think that tariffs and immigration curbs will be bad news for inflation and economic growth.

Earnings pick up the baton

As investors turn more defensive, they will look for corporate earnings to take over from valuations as the main driver of share prices. That means that the fourth quarter earnings season, which kicks off this week, will be in focus. As usual the banks start the ball rolling, with results due from the likes of Goldman Sachs, Morgan Stanley and Citigroup this week.

Overall, analysts expect a 7% rise in profits this quarter compared to a year ago. And as results often come in a bit ahead of expectations, the chance of another double digit rise in earnings is good. That could help push shares ahead even if valuations stagnate or even fall back a little from their currently elevated level.

Turning defensive

Despite this, some big asset managers are starting to caution their clients to take a more defensive position and to weight their portfolios more towards bonds and away from equities. That’s despite rising bond yields being bad news for bond prices in the short term. After the re-pricing has occurred, those higher yields will make bonds look increasingly attractive to investors compared to equities.

Vanguard said in its 2025 Outlook that advisers should allocate only 38% of their clients’ money to equities, effectively turning the traditional 60/40 portfolio on its head. That caution chimes with a recent warning from Goldman Sachs which suggested that today’s elevated valuations could result in disappointing long term returns from equities.

Bad to worse for the Chancellor

Meanwhile, here in the UK, the new Labour government is wondering what has happened since last summer’s triumphant return to Downing Street. First, October’s Budget was greeted with dismay by businesses clobbered with a big hike in National Insurance. Now, the bond market has turned on the Chancellor, Rachel Reeves, pushing yields higher as investors worry that a heavy borrowing requirement and a growing threat of stagflation - persistent inflation and sluggish growth - could force the government into raising taxes or cutting spending or both. At 4.93%, the 10-year government bond yield has pushed borrowing costs to their highest level since the financial crisis.

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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. 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.