The past few months in markets have been dominated by oil, inflation, bond yields and Artificial Intelligence (AI). The questions stay the same, even if the answers change.
This week has continued that theme. A re-escalation in the Middle East has pushed oil prices back towards US100 per barrel. That’s raised concerns about inflation and prompted bond yields to rise. Intuitively that makes sense. As you’d imagine, there’s a link between changes in the oil price and changes in consumer prices – as the chart below illustrates.
And it’s not just the headline price of crude that’s at issue. Refined product prices have also risen. The chart below shows the crude oil crack spread – a measure of refiner profitability, which sits at its highest level in a decade.
Faced with potentially higher inflation, investors have asked to be better compensated for those risks. In other words, bond yields have risen. The chart below shows 10-year yields for Italy, the US and the UK. The move higher in yields has been quite sharp in recent months and that has put some pressure on fixed income markets, even if it’s much more muted than the 2022 experience. At the same time, central bankers have been forced to react. The European Central Bank raised its policy rate on Thursday and investors expect the US Federal Reserve to do the same at its next meeting.
In theory, higher government bond yields should also have an impact on equity valuations. And, perhaps reassuringly, we are seeing equity valuations come down. As an example, the chart below shows the forward Price/Earnings ratio for the S&P 500.
On these numbers, US equity valuations are back at their 10-year average. We’ve seen equities in a bit of a holding pattern over the past couple of months, following strong performance earlier in the year. At the same time, corporate earnings growth has been pretty robust and earnings expectations have moved higher.
It is worth noting that the relationship between government bond yields and equity valuations isn’t clear cut. All else equal, you might think that higher bond yields means lower equity valuations. But this scatter plot suggests the data is inconclusive. One possible explanation is growth expectations. If higher yields reflect stronger growth, equity investors might view that positively. And, if you’re an AI optimist, faster growth is exactly what you might be looking for going forward.
So where does this get us? Higher oil prices have persisted longer than many had hoped and that has complicated decisions for households, investors and central bankers. We continue to prefer shorter-dated bonds, although the rise in yields has been quite sharp. At the same time, equities have held up fairly well so far. We think that reflects strong earnings growth, particularly related to tech spending. For now, we remain constructive on the outlook for AI spending where we think that demand for Artificial Intelligence – broadly defined – is still running ahead of supply. That’s something we’ll continue to monitor closely in the coming months.
*As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. It is important to consider your risk tolerance and investment objectives before proceeding.
