Inflections: Beyond the Split-Screen – Inflation Meets Bonds and Equities

Since early March, investors have been confronted with a disjointed split-screen. Sharply rising energy prices, and severe supply shortages of key materials sat alongside reports of resilient economic growth, strong corporate earnings, massive AI capex spend, and record-high stock prices, particularly in the tech sector.

This apparent dichotomy may be about to change. After two years of cooling, inflation is rearing its head again due to a range of factors beyond just energy. Term premia in bonds are rising, with scope to go further. The bond-equity relationship has reached an inflection point. For the first time in this market cycle, bonds are out-yielding stocks. For example, US 10-year yields at c. 4.6% are just above the 4.5% earnings yield on the S&P 500.

With global bond yields rising sharply, equity markets have started to react with small retracements visible (since the mid-May peak, the S&P 500 is down c. -2%). As correlations rise, simple equity-bond portfolios could be challenged. Hence, we believe that ensuring portfolios have healthy allocations to less correlated asset classes, such as Absolute Return will be particularly important to boost resilience.

Rising inflation is not only about oil

Since the war in Iran began in late February, Brent Crude prices have risen from $65 per barrel (bbl) at the start of the year to over $100/bbl. A combination of excess inventories, releases from strategic reserves, and other measures has so far limited both the scale of the rise and the broader impact on the global economy.

Rising oil prices are now contributing (with a lag) to inflation. On a global basis, energy prices boosted both March and April consumer prices, which are on track to deliver a 5.8% annual rate (ar) rise in current-quarter headline CPI. The US Producer Price Index was particularly hot, rising 6.0% y/y¹, suggesting upstream price pressures are building.

Beyond energy prices, there is a robust cyclical bounce supporting inflation, owing to fading business caution (AI capex boom), supportive fiscal policies (OBBBA tax refunds), and the global monetary easing cycle that began in 2024.

The tech sector boom, in particular, is contributing to this pressure. AI-related imports, which are primarily semiconductors, now represent 20% of all US imports, up from just 5% in 2024.² Beyond the goods complex, the strongest message of stickiness in global inflation comes from the services sector, which has also firmed in recent months. US service price inflation accelerated to a 4% ar in the three months through April. Similarly, Euro area service inflation rose at a 3.6% ar.³

AI-related imports as a share of US total imports

Inflation could prove persistent over the longer term

A key narrative during the early part of the Covid pandemic was that supply chain disruptions would be temporary; hence their inflationary effects would be transitory. As a result, central banks were slow to raise rates. This slow approach proved spectacularly wrong. US inflation has remained well above its 2% target in the five years since 2021⁴, with similar results in the Eurozone and the UK. Long-term inflation expectations are critical as they impact household consumption behaviour, corporate investment, and central bank policy.

Two key structural forces will likely keep inflation higher than markets are pricing.

1. Rising geopolitical fragmentation
   Rising trade barriers, as well as existing and potential military conflicts, will affect thinking about prioritising national security and industrial resilience over simple cost optimisation. Governments around the world are deeply concerned about energy and supply-chain security. If one of the economic consequences of the Iran war is to loosen fiscal policy, then inflationary pressures are more likely to get a boost from government budgets. Europe has announced specific fiscal supports in response to the energy crisis, at roughly 0.3% of Eurozone GDP.⁵ Canada recently launched the Build Communities Strong Fund, a $51B⁶ infrastructure program spanning 10 years that mandates a “Buy Canadian” policy to support local workers, steel, and lumber. Governments are spending into the inflation, not against it.
   
   
2. Elevated inflation anxiety
   Since the Covid inflation episode was so painful for households and businesses, expectations of inflation may be more easily triggered now than might otherwise have been the case. Inflation anxiety could soon feed into price- and wage-setting behaviour, spurring further inflation.
   
   Clearly, there are also opposing disinflationary forces. These include AI-driven productivity gains and perhaps most impactful of all, an eventual economic growth deceleration resulting from high interest rates.

Interest rates are likely to stay higher for longer

• Short-term interest rates are rising. Central bankers are balancing growth concerns against the rising risk that core inflation may step up. As of last week, the Fed Funds forward markets are pricing a small chance of a single rate rise into year-end. Historical evidence suggests that if the Fed starts hiking rates, it will likely be more than once (the last example of a single hike was nearly 30 years ago in 1997).
  
• Longer-dated bond yields will be driven by rising term premia. Term premia (or additional risk premia on longer-dated bonds) will be boosted by concerns of sustained inflation risks, high government deficits and fewer buyers. 2026 will be the third consecutive year where G7 gross issuance, net of redemptions, will exceed $2.5T.⁷ The same factors (supply chain resilience and defence spending) that keep inflation elevated will also widen deficits. Following the Iran war, the US administration has requested an additional $200B of military funding from Congress.⁸ Federal deficits will also be pressured by rising interest costs. Net interest payments are currently running at c. $1T per year and are forecast to double over the next ten years.⁹ Finally, all this is occurring in a policy environment that is shifting away from the increasingly unpopular quantitative easing (QE) policies of the last decade, thus removing another source of demand for Treasuries.

Economic growth risks are real – diversifying away from equities and bonds is critical

• If borrowing costs rise too sharply, the odds of a recession will increase. Such a scenario seems unlikely in the near term, given the strong underlying economic momentum and relatively low leverage levels on both household and corporate balance sheets. The tech buildout also shows no signs of near-term abatement. However, if interest rates continue rising and remain high for an extended period, slower growth rates become far more likely. If the AI buildout also falters for any reason, sharper recession odds come into focus.
  
• Equities could become vulnerable as higher bond yields start to bite. In the US, 10-year notes at 4.6% now yield more than the earnings yield on the S&P 500 (currently 4.5% using a 22x forward P/E). Investors expect earnings to grow rapidly (the current consensus is for c. +20% EPS growth over the next 12 months¹⁰). Hence, any slowing of elevated growth expectations could expose a critical vulnerability.
  
• Absolute Return Strategies will be important. We believe higher interest rate volatility may provide scope for outperformance for leading active managers, while less correlated returns provide portfolio resilience in an environment of elevated macro risks.

Sources

1. BLS
2. USITC
3. J.P. Morgan
4. Bloomberg
5. Bruegel
6. Chatham House
7. G7 Finance Ministries
8. National Defense Magazine, 25 March 2026
9. Committee for a Responsible Budget
10. I/B/E/S