It’s geopolitics, stupid

At first glance, the recent equity rally and credit spread tightening looks reassuring. Risk-facing assets are expressing a medium-term growth view that assumes today’s shocks will ease.

Government bond markets are telling a more negative story. There is still stress evident in the market – you can see it in higher short-term interest rates and in flatter-than-expected yield curves. Yields increasingly reflect an outlook shaped by geopolitics rather than by incremental macro data.

This also highlights why bonds often act as early-warning indicators during geopolitical crises. Bond investors are forced to confront inflation and supply risks immediately. Equity markets can afford to avoid them for longer.

Yield curves are flashing red, too. Until the end of February, most major economies saw inflation slowly declining towards target. The US-Iran conflict has raised the chance of more interest-rate rises, which is pushing up short-term borrowing costs. Short-term rates are still much lower than long-term rates, but signs of inflation are starting to pick up again. The bond market is telling us that inflation risks are still present under the surface. Ten-year Treasury rates remain well above the 0.5-3% range we’ve been accustomed to over the past decade.

Volatility is still a key driver

The result is a clear divergence in how different asset classes are behaving. Equities are pricing-in resilient earnings and a degree of optimism – reinforced by repeated episodes of buying when markets fall. Government bonds, by contrast, are showing short-term uncertainty over inflation and policy risk. Investment-grade bonds and high-yield credit currently sit closer to equities. Investors are staying positive about the next few years and taking advantage of today’s higher yields.

Volatility still matters. Chart one compares interest-rate volatility with the extra yield that investment-grade bonds have offered compared with US government bonds over the past five years.

Investors demand a higher risk premium during times of stress as volatility raises uncertainty. We are seeing this feed through into the extra yield investors demand for credit risk, even when default fundamentals remain benign.

After a spike higher, interest-rate volatility has fallen from its highs since the initial Iran war-driven shock. Credit markets have improved and risk premiums have fallen, as a result. Some caution is advisable, though, as the market is susceptible to another volatility spike if energy prices remain elevated.  

Natural diversifiers

Equities and bonds are often thought of as natural diversifiers – consider the 60% equities/40% bonds portfolio favoured by many. However, history offers important context. Equities and bonds don’t always move together – it depends on what’s driving markets at the time. Inflation stress, in particular, can cause major swings in the equity-bond correlation. 

Our analysis of US equities and government bonds (chart two) shows that the diversification benefit of owning bonds over equities tends to break down during periods of large or volatile inflation moves. We see similar evidence of this when comparing the FTSE 100 and Gilts in the UK market. Equity and bond diversification improved when inflation was low or below policymakers’ targets – such as during the mid-2010s. But we saw the opposite after the Global Financial Crisis and again during the post-Covid inflation shock.

Current inflation uncertainty remains high, and the equity-bond correlation is strongly positive. Diversification benefits may be less reliable, as we’ve seen in recent weeks. When that happens, asset allocation choices matter more.

What should investors do now?

Sharp market rebounds don’t automatically mean that risks have cleared – we’re probably not out of the woods yet. Today’s divergence across asset classes reflects differing time horizons and sensitivities, not a clean resolution to uncertainty. For investors navigating volatile conditions, paying attention to what bond markets are signalling remains essential – even, or especially, when equities appear calm.

We think current conditions present an opportunity to add to bond exposures. The starting point for bonds is materially better than it has been for many years. The overall yield on offer is very attractive, even though the extra return you receive for taking credit risk is relatively low. Investment-grade bonds are yielding over 5%, which is well above the 10-year average. This offers investors the potential for attractive total returns. For investors more concerned about downside risks, sovereign bonds also offer generous yields, with more defensive characteristics.

Final thoughts...

For investors weighing up government versus corporate bonds, the right mix depends on your risk appetite and existing portfolio tilts. However, the main point still stands: bonds offer a much more attractive balance of income and protection than has been available for much of the past decade.

In a market still dominated by geopolitical inflation risk, we believe bonds – not equities – remain the more reliable way to stay invested. Cross-over credit strategies can offer the potential for higher returns, while keeping risks at a more moderate level. Meanwhile, enhanced-income strategies can help investors to achieve a steady income over cash, with reduced volatility.