Bond Market Rout May Be Overdone, But AI Rally Faces Bigger Risks
Capital Economics expects government bonds to recover as inflation and rate expectations ease, but warns the AI-led equity boom could eventually turn into a sharp market correction
The recent sell-off in global bond markets may be nearing a turning point, according to Capital Economics, although a recovery in bonds does not necessarily mean equity markets are about to receive fresh support.
The firm's markets strategy team says three major themes have dominated financial markets in recent months: changing investor enthusiasm for AI-related equities, sharp movements in commodity prices, and a significant rise in government bond yields. Capital Economics believes all three trends could be approaching important turning points.
Bond yields could reverse
Capital Economics expects the recent decline in government bond prices and rise in yields to begin unwinding over the coming year.
Chief Markets Economist Jonas Goltermann said the sell-off in developed-market government bonds could reverse as energy prices fall and central banks ultimately tighten monetary policy by less than markets currently expect.
That could create more favourable conditions for bond investors if yields decline from their recent highs.
However, the outlook for corporate bonds is less encouraging. Capital Economics expects corporate bond spreads to widen significantly, particularly if the AI-driven equity rally eventually reverses. The firm's concern has increased because heavy AI-related borrowing has created a more direct connection between the technology boom and credit markets.
AI rally faces growing risks
While the bond outlook could improve, Capital Economics is considerably more cautious on equities.
The firm believes the AI-driven share market rally has become stretched and could eventually turn into a sharp decline. Although predicting the timing of a market crash is difficult, its current forecasts envisage a major correction next year.
Capital Economics also leaves open the possibility of a final "blow-off" phase before the downturn, meaning technology shares could continue rising for a period before experiencing a much sharper reversal.
The concern reflects the scale of investor enthusiasm surrounding AI-related companies and the extent to which expectations have already been built into valuations.
Commodity prices could also turn lower
Commodity markets are another area where Capital Economics expects a potential shift. The firm forecasts that commodity prices could decline from current levels, although it acknowledges that the outlook for energy remains heavily dependent on developments around the Strait of Hormuz.
A sustained decline in energy prices could also help reduce inflationary pressure, potentially giving central banks more room to slow the pace of monetary tightening.
What it means for investors
For investors, the outlook points to a potentially important change in the relationship between bonds, commodities and equities. A recovery in government bonds could benefit fixed-income investors, while lower energy prices could ease inflation pressures.
However, Capital Economics' warning on AI equities suggests investors should not assume that falling bond yields will automatically support the broader share market.
The key question is whether markets move towards a more balanced environment of lower inflation and easing bond yields, or whether the current AI enthusiasm continues into a final phase before a broader correction.
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