Key points
- HSBC cuts its stock recommendation to neutral
- Government bonds get an upgrade ahead of the midterms
- Persistent inflation could complicate the bond call
HSBC is less convinced by stocks and more interested in government bonds. On Monday, October 26, the bank cut its recommendation for global equities to "neutral" from "max overweight", citing Middle East tensions and concerns about potential AI regulation ahead of next week's US midterm elections.
It also upgraded developed-market government bonds to "overweight" from "max underweight," reversing its recommendation to hold less of them.
HSBC explained it this way in the note: "We've been max overweight stocks and max underweight sovereign bonds since mid-March. Given the constant narrative bingo we just can't have the same level of conviction any longer."
Narrative bingo. I've been playing that game all month, so I get it.
HSBC sees two midterm outcomes that could help bonds
HSBC tied its bond upgrade to the midterms. If Democrats win, a potential AI slowdown could support government bonds. If the result is gridlock, worries about government spending could ease, and that could help bonds too. The bank also questioned whether a Democratic sweep will happen. "Betting odds may well be too confident on a 'Blue Wave'. But if it does materialise, AI regulation concerns might be another near-term blow," it said.
The bond market was already leaning that way. The 10-year Treasury yield fell about 20 basis points last Thursday, October 22, closing at 4.95%, by our check of Yahoo Finance data. It briefly touched 5.00% early Monday before slipping back to about 4.97% by 10:30 a.m. ET. The iShares 20+ Year Treasury Bond ETF (TLT) was at $81.86 at that time, above any closing price in the past month. When yields fall, bond prices rise.
As of Monday morning, the Nasdaq was down about 5% from its one-month high, after its worst week since June earlier this month.
The catch is inflation
Jamie McGeever, a Reuters columnist, argues that AI worry is sending people into bonds while energy prices push inflation the other way. "AI skittishness has put the brakes on Wall Street's rally, resuscitating demand for US Treasuries as investors seek to protect portfolios, even as surging energy prices stoke inflation," he wrote. He calls it a possible "stagflationary bind" for the Federal Reserve.
Stagflation is the ugly combo of slow growth and high inflation. Bonds can cushion a growth slowdown, especially when interest rates fall. Persistent inflation complicates that protection, because it can keep rates higher for longer and erode the value of fixed payments.
Brent crude futures closed at $116.72 on Friday, October 23, up about 6% for the week, by our check of Yahoo Finance data. McGeever notes that producer prices are rising at the fastest pace in four years. One-year inflation expectations, measured by inflation swaps, hit 2.80% last week, the highest since June. He also cites UBS economists: "We expect little easing in inflation before the spring of next year."
The Fed raised its target range by a quarter point, to 3.75% to 4%, on September 16, and McGeever expects it to hold at this Wednesday's meeting. His line on the bond rally: "the move back toward Treasuries may not be a simple switch to flick."
What this means if you're mostly in index funds
My AI stocks have taken a beating, but most of my money is in index funds, so this is the part I actually care about. Own stocks for growth, own bonds for when stocks fall. In a growth slowdown, bonds can help cushion losses in stocks.
It can work less well when inflation is the problem. In 2022, stocks and bonds fell together, and people learned the hard way that bonds aren't always a safety net. HSBC's call works best if this round looks like a growth scare, where bonds do their job. McGeever is warning that inflation could make the bond side less reliable than that.
HSBC's own note has a funny wrinkle. It also raised oil to "overweight." That creates a tension in its outlook, since stronger oil prices could keep inflation elevated and make its government-bond call harder to get right.
Our AI Bubble Index gives a different read on the same month. It's at 59, in the "Heated" band, as of Monday morning, down from 63 on October 13. Each of its nine parts is scored from 0 to 100, and the drop came from the market side. Momentum, which tracks how far AI stocks sit above their 200-day average, fell to 37 from 58. Complacency, our inverted read of the VIX, fell to 41 from 63. Our valuation score, based on forward price-to-earnings ratios, fell to 31 from 39.
The financing risks remained elevated. Circular financing, which measures chipmakers' loans and guarantees for their own customers, stayed at 96, while our cost-of-money score rose to 65 from 59. Some froth came out of share prices, but not out of the financing, and that's why a 59 still reads "Heated."
China offers a warning about how quickly AI enthusiasm can unwind. The STAR50 index of AI and chip leaders fell about 40% in under four months.
Over the next two weeks, I'm watching three things. First, the Fed decision on Wednesday, October 28. Second, whether oil keeps climbing. Third, the midterms on November 3, since HSBC tied its bond call to the result. Cooler oil prices would ease one risk to HSBC's bond call. Persistent energy inflation would make that call harder to get right, even if growth slows.
This column is my personal opinion. I am not a financial advisor, and nothing here is investment advice.
