U.S. stocks face inflation and geopolitical risks amid strong earnings and AI growth

As U.S. stock markets remain at elevated levels, inflation risks and upward pressure on interest rates are gradually emerging. Investors are increasingly concerned that current pricing has not fully accounted for potential inflationary shocks, and the rapid rise in bond yields has already begun to undermine the market’s previous optimism.

Over the past week, U.S. Treasury yields rose significantly: the 30-year U.S. Treasury yield breached 5%, while the 10-year yield climbed above 4.5%. This shift directly impacted risk asset pricing and triggered a market correction last Friday, leading to more cautious market sentiment.

Paul Karger, co-founder and managing partner of TwinFocus, noted that in communications with clients, nearly all questions revolve around the same contradiction: companies are showing strong profitability, yet energy prices and inflationary pressures are building uncertainty. He said, “Whether it’s breakfast, lunch, or dinner, the question everyone keeps asking is, how should we navigate such a divided outlook?”

In asset allocation, Karger adopts a "barbell" strategy, heavily weighting one end with cash, gold, and commodities, while maintaining positions in top-performing mega-cap growth stocks at the other end to navigate an uncertain environment.

Rising bond yields indicate higher financing costs, which may not only dampen corporate profits and overall economic growth but also increase the attractiveness of bonds relative to stocks, thereby putting downward pressure on stock market valuations.

Current U.S. stock valuations are clearly elevated. According to LSEG Datastream, as of last Thursday, the forward 12-month price-to-earnings ratio of the S&P 500 index stood at 21.3x, significantly above the long-term average of 16x. Although improved corporate earnings expectations have provided some support for valuations, the overall level remains high.

Peter Tuz, President of Chase Investment Counsel, said: “I truly believe there is genuine panic in the market that inflation is taking root in the future economy like a chronic illness.” He emphasized that there are currently no signs of inflation easing, and if it continues, it will significantly weigh on the stock market.

Sustained high energy prices are a major source of current inflationary pressures. Since the end of February, when the United States and Israel clashed with Iran, oil prices have continued to rise and have remained above $100 per barrel.

Jack Ablin, Chief Market Strategist at Cresset Capital, noted that if the reopening of the Strait of Hormuz is delayed by several months, it could trigger a "completely new form of inflation that investors are entirely unprepared for."

The U.S. Producer Price Index (PPI) for April recorded its largest increase in four years, further intensifying market concerns about inflation. In a report, John Higgins, Chief Economic Advisor for Financial Markets at Capital Economics, warned that markets have not fully priced in the extreme scenario of a prolonged blockade of the Strait of Hormuz, which could severely impact economic growth and corporate profits.

Matthew Gertken, Chief Geopolitical Strategist at market analysis firm BCA, also noted: "The Iran crisis could very well completely reshape the trajectory of markets for the remainder of this year."

Earnings reports and AI support market resilience, but divergences are intensifying.

Despite rising risks, U.S. stocks have remained relatively resilient, with key support coming from corporate earnings. Investment managers generally believe that first-quarter earnings significantly exceeding expectations have been a major driver of the market's upward movement.

Data shows that U.S. public company profits are expected to grow by approximately 28% year-over-year, marking the largest increase since the end of 2021. Jeremiah Buckley, portfolio manager at Janus Henderson, said, “We are directly experiencing the power of the AI spending surge and the resulting productivity gains,” and expects this trend to continue through 2027.

Investments related to artificial intelligence have increased significantly, particularly in data centers and infrastructure, driving demand for key components such as chips. However, the high valuations in these sectors have prompted some market participants to remain cautious about potential correction risks.

Additionally, investors' fear of missing out (FOMO) is supporting the market. Tim Murray, Capital Markets Strategist at T. Rowe Price, noted that traders are reluctant to shift to a defensive stance too early if the anticipated crisis in the Strait of Hormuz is expected to ease within weeks.

After initially triggering a market decline at the start of the conflict, U.S. stocks quickly rebounded. The S&P 500 has risen over 17% since its late March low and is up more than 8% for the year, despite a nearly 1% pullback last Friday.

However, as inflationary pressures, geopolitical risks, and rising interest rates converge, uncertainty within the market is increasing. The bond market has begun repricing for inflation, while the stock market has lagged in its response—a misalignment that some institutions view as a potential source of risk.

Amid interwoven variables, investors are reassessing their asset allocation and risk exposure, and uncertainty around future market movements has significantly increased.