The rise in long-duration bond yields is complicating the outlook for global equity valuations, according to chief investment officers (CIOs) at Schroders and DWS Asset Management.

So far global equities have shrugged off higher bond yields as the ongoing artificial intelligence boom has continued to show up in earnings momentum.

However, Johanna Kyrklund, chief investment officer at Schroders warned that higher bond yields would be “the ultimate constraint” on the current equity bull market.

“We are currently in phase one, where rising bond yields raise the barfor equity performance because they represent a competing asset to generate return and because the level of corporate bond yields sets the hurdle for corporate performance, particularly in AI, where some data-centre financing deals are yielding 10% now,” she said in a recent note.

The investment chief also said the firm’s equity investors believe scale of AI opportunity still underestimated and pointed to the ongoing AI adoption and surging revenues from the hyperscalers and frontier labs.

“Phase two would be when bonds sell off because of concerns about the sustainability of debt,” she said. “We are not there yet. In the US, strong growth is helping to keep the show on the road and bond markets are already providing some fiscal discipline to European governments.”

Kyrklund argues that looser fiscal policy, the AI boom, higher defence spending and a focus on securing supply chains in a geopolitically uncertain world all point to stronger nominal growth “which is great for equities”.

She noted that the environment still appears very strong, despite the rising risks posed by persistently energy prices.

“We are still in phase one, where the beneficial impact of higher nominal growth on equities is outweighing the risks for bonds,” she explained. “We therefore favour equities over bonds, but as bond yields rise, the burden of proof is increasing.”

This view is echoed by Vincenzo Vedda, global chief investment officer at DWS Asset Management, who suggested equities need to report blockbuster earnings or risk disappointment.

“Given the sharp rise in bond yields, equities’ relatively modest decline is noteworthy, although performance was driven by a narrow group of sectors,” he said.

“As for profits, we are entering the third-quarter reporting season with higher expectations than in the second quarter, slightly increasing the risk of disappointment even if the numbers are good.”

“Equities will need to show sufficiently broad earnings momentum to offset higher bond yields, which are normally a drag on most sector valuations.”

As such, he remains constructive on equities as valuations have become more attractive amidst a derating on a price-to-earnings (P/E) ratio basis.

He noted that the MSCI AC World has experienced the largest derating in a rising market in over 30 years, with the P/E ratio has declined by 7% meanwhile 12-month forward earnings estimates increased by over 10%.

“While we see few reasons to expect a sudden slowdown in earnings growth, markets still face several headwinds heading into the fourth quarter,” he said.

“Above all, higher bond yields remain a concern. With 10-year Treasury yields trading above 5%, valuation pressure is increasingly affecting many parts of the market.”

Aside from equities, Vedda is also constructive on US Treasury bonds given the high yields on offer.

“U.S. Treasuries remain attractive following the recent yield repricing, as we continue to see market expectations for Fed tightening as overly aggressive relative to our central economic outlook,” he said.

“Higher yields have improved valuations, while a slowdown in growth and easing inflationary pressures could provide support for both the front and long ends of the Treasury curve.”