June 8, 2026 (MLN): The S&P 500 hit all-time highs 19 times in the first five months of 2026, returning 9.8% year-to-date.
Rapid growth in artificial intelligence profits, solid industrial activity and entrenched inflation expectations are keeping stock markets resilient despite the oil crisis triggered by the U.S.-Iran war, persistent inflation and the Federal Reserve’s “prolonged high” policy direction, according to the Capital Markets Outlook from Merrill’s Chief Investment Office.
Five AI stocks account for about half of the index’s year-to-date returns, and the index has posted six consecutive quarters of double-digit growth in earnings per share.
While long-term Treasury yields remained within the narrow range established since 2023, they recovered from a 9.1% drawdown to reach a new record in just 11 business days.
Macro strategy: Rising yields are acceptable but not a recession
The report’s central macro argument is that the current environment of rising U.S. Treasury yields does not signal an impending recession or financial instability, and that markets have already priced in this distinction.
As yields rise along with strong growth, productivity, and profits, stock prices are likely to continue rising.
Risk assets will only come under sustained pressure if interest rates rise due to unanchored inflation expectations, the prospect of significantly tighter policy, and deteriorating fiscal dynamics.
Since the Hormuz-related oil crisis began in early March 2026, the 10-year Treasury yield has risen from about 4% near the bottom of the three-year range to about 4.67% near the high, before settling at 4.44%.
Notably, stability in both long-term premiums and long-term inflation expectations has limited negative stock market reactions, and signals across assets remain constructive, with credit spreads tight, VIX below average, and cyclical sectors including industrials and technology outperforming.
While copper prices are rising, gold prices are lagging behind what would be expected under a full-blown fiscal stress or inflation panic scenario.
While the yield curve is not steep, it has not historically reversed sufficiently restrictive policy assumptions to significantly dampen growth and profits.
The report adds that AI and business investment-driven productivity growth of 2.0% to 2.5% could significantly improve the long-term debt-to-GDP trajectory compared to more conservative baseline projections and alleviate concerns about fiscal sustainability.
Regarding the real economy, despite the headwinds from the oil crisis affecting some parts of the manufacturing industry, industrial production in April was revised upward significantly and unexpectedly.
AI-related investments in electronics, electrical equipment, and infrastructure, coupled with fiscal support for defense and aerospace and vehicle production due to wealth effects, drove the beat.
Increased inventory replenishment needs are expected to further strengthen the industrial sector’s growth trajectory, which the report notes will be an important multiplier for the overall economy and corporate profits.
Earnings expectations are rising for both large- and small-cap stocks.
The report argues that AI-related investments, large fiscal deficits, strong wealth effects, and capital flows into energy, defense, and reshoring are all boosting corporate cash flows in a self-reinforcing cycle that sustains labor demand and business investment.
Market View: Stock-bond correlation is at its most positive level since 1999
For most of the period from roughly 2000 to 2021, bonds reliably hedged against equity drawdowns and cushioned portfolio losses when stocks fell and bonds rallied.
The relationship became increasingly unstable.
The correlation between short-term rolling stocks and bonds has now soared to its most positive level since 1999, due to new inflationary pressures from US and Iranian supply shocks and uncertainty over Fed policy.
Both asset classes have fallen together, limiting the ability of portfolios to cushion the downside.
The pandemic era has reached a turning point. A surge in fiscal and monetary stimulus has pushed inflation to multi-decade highs and prompted the Fed’s aggressive tightening cycle.
The impact in 2022 was significant, with both stocks and bonds plummeting, and a 60/40 allocation experiencing a drawdown of about 16%, its worst annual performance since 2008.
Since then, higher yields have improved bond returns and the 60/40 framework has partially regained diversification status.
The standard 60/40 allocation returned 18% in 2023, 16% in 2024, and 14% in 2025.
During last year’s tariff-induced stock sell-off, the Bloomberg U.S. Aggregate Bond Index rose about 1% from mid-February to early April 2025, even as the S&P 500 index fell about 18%.
Overall, a 60/40 allocation has yielded positive annual returns in 29 of the past 36 years.
The report argues that diversification has not collapsed, but regime dependence has increased.
In a low and stable inflation environment, growth concerns prevail, falling stock prices create an inverse correlation that investors rely on, and bonds benefit from Fed rate cuts.
In an inflationary or stagflation environment, inflation concerns prevail, the Fed’s ability to respond to slowing growth is constrained by rising prices, and stocks and bonds can fall simultaneously.
The practical conclusion to be drawn from this is that investors need to adapt rather than abandon the 60/40 framework.
The report recommends increasing diversification into inflation-sensitive real assets, commodities, infrastructure and real estate, and accessing private markets through alternative investment strategies for accredited investors.
This indicates an increase in concentration risk within stocks. The top 10 stocks in the S&P 500 now account for about 39% of total market capitalization, up from 23% at the beginning of 2020, making intentional sector, style, and geographic diversification more important than ever.
Current nominal and real yields are near their highest levels since 2008, improving the overall return outlook for bonds and reinforcing their continued value within a balanced portfolio even in a more volatile correlation environment, the report added.
Economic forecasting and asset allocation
|
indicator |
1st quarter of 2026A |
Q2 2026E |
Q3 2026E |
Q4 2026E |
2026 E |
2027E |
|
US real GDP (annualized % sequentially) |
1.6% |
2.5% |
1.9% |
1.9% |
2.1% |
2.2% |
|
CPI inflation rate (%y/y) |
2.7% |
4.1% |
4.0% |
3.7% |
3.6% |
2.3% |
|
Core CPI (%y/y) |
2.5% |
2.8% |
2.7% |
2.9% |
2.7% |
2.6% |
|
unemployment rate |
4.3% |
4.3% |
4.3% |
4.3% |
4.3% |
4.2% |
|
Federal funds rate (terminating period) |
3.63% |
3.63% |
3.63% |
3.63% |
3.63% |
3.13% |
Source: BofA Global Research / GWIM ISC, as of May 29, 2026
The CIO is overweight global equities, with a focus on growth and value in large-cap U.S. stocks, and at the sector level, overweight industrials, consumer discretionary, financials, and information technology.
With expectations for range-bound yields, we are underweight bonds overall relative to equities, with a neutral duration stance to fund our overweight equities.
On the fixed income side, we are underweight in US government, mortgages, and municipalities, while overweight in US investment grade companies.
The CIO sees temporary market volatility as a potential buying opportunity for long-term investors, and expects S&P 500 earnings growth to remain in double-digit territory through 2026.
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