Higher Bond Yields cause allocators to re-evaluate

WHAT CHANGED IN THE PORTFOLIOS?

• Increased government bond exposure as yields reached more attractive levels.
• Reduced equity exposure modestly and moved portfolios closer to neutral.
• Eliminated the underweight position in government bonds.
• Maintained a neutral duration stance.
• The changes are reflected across the following strategies: CI Global Income & Growth, CI Canadian Income & Growth, and CI Canadian Asset Allocation.
   

When Good News Isn't Enough

We share some recent thoughts from our Asset Allocation Committee meeting…
 

September served as another reminder that markets rarely move in straight lines. While major equity indices finished the month largely unchanged, market leadership became increasingly fragmented. As one member of the Committee observed, "One day the market is rewarding companies tied to AI infrastructure, the next it is focused on semiconductor developers, and shortly after attention shifts to an entirely different segment of the technology ecosystem." Rather than being driven by a single dominant theme, markets appear increasingly dependent on shorter-lived rallies within individual sectors and industries.

Against this backdrop, the Asset Allocation Committee spent less time discussing strong year-to-date market performance and more time debating a much more important question:

What Happens When Expectations Become the Risk?

After a multi-year bull market fueled by resilient economic growth, strong corporate earnings and significant enthusiasm surrounding artificial intelligence, investors remain eager to buy every market dip.

Yet beneath the surface, several signals suggest the balance of risks may be beginning to change.

As one committee member observed:
"The market is clearly looking for reasons to rally, but It is becoming increasingly difficult to push it higher."

The discussion ultimately centered on three key themes:

1. The growing appeal of government bonds
2. Elevated expectations in equity markets
3. The possibility that bonds and equities are telling very different stories and how this impacts growth
    

Are Government Bonds yielding an Advantage?

Government bonds became one of the most heavily debated topics at the meeting. For much of the last several years, maintaining an underweight position in government bonds has been beneficial for portfolio performance. However, the investment landscape is changing. The U.S. 10-year Treasury yield has approached 5%, while longer-dated government bonds have reached levels not seen in decades. Similar moves have occurred across most developed markets. In Canada, the 10-year Government of Canada bond has risen from 3.47% at the beginning of the year to approximately 4.00% today. Source: Bank of Canada. This has led to a question we have increasingly received from advisors: Is it finally time to lean back into government bonds?

The Committee's conclusion was not that interest rates are poised to decline sharply. Rather, higher yields are beginning to offer investors reasonable compensation for uncertainty. As one member put it:

"Do I prefer bonds over cash today? Yes. Do I have a strong conviction that rates are going dramatically lower from here? No.“

The Committee acknowledged that inflation risks remain present and that higher commodity prices could continue to place upward pressure on yields. However, current starting yields have improved the potential return profile for government bonds considerably compared to earlier in the year. As a result, the Committee elected to eliminate its underweight position in government bonds and move portfolios closer to neutral positioning. This adjustment was funded equally through reductions in cash and equities, while maintaining a neutral duration stance.
 

The Problem Isn't Earnings. It's Expectations.

The Committee remains constructive on long-term earnings growth, particularly among businesses benefiting from ongoing AI-related investment spending. However, a recurring theme throughout the discussion was that the greatest challenge facing equities today may not be deteriorating fundamentals. It may be expectations. Many of the market's leading companies continue to report exceptional earnings growth. However, growth rates of 60-70% cannot continue indefinitely. Eventually, even outstanding businesses face the law of large numbers. The important question for investors is not whether growth remains strong. The question is: How will markets react when growth remains good, but simply becomes less extraordinary?

In many areas of the market, valuation multiples already reflect a highly optimistic outlook. As a result, companies may increasingly find themselves in a position where strong earnings are rewarded less generously than they have been over the past several years.

The Committee did not advocate for a wholesale reduction in risk assets, nor did it become negative on equities. However, there was broad agreement that the risk-reward profile has become somewhat less attractive following recent market gains. To reflect this assessment, the Committee modestly reduced equity exposure, bringing portfolios closer to neutral positioning.
 

Two Markets, Two Stories

Perhaps the most interesting discussion centered on the growing disconnect between signals from the bond market and the equity market. On one hand, bond investors continue to demand significantly higher yields. On the other hand, equity markets remain remarkably resilient, supported by strong earnings growth and continued confidence in the economic outlook. One Committee member summarized the situation succinctly: "You have 10-year yields around 5%, and the equity market acts as if nothing is wrong.“

Another member offered the opposing perspective: "If you're growing revenues at 50% year-over-year, does it really matter whether you're paying 4%, 5% or 6% for your debt?“

Both arguments have merit. Ultimately, the Committee's view is that continued AI-driven investment spending and economic growth should remain supportive of risk assets. However, if either economic momentum or earnings growth begins to moderate, government bonds appear considerably better positioned to provide portfolio diversification than they have in recent years. This distinction is important because stock-bond correlations are highly dependent on the dominant market fear. 

When inflation is the primary concern, stocks and bonds often fall together. When growth becomes the primary concern, bonds typically resume their traditional role as a portfolio ballast. With yields now substantially higher, the Committee believes bonds once again have the potential to provide meaningful diversification should growth expectations begin to soften.