Stock Markets Rally Despite Geopolitical Turmoil, Bond Markets Signal Caution

Global stock markets have been on a tear in 2026, extending last year's rally as traders look through geopolitical turmoil and inflation fears.

But bond markets are painting a different picture — and the growing divergence is ringing alarm bells for some investors.

While many major stock indexes have erased losses incurred at the start of the Iran war, government bonds have largely taken a more cautious approach, continuing to price in higher inflation and widespread interest rate hikes.

In the U.S., for example, the S&P 500 — up 7.4% year-to-date — has risen almost 7% since the conflict began in late February.

The S&P 500 and the Nasdaq Composite hit new all-time highs last week, but rising bond yields have put stocks under pressure in recent days, causing both indexes to pull back from the rally.

That divergence is also visible in markets beyond the U.S. The MSCI World Ex USA index has clawed back a lot of its wartime losses, and is now down by around 3% from the start of the conflict. At its low around one month into the war, the index had shed almost 9%.

At the same time, the FTSE World Government Bond index — a measure of sovereign debt from more than 20 countries — has seen an aggregated rise in yields of about 55 basis points. Bond yields and prices move in opposite directions.

Various developed economy markets have demonstrated a similar pattern of rising optimism in equity markets, while macroeconomic concerns put pressure on sovereign bonds.

In its latest fund manager survey, the results of which were published on Tuesday, Bank of America found there had been record growth in equity allocations in May. The poll — which had responses from panelists collectively managing assets worth $517 billion — saw fund managers shift from being net 13% overweight on equities in April to net 50% overweight this month.

But BofA's analysts warned their Bull & Bear Indicator was nearing a "sell-signal" level, and that early June was "ripe for profit taking," with bond yields set to determine the degree of any pullback.

In a Tuesday morning note, analysts at Barclays said stocks had seen the fastest rebound in decades, with U.S. equity funds seeing net new inflows totaling $70 billion over the past 7 weeks. This marked a 97th-percentile streak since 2000, they said — but they warned that "now the pendulum could swing backwards."

"Foreign demand for U.S. equities over [the rest of the world] is accelerating amid persistently high oil prices," Barclays' analysts said, noting that year-to-date inflows to U.S. equity funds were tracking at $180 billion, more than double the five-year median.

"However, with portfolios fully invested and macro headwinds mounting, the risk of a near-term unwind has materially increased," they added.

Barclays said their analysis showed portfolio managers had reduced their exposure to equities in recent days, while Commodity Trading Advisors — key drivers of the recent rebound — were now near their maximum long U.S. equity positioning.

"Iran aftershocks and the April CPI surprise led markets to reprice central bank assumptions; we see room for positioning to retrace further in the near term," the bank's analysts said, before raising the question of whether bonds will "crash the AI party" in equity markets.

"Notably, rising yields and inflation concerns continue to anchor sizeable shorts in US Treasuries, but U.S. equity longs remain vulnerable as yields approach a critical inflection point where higher rates have historically begun to weigh on equities."

"Spillover risk from higher yields into equities has re‑emerged, with the Iran conflict having already pushed stock‑bond correlations back into negative territory and reviving a Covid‑era regime where equities strongly react negatively to inflation surprises and positively to growth surprises."

Paul Skinner, investment director at asset management giant Wellington, also said on Tuesday that the divergence between bond and stock markets was putting equity portfolios at risk.

"We do think it leaves [equities] vulnerable to a correction," he told CNBC's "Squawk Box Europe."

But he noted that Wellington does not believe inflation is now embedded in the global economy for the long term.

"This could be just a correction rather than [the] start of a bear market in equities," he said. "But there's going to be huge disparity across the world because of how central banks are reacting."

If central banks take too long to react to rising inflation, Skinner told CNBC, it could result in a stagflationary environment that's "catastrophic for risk assets," pointing to the U.K. in the early 1970s.

"We want [this] to be more like the '79 oil shock, where central banks kept rates high and we avoided that stagflationary problem," he said. "Risk assets did far better, even though they kept rates high. So, there's going to be a difference in how markets react depending on how your central bank has responded to this."

Neil Birrell, Chief Investment Officer at Premier Miton Investors, told CNBC in an email that it was a matter of time before sentiment and trading patterns in the bond market began to weigh on equities.

"Bond and equity markets have taken diverging views to the macro environment, with bonds reflecting underlying pessimism and risk-off, whilst equity markets have worked on the optimistic basis that the Iran war will get resolved sooner rather than later and macro risks will dissipate," he said, noting that corporate earnings have supported the bull case for equities.

"Sell-offs are followed by buyers taking advantage of lower prices, but eventually, ongoing high bond yields when combined with any or all of higher inflation, slowing growth, Iran war escalation or elongation, weaker corporate earnings, AI-induced strain or more geopolitical stress, are likely to have a negative impact on equity markets," Birrell warned. "It's a case of how much and how long before the buyers appear again, but it's possible they step to the side."

But analysts at Deutsche Bank think the resilience seen in equity markets this year makes more sense than it might appear at first glance.

"Although the last couple of sessions have seen a slight pullback for risk assets, none of the conditions are yet in place that caused more aggressive selloffs in the past," analysts at the bank said in a note on Tuesday morning.

They added that analysis of past shocks showed a more pronounced selloff would require either a sustained oil shock, economic data that is "clearly in contractionary territory," or aggressive central bank tightening — or a combination of these conditions.

"So far, it's tough to argue we have any of these," Deutsche Bank's note said. "The closest is the point on the 'sustained' oil shock, as markets are increasingly pricing in a longer period of elevated oil prices."

But they noted that the six-month Brent future was still trading marginally above $90 per barrel, adding that "declining energy intensity means that a given level for oil prices doesn't create the economic shock it used to."

"So unless we see a clear change in these fundamentals, then the resiliency of risk assets is not particularly remarkable, but is in keeping with the historical record of recent decades," they said.