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Investment Weekly: Bonds stalk the stock market

25 May 2026

Key takeaways

  • It’s a classic emerging markets story: a spike in a country’s bond yields that coincides with a slide in its currency. Yet, that’s exactly what we’ve seen play out in the UK in recent weeks. So, what should we make of it?
  • Against a backdrop of volatile inflation, narrow stock market leadership, and less reliable traditional diversifiers, there’s a strong case for adding defensive growth to portfolios. One way to do that is to prioritise income and focus on high dividends paid by good quality stocks.
  • An unsung story in global stocks over the past five years has been Asia’s small-cap stocks. Over that period, they have outperformed their large-cap peers in the region by nearly 3% annualised at the index level – and done so with lower volatility and more balanced sector diversification.

Chart of the week – Bonds stalk the stock market

Global bond yields are on the rise, with US 10-year Treasury yields up around 0.2% in recent weeks, and investors are asking whether this spike is finally what kills the stock market? The answer is that it depends on whether the bond move is “good” or “bad”.

“Good” bond yield rises come from stronger growth. Think of the late 1990s tech boom. If the investment narrative assumes a productivity surge, or rapid profit growth, higher yields can still be a benign backdrop for stocks.

“Bad” yield rises come when there’s no growth to offset higher discount rates. 2022 is the classic example: inflation surged, real rates reset higher, and equities had to de-rate.

So, which is it now? The answer is: it’s not too bad. Since February, most of the move in bond yields has been at the short end, with a big shift in central bank policy expectations. At the long end, the term premium has edged higher. But while nominal yields are up, inflation adjusted “real” yields remain low across the curve. That’s good news for stocks, which are naturally inflation hedged, and sensitive to real rates. Meanwhile, profit growth stays gangbusters and expected growth is outpacing the rise in the discount rate – for now.

It is worth keeping a close eye on bond yields… but right now, it’s a move that stocks can live with, albeit with some volatility. The weapon is blunt.

Market Spotlight

From tankers to turbines

Disruption in the Strait of Hormuz is proving a challenge for Asia, with the energy shock presenting upside risks to inflation and headwinds to growth. Ultimately, though, it could speed up the region’s shift towards renewables.

With Asia the main destination for Gulf oil and gas, higher prices and supply risks are a major headache. In the short term, governments have been able to rely on stockpiles and alternative fuels. But longer term, some energy transition experts argue that countries are likely to accelerate the shift to renewables to build energy resilience.

Even before the current crisis, Asia’s energy transition was well under way, helped by improving economics. There have been encouraging trends in generation costs for renewables versus other energy sources, driven by falling technology costs – especially in solar PV production and batteries. The relatively quick pace of construction is also appealing to both governments wanting to boost capacity and investors seeking to minimise development risk.

So, while the supply shock has been painful, the longer-term impact on policy and capital allocation could be a catalyst for Asia’s energy transition. That’s good news for investors at a time when infrastructure is playing a key role in portfolios as a defensive, longer-duration diversifier.

The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. The level of yield is not guaranteed and may rise or fall in the future. Past performance does not predict future returns. For informational purposes only and should not be construed as a recommendation to invest in the specific country, product, strategy, sector, or security. Diversification does not ensure a profit or protect against loss. Any views expressed were held at the time of preparation and are subject to change without notice. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. You cannot invest directly in an index. Source: HSBC Asset Management, Factset, Bloomberg, Macrobond. Data as at 7.30am UK time 22 May 2026.

 

Lens on…

Gilty verdict

It’s a classic emerging markets story: a spike in a country’s bond yields that coincides with a slide in its currency. Yet, that’s exactly what we’ve seen play out in the UK in recent weeks. So, what should we make of it?

Analysts have been poring over the UK’s public finances, productivity, inflation, and politics. But the subsequent sell-off in both Gilts and sterling is eye-catching because it’s reminiscent of how EM markets have responded to similar challenges in the past.

The irony is that, thanks to a combination of factors, many EMs have reduced bond volatility in recent years, reassuring domestic investors. Fiscal discipline has strengthened fundamentals, with EM debt dynamics now steadier than in some developed markets. Ratings momentum has picked up, and economies are more resilient in the face of US dollar strength – helped by credible central banks and deeper reserve buffers.

By doing this, EMs have shown that domestic investors can be a powerful and stabilising force for long-term bonds. With Gilt yields now at their highest since Bank of England’s independence, the question is: can the UK re-establish a domestic bid for the long end?

Defensive dividends

Against a backdrop of volatile inflation, narrow stock market leadership, and less reliable traditional diversifiers, there’s a strong case for adding defensive growth to portfolios. One way to do that is to prioritise income and focus on high dividends paid by good quality stocks.

“Dividend aristocrats” – firms that have upped their payouts for more than 25 years – are a rare breed. Not only have they outpaced the Nasdaq over time, but they have also been less volatile. One reason for this is that long-term dividend growers often have stable, cash-generative models – and that makes their dividends resilient to headwinds. Indeed, global dividends have proved to be much more resilient than earnings during recessions.

Second, the ability of firms to maintain strong balance sheets and capital discipline over multi-decade horizons is demanding. Tilting towards these firms tends to screen out over-leveraged and highly cyclical stocks that can be more speculative and volatile. Third, the compounding effect of reinvested dividends can have a positive influence on returns over time.

Overall, high and growing dividends in high-quality firms can be a diversifying source of returns for portfolios – as well as a defence against inflation spikes and market volatility.

Hidden gems

An unsung story in global stocks over the past five years has been Asia’s small-cap stocks. Over that period, they have outperformed their large- cap peers in the region by nearly 3% annualised at the index level – and done so with lower volatility and more balanced sector diversification.

Key to this is the rapid returns that smaller firms can deliver. Let’s look at the performance stats of 150 stocks promoted to the MSCI Asia ex-Japan large-cap index from the small-cap index in the early 2020s. The year before promotion, those stocks saw stunning average gains of 245%, but that fell to 18% in their first year as large caps.

In terms of diversification, the global tech rally means that Taiwan and South Korea now have significant weightings in both the Asia small cap and large cap indices. Another country heavily weighted in the small-cap index is India, which some analysts highlight as a source of under-researched opportunities and potential profit growth.

Overall, this blend of robust performance and broad sector exposure supports the case for thinking big on Asia.

Past performance does not predict future returns. The level of yield is not guaranteed and may rise or fall in the future. For informational purposes only and should not be construed as a recommendation to invest in the specific country, product, strategy, sector, or security. Diversification does not ensure a profit or protect against loss. Any views expressed were held at the time of preparation and are subject to change without notice. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. You cannot invest directly in an index. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. Costs may vary with fluctuations in the exchange rate. Source: HSBC Asset Management. Macrobond, Bloomberg, Refinitiv, Factset. Data as at 7.30am UK time 22 May 2026.

Key Events and Data Releases

Last week

This week ahead

For informational purposes only and should not be construed as a recommendation to invest in the specific country, product, strategy, sector or security. Any views expressed were held at the time of preparation and are subject to change without notice. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. Index returns assume reinvestment of all distributions and do not reflect fees or expenses. You cannot invest directly in an index.  Source: HSBC Asset Management. Data as at 7.30am UK time 22 May 2026.

Market review

Global equities softened as renewed concerns over high valuations offset strong Q1 US earnings. In the US, the S&P 500 and Nasdaq indices retreated, with Nikkei 225 also weak and Euro Stoxx 50 index little changed. EM Asia stock markets were broadly lower, with disappointing Chinese economic data weighing on the Shanghai Composite and Hang Seng. The tech-heavy Kospi and the Sensex were also down. In fixed income, 10-year US Treasury yields were higher on rising domestic inflation worries, with FOMC minutes signalling that members expect that elevated inflation could require higher for longer rates. Ten-year Japanese government bond yields rose on fiscal concerns, while UK Gilt yields stabilised on weak labour market data. In FX markets, the US dollar built on recent gains against major peers. Oil prices rose and gold fell.

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