Morgan Stanley Sees Risks Building for US Stocks as Bond Yields Rise

US equities have continued to hold near elevated levels despite rising Treasury yields, but Morgan Stanley Wealth Management says higher borrowing costs, inflation risks, oil prices and consumer pressure could increasingly test the stock-market rally.

The US stock market has so far shown considerable resilience in the face of higher interest rates.

According to the information cited in the Morgan Stanley Wealth Management outlook, 10-year and 30-year US Treasury yields have moved above 5%, while major US equity benchmarks have continued to trade near elevated levels.

That creates an important question for investors: Can stocks continue to rise if bond yields remain high?

Morgan Stanley Wealth Management’s investment committee sees room for equities to advance, but its outlook also highlights several risks that could become more important as markets move toward 2027.

The assessment was presented by Lisa Shalett, Chief Investment Officer at Morgan Stanley Wealth Management, according to the material cited in the report.

Why US stocks have remained resilient

One of the main supports for equities has been corporate earnings.

Companies have continued to report profit growth, providing fundamental support for share prices even as the cost of borrowing has increased.

The Morgan Stanley view cited in the report expects S&P 500 earnings growth to remain healthy, making corporate profitability an important part of the argument for continued equity strength.

This matters because rising bond yields can put pressure on stock valuations. When safer government bonds offer higher yields, investors can demand greater returns from equities.

Strong earnings growth can partly offset that pressure if companies are able to increase profits fast enough.

AI investment remains another major market driver

Artificial intelligence has become another important source of investment across the US economy.

Companies are committing substantial amounts of capital to data centres, computing capacity, semiconductor infrastructure and other AI-related systems.

The impact extends beyond the technology sector.

Higher investment in computing and infrastructure can also create demand for areas such as:

• Energy
• Industrial equipment
• Manufacturing
• Data-centre infrastructure
• Utilities
• Technology services

The market’s performance has also broadened beyond a small group of mega-cap technology companies, according to the Morgan Stanley assessment cited in the report.

That broadening is significant because a rally supported by a wider range of industries can have a different risk profile from one driven primarily by a handful of large technology companies.

Why rising Treasury yields matter for stocks

The bond market is one of the key areas investors are watching.

Treasury yields influence the cost of capital across the economy and are also used in many financial models to value future corporate earnings.

When yields rise substantially, the present value of future earnings can fall, particularly for companies whose expected profits are further in the future.

Higher yields can also make bonds relatively more attractive compared with stocks.

That does not automatically mean equities must decline. Corporate earnings, economic growth and investor expectations can counteract the valuation pressure.

The question for investors is therefore not simply whether yields are rising, but how high they go and what is causing them to rise.

Inflation and oil prices remain important variables

Oil prices are another factor in the outlook.

A sustained increase in energy prices can feed into transportation, manufacturing and household expenses. If higher energy costs contribute to broader inflation, central banks may have less room to reduce interest rates.

The report also points to geopolitical tensions, including concerns involving the Strait of Hormuz, as a potential source of energy-market volatility.

For financial markets, the concern is the possibility of a combination of higher oil prices, persistent inflation and elevated bond yields.

Such a combination could create a more difficult environment for both consumers and companies.

Federal Reserve policy adds another layer of uncertainty

US monetary policy remains central to the outlook for stocks and bonds.

If inflation remains persistent, the Federal Reserve may have less flexibility to lower interest rates.

At the same time, investors closely monitor the central bank’s communication because expectations about future interest rates can move Treasury yields and equity valuations before policymakers actually change rates.

The material supplied for this article characterises incoming Fed leadership and policy decisions as another source of uncertainty. Those specific leadership and policy details should be independently checked against current Federal Reserve records before publication.

Are US consumers beginning to feel the pressure?

Another concern identified in the outlook is the financial position of lower-income US households.

Higher everyday expenses can reduce consumers’ discretionary spending power, particularly when wage growth does not keep pace with inflation.

The supplied report points to increasing stress in areas including auto loans, student loans and credit-card debt.

That does not necessarily indicate that the entire US consumer sector is in severe distress.

However, consumer spending is a major component of the US economy. A sustained deterioration among households could affect economic growth and, eventually, corporate revenue and earnings.

This makes the labour market particularly important.

If employment and wage growth remain supportive, consumers may continue spending despite higher costs. If the labour market weakens materially, the pressure could become more visible in corporate earnings.

Morgan Stanley’s approach to equities

According to the outlook described in the supplied material, Morgan Stanley’s Global Investment Committee continues to favour equities while emphasising quality.

The strategy focuses on large US companies with strong cash generation and comparatively durable business models.

The committee is also described as being more cautious about smaller, lower-quality companies following their recent performance.

Beyond the US, the outlook identifies emerging markets and Japan as areas investors could consider for diversification.

These are asset-allocation views from Morgan Stanley and should not be interpreted as a guarantee of future performance.

What about bonds?

Higher Treasury yields have created a complicated environment for fixed-income investors.

On one hand, higher yields can eventually provide better income opportunities for bond investors. On the other, investors holding longer-duration bonds can face price declines when yields rise further.

The Morgan Stanley view described in the report therefore takes a cautious approach toward making a large directional bet on interest rates.

The uncertainty comes largely from the competing forces affecting inflation and monetary policy.

If inflation falls, yields could eventually come under downward pressure. If inflation remains persistent or fiscal concerns push yields higher, the opposite could happen.

Why diversification could matter more

The traditional relationship between stocks and bonds is also worth watching.

Historically, investors have often used government bonds to diversify equity risk. But when stocks and bonds fall together, that protection can become less effective.

The outlook therefore discusses alternative sources of diversification, including:

• Gold
• Commodities
• Real estate
• Infrastructure
• Hedge funds
• Selected private-market investments

Each carries its own liquidity, valuation and risk considerations, so diversification does not eliminate investment risk.

The bigger question for the stock market

The central issue for US equities is whether earnings growth can continue to justify elevated valuations while interest rates and inflation remain relatively high.

So far, according to the Morgan Stanley assessment cited in the report, the earnings picture and continued investment in areas such as AI provide reasons for optimism.

At the same time, investors are facing several variables that could challenge that outlook: higher Treasury yields, energy prices, inflation, monetary policy, fiscal uncertainty and pressure on some consumers.

That leaves the bond market as an important signal to watch.

For investors, the key distinction is between a rise in yields driven by stronger economic growth and a rise driven by persistent inflation, fiscal concerns or other risk factors. Those scenarios can have very different implications for stocks.

Morgan Stanley’s message, as described in the supplied material, is therefore not that rising yields necessarily spell the end of the equity rally. Rather, the higher rates remain elevated, the more closely investors may need to watch whether corporate earnings and economic growth can keep pace with the changing cost of capital.