AI stocks, earnings boom shield S&P 500 from oil shock, rate fears

June 08, 2026 (MLN): The S&P 500 has posted 19 all-time highs in the first five months of 2026, a 9.8% year-to-date return.

Surging artificial intelligence-driven earnings, robust industrial activity, and anchored inflation expectations have kept equity markets resilient despite a US-Iran war-triggered oil shock, persistent inflation, and a "higher-for-longer" Federal Reserve policy path, according to a Capital Market Outlook published by Merrill's Chief Investment Office.

Five AI-oriented stocks have accounted for roughly half the index's year-to-date return, the index has logged six consecutive quarters of double-digit earnings-per-share growth.

 It recovered a 9.1% drawdown in just 11 trading days to reach a fresh record all while long-term Treasury yields remained contained within the narrow range established since 2023.

Macro Strategy: Higher Yields Tolerable, Not Recessionary

The report's central macro argument is that the current environment of elevated Treasury yields does not signal impending recession or financial instability, a distinction it says markets have already priced in.

When yields rise alongside stronger growth, productivity, and profits, equity prices can continue to advance.

It is only when rates are pushed higher by unanchored inflation expectations, prospects for materially tighter policy, or deteriorating fiscal dynamics that risk assets come under sustained pressure.

Since the onset of the Hormuz-related oil shock in early March 2026, the 10-year Treasury yield rose from approximately 4% near the bottom of its three-year range to a high of around 4.67%, near the top, before settling at 4.44%.

It is noted that stability in both the long-run term premium and long-term inflation expectations has limited the equity market's negative response, with cross-asset signals remaining constructive: credit spreads tight, the VIX below average, and cyclical sectors including Industrials and Technology outperforming.

Copper prices have strengthened while gold has lagged the opposite of what would be expected under a genuine fiscal stress or inflation-panic scenario.

The yield curve, while not steep, has not inverted historically a precondition for policy sufficiently restrictive to materially weaken growth and profits.

The report adds that AI- and business-investment-led productivity growth running at 2.0%–2.5% could materially improve the long-run debt-to-GDP trajectory relative to more conservative baseline projections, easing fiscal sustainability concerns.

On the real economy, April industrial production surprised sharply to the upside despite oil shock headwinds to parts of manufacturing.

AI-related investment in electronics, electrical equipment, and infrastructure, combined with fiscal support for defense and aerospace and wealth-effect-driven motor vehicle output, drove the beat.

Growing inventory restocking needs are seen further cementing the industrial sector's growth path, which the report flags as a significant multiplier for the broader economy and corporate earnings.

Earnings expectations have risen for both large- and small-cap companies.

The report argues that AI-related investment, large fiscal deficits, strong wealth effects, and capital flowing into energy, defense, and reshoring are all boosting corporate cash flows in a self-reinforcing cycle that sustains labour demand and business investment.

Market View: Stock-Bond Correlations at Most Positive Level Since 1999

For much of the period from roughly 2000 to 2021, bonds reliably hedged equity drawdowns  when stocks fell, bonds rallied, cushioning portfolio losses.

That relationship has become increasingly unstable.

Short-term rolling stock-bond correlations have now surged to their most positive level since 1999, driven by renewed inflation pressures from the US-Iran supply shock and uncertainty around Fed policy.

Both asset classes have moved lower together, limiting the portfolio's ability to cushion downside.

The pandemic era marked the inflection point. A surge in fiscal and monetary stimulus drove inflation to multi-decade highs, prompting an aggressive Fed tightening cycle.

In 2022, the consequences were stark: both stocks and bonds declined sharply, producing a roughly 16% drawdown for a 60/40 allocation, its worst annual performance since 2008.

Since then, higher yields improved fixed income's return profile, and the 60/40 framework partially recovered its diversification credentials.

A standard 60/40 allocation returned 18% in 2023, 16% in 2024, and 14% in 2025.

During last year's tariff-driven equity selloff, the Bloomberg US Aggregate Bond Index rose approximately 1% even as the S&P 500 fell roughly 18% from mid-February to early April 2025.

Overall, a 60/40 allocation has delivered positive annual returns in 29 of the last 36 years.

The report argues that diversification has not broken down but has become more regime-dependent.

In low-and-stable-inflation environments, growth concerns dominate and bonds benefit from Fed rate cuts as equities fall producing the negative correlation investors rely on.

In inflationary or stagflationary environments, inflation concerns dominate, the Fed's ability to respond to slowing growth is constrained by rising prices, and stocks and bonds can decline simultaneously.

The practical takeaway that is drawn is that investors should adapt, not abandon, the 60/40 framework.

It recommends broadening diversification into inflation-sensitive real assets commodities, infrastructure, and real estate and accessing private markets through alternative investment strategies for qualified investors.

Within equities, it flags rising concentration risk: the top 10 S&P 500 stocks now account for roughly 39% of total market capitalization, up from 23% at the start of 2020, making deliberate sector, style, and geographic diversification more important than before.

Current nominal and real yields, near the higher end of their range since 2008, have improved the overall return outlook for fixed income, the report adds, reinforcing its continued value within a balanced portfolio even in a more volatile correlation environment.

Economic Forecasts and Asset Allocation

Source: BofA Global Research / GWIM ISC, as of May 29, 2026

The CIO maintains an overweight on global equities, led by US large-cap growth and value, and overweights on Industrials, Consumer Discretionary, Financials, and Information Technology at the sector level.

It is underweight on fixed income overall relative to equities to fund the equity overweight, with a neutral duration stance amid expectations for range-bound yields.

On the fixed income side, US governments, mortgages, and municipals are underweighted, while US investment-grade corporates are overweighted.

The CIO views episodic 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 full-year 2026.

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