Strategists urge investors to turn defensive as election uncertainty, rising Treasury yields and an uneven U.S. economy threaten to expose vulnerabilities in equities
The U.S. stock market’s powerful rally could face a major test after November’s midterm elections, with Bank of America strategists warning that a Democratic sweep of Congress could trigger a sharp reversal in risk assets.
The bank’s strategists, led by Michael Hartnett, said investors should reduce exposure to riskier assets and adopt a more defensive positioning in the months ahead. They described the election as a potential “referendum on populist capitalism vs populist socialism” and flagged the possibility of a “big” reversal in stocks after voters go to the polls.
The warning comes after a prolonged equity rally that has lifted U.S. stock valuations and generated roughly $9 trillion in market gains over the past two years. BofA said the increase in household wealth from higher stock prices has become an important source of economic support, creating a potential vulnerability if markets reverse sharply.
“Investors should eschew risky assets and head into defensive investment in the near-term,” Hartnett’s team wrote in a note on Friday.
The strategists said they favor gold as a hedge against risks associated with what they described as a K-shaped economy and an electorate that could deliver an “it’s the economy, stupid” midterm result.
The K-shaped economy refers to the widening divergence between higher-income households, which have benefited from rising financial and property values, and lower- and middle-income households facing greater pressure from inflation and a difficult labor market.
That divide could become politically significant if economic conditions deteriorate or financial markets weaken. Higher-income households tend to have greater exposure to equities and other financial assets, meaning a prolonged market decline could weaken the wealth effect that has supported consumer spending.
BofA said the U.S. economy’s recent resilience has been supported in part by the increase in household wealth created by rising asset prices. That creates a feedback risk: if stocks fall significantly, consumers could respond by cutting spending, potentially weakening economic growth and corporate earnings.
Treasury Yields Emerge As A Bigger Threat
BofA also warned that the bond market could become the more immediate threat to the equity rally.
Strategists said yields could move substantially higher if investors become more concerned about inflation and the U.S. government’s fiscal position. A sharp rise in borrowing costs would increase financing expenses for businesses, put pressure on equity valuations and make bonds more attractive relative to stocks.
In a more severe scenario, higher yields could become the catalyst for a broader risk-off move and potentially puncture the market’s enthusiasm for artificial intelligence stocks.
“Bonds end booms and bubbles, and this one ends once ‘higher yields-lower dollar’ vigilante event forcing fiscal policy U-turn, and asset allocation from stocks to bonds rise,” the strategists said.
They described rising yields as a “canary in the coalmine” for investors.
The 10-year U.S. Treasury yield has already climbed to around 4.67%, above the 4.5% level closely watched by investors. So far, the increase has not been enough to derail equities, but a further rise could put greater pressure on stocks whose valuations depend heavily on expectations of strong future earnings.
The concern is particularly relevant for large technology and AI companies. Their share prices have risen sharply as investors anticipate years of rapid growth in AI infrastructure, software and computing demand. Higher discount rates can reduce the present value investors assign to those future cash flows, making high-growth stocks especially sensitive to movements in Treasury yields.
Election Risk Adds Another Layer Of Uncertainty
The November midterms could introduce another source of volatility.
BofA’s warning centers on the possibility that Democrats could win control of both chambers of Congress. Such an outcome could alter expectations for taxation, spending, regulation and fiscal policy, potentially prompting investors to reassess sectors and companies that have benefited from the current policy environment.
The election could also become a referendum on the distribution of economic gains. While financial markets have performed strongly, the benefits of higher asset prices have been unevenly distributed, leaving households with little exposure to stocks or property more vulnerable to inflation and employment pressures.
That dynamic could increase the importance of economic conditions in determining voter behavior and, in turn, market expectations.
Other Wall Street strategists have also warned of elevated volatility as the election approaches.
Oppenheimer analysts said in an earlier note that in midterm years when the president is serving a second term, the S&P 500 tends to experience a correction during the third quarter.
Goldman Sachs strategists have also pointed to a seasonal pattern. In all midterm years since 1974, the S&P 500 has produced a median return of 0% from August 1 through election day in November.
Those historical patterns do not establish that stocks will fall this year, but they highlight a period when political uncertainty and changes in expectations about economic policy have historically increased market sensitivity.
The Bull Market Faces A Three-Way Test
The risks identified by BofA ultimately converge around three forces: asset valuations, Treasury yields and the distribution of economic growth.
The equity rally can continue if corporate earnings remain strong enough to justify elevated valuations, inflation stays contained, and Treasury yields remain manageable. Strong earnings would also help offset concerns about expensive technology stocks and the sustainability of AI-related investment.
The risk is that higher inflation or worsening fiscal concerns push bond yields significantly higher at the same time that economic dissatisfaction becomes more politically important. Such a combination could weaken both the economic backdrop and investors’ willingness to pay high prices for future earnings.
For now, the market has tolerated higher yields and continued to reward companies delivering strong earnings growth. BofA’s warning is that this tolerance may not last if the bond market begins demanding a substantially higher return to hold U.S. government debt. That makes the months between now and the November elections particularly important for investors.
