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US MARKETS CALL: Is The 10-Year Bond Yield Back To The Old Normal?
I. Bonds The Economist just rang the all-clear siren for the bond market (chart). It is safe to buy bonds now that the front cover of the October 10 magazine is titled "Will bonds blow up?" This and other national magazines’ cover stories often have been great contrary indicators. It’s the “front-page curse” (once magazines put in the time it takes them to produce a cover article on a financial market trend, investors have moved on). We think the 10-year Treasury bond yield is back to normal this year, i.e., in the 4.00% to 5.00% range (chart). We've disputed the widespread notion that "interest rates are likely to remain higher for longer." That implies that they should come back down at some point. We've argued that "interest rates are likely to stay normal for longer." They were abnormally low between the Great Financial Crisis and the Great Virus Crisis, when central banks rigged the fixed-income markets with zero and near-zero interest-rate policies and quantitative easing. As bond yields rose in recent months to the top end of what we consider the normal range, we expected buyers to be attracted by higher yields, so we expected the range to be maintained (that’s what happened in in 2023, when the yield spiked to 5.00% in late October). This time, the yield spiked above the normal range, to around 5.25% (as it did during the 4.00%-5.00% normal-range period from 2002-07). In recent conversations with several of our institutional accounts, many expressed interest in buying bonds at levels above 5.00%. A slice-and-dice analysis of the 10-year yield shows that its rise this year has been almost entirely attributable to the rise in the comparable TIPS yield (chart). The spread, which is a proxy for inflation expectations over the next 10 years, has been range-bound roughly between 2.00% and 2.50% since 2023. Since 2023, the TIPS yield has closely tracked the Weekly Economic Index, which tracks the growth rate in real GDP on a y/y basis (chart). This supports our view that the increase in US nominal yields has been driven by better-than-expected economic growth. In the past, the expected inflation spread was highly correlated with the price of a barrel of crude oil (chart). That correlation has been weaker since 2023. Bond investors seem to believe that inflation will remain low in the 2.00%-2.50% y/y range over the rest of the Roaring 2020s into the Roaring 2030s. We agree. Nevertheless, we can't rule out the possibility that another spike in oil prices, driven by a re-escalation of the war in the Middle East, won't push nominal bond yields higher. If so, that will likely be another buying opportunity. By the way, the expected inflation spread closely tracks the 10-year forward inflation-linked swap (chart). All major forward inflation-linked swaps are roughly in the 2.00%- 2.50% range (chart). Meanwhile, the link between the 13-week change in the 10-year nominal yield and the Citigroup Economic Surprise Index suggests that the former's recent climb should abate (chart). II. Stocks The steep rise in bond yields since mid-August has weighed on the S&P 500 equal-weight stock price index, while the market-weight index rose to record highs last week (chart). The former may be finding support at its 200-day moving average. The gap between XMAGS's outperformance and MAGS's underperformance has narrowed since mid-August as bond yields jumped (chart). Over the past couple of weeks, they both did well. The Russell 2000 also dipped as bond yields soared since the late summer (chart). The index is back at its 200-day moving average, which should hold if US bond yields continue to stabilize. III. Sentiment Investor sentiment turned more bullish last week according to the two bull-bear ratios we track. (chart). Like the front-page curse, they also tend to be contrary indicators. However, they aren't bullish enough to be bearish for stocks.
Lots Of FEMO In Q3's Earnings Reporting Season
I. FEMO in Q3 We have spent much of the past few months marveling at Corporate America's Fabulous Earnings Momentum (FEMO). S&P 500 earnings per share growth approached 30% y/y in Q1 and accelerated to more than 50% in Q2, although unusually large mark-to-market investment gains boosted both figures. Even excluding those gains, earnings grew roughly 20% and 25%, respectively. Q2 also marked the fifth consecutive quarter with record earnings. Q3 is shaping up to be another blockbuster quarter. As Joe reported this week, industry analysts' consensus forecast for Q3-2026 S&P 500 EPS growth started the quarter at an already remarkable 27.6% y/y. Rather than declining as it typically does during the quarter, it climbed 3.0 ppts to 30.6%. The level of expected Q3 EPS rose 2.2% over the quarter, ranking as the 12th-largest upward revision in the 130 quarters since Q2-1994. That's no small feat! Better yet, FEMO is broadening across Corporate America. Analysts expect all 11 S&P 500 sectors to deliver positive y/y growth in both revenues and earnings. Only once before, in Q2-2021, has such a perfect sweep occurred in the 25 years we've tracked the data. Overall, S&P 500 revenues are expected to grow 11.6% y/y, compared with earnings growth of 30.6% (chart). Energy is expected to lead Q3 earnings growth at a whopping 114.7% y/y, followed by Information Technology, Communication Services, and Materials (chart). Energy's expected earnings growth has surged from negative territory earlier this year, while Information Technology's has climbed steadily, reflecting the AI investment boom. II. Financials in Q3 Q3 earnings season kicks off next week with the big banks. The latest banking data suggest there is plenty to be optimistic about. Commercial and industrial loans rose 9.7% y/y during the week of September 23, while total bank loans and leases increased a robust 7.6% (chart). Both point to strong bank lending. Large domestic banks are leading the charge, with loan growth of 7.6% y/y compared with 5.5% at smaller banks (chart). Strong bank lending is another reflection of a resilient economy. Commercial banks' allowances for loan and lease losses stood at $203 billion during the week of September 23, little changed over the past two years, confirming that banks do not see a deterioration in credit quality. Meanwhile, new US corporate bond and equity issuance reached a record $3.1 trillion over the 12 months through August (chart). That's good news for investment banking activity and another sign of robust demand for capital across Corporate America. III. What could go wrong? All this sounds bullish, and it is! But our worry list remains long, not least because of the ongoing conflict in the Middle East. The bid-ask spread between Washington and Tehran remains wide. The risk of a military re-escalation is increasing. For now, we expect energy prices to remain higher for longer, keeping inflation and bond yields elevated (chart). Meanwhile, global bond yields keep rising (chart). In the US, stronger nominal GDP growth and a higher neutral rate partly explain the rise. The energy shock, the unwinding yen-carry trade, and mounting concerns about fiscal excesses are adding fuel to the fire. In France, the Bond Vigilantes are pushing yields above nominal GDP growth amid high debt, weak growth, and political gridlock. The risk is contagion across Europe. Other worries include second-round inflation effects, more aggressive Fed rate hikes, rising US debt-service costs, an AI investment slowdown, post-midterm political gridlock, and mega IPOs draining liquidity from the stock market. Against this backdrop, we recently moved our 8,400 target for the S&P 500 from the end of this year to the middle of next year. Importantly, we haven't lowered our earnings outlook. S&P 500 forward EPS reached a record $406.45 on October 1, and we still expect it to climb to $425 by year-end (chart). Instead, we reduced our target forward P/E from 19.8 to 18.6 to reflect valuation risks.
On Global Borrowing Binge & Nuclear Fusion
Globally, countries have been spending way beyond their means, absolutely and as a percentage of GDP. And the problem has been worsening, Jackie reports. Rarely has global debt issuance as a percent of GDP approached the 23% expected this year. With higher interest rates escalating governments’ interest expenses and wars necessitating higher defense spending, the end of this tunnel is dark. … Also: A look at the junk bond funding of two data center construction projects. … And: The promise of nuclear fusion is attracting big bucks from Big Tech investors. Five fusion-focused startups are cases in point.
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