Farmers & Merchants Bank

Much of the rise in bond yields is attributed to higher term premiums. This could be due to changing correlations with equities, higher deficits, or several other factors. Despite the rise, term premiums remain a full standard deviation below the 40-year average. All else equal, if they return to the mean, it would add 1.25% to the 10-year Treasury yield.

Economic Data Remains Robust

The economic data continues to surprise towards the upside. The Federal Reserve has increased rates at the fastest pace in four decades. The yield curve has been inverted for a significant length of time. Those calling for a recession have doubled down. Given this setup, it seems market participants continue to expect immediate weakening in economic data. When it doesn’t transpire, then yields move higher. The dollar continues to be strong and when you have both yields and the dollar up, it tends to push equities down.

This week saw retail sales come in better than expected. Economists were looking for a month-over-month increase of 0.1% in the core group and instead, we got a 0.6% increase. Add this to the big employment report beat to start the month and rising PMI new orders. Next week brings the first look at third-quarter GDP. Economists expected 0% growth in June, but they have moved it all the way up to 3.5%. Meanwhile, the Atlanta Fed GDPNOW forecast is over 5%. Jobless claims today were reported at 198,000, the lowest reading since January of this year.

Will Earning Growth Return?

Earnings season is underway, and S&P 500 earnings growth is expected to be roughly flat compared to the prior year. As a reminder, earnings growth has been negative for three consecutive quarters. This was an inflationary environment, so real earnings have been very weak. Still, the S&P 500 has increased because the price-to-earnings ratio has expanded by 20% over the last year. Logically, these conditions don’t appear to be sustainable. This is especially true when factoring in a much lower equity risk premium versus government or corporate bonds. Resumption of earnings growth will likely be a necessary step to sustained equity gains.