Key takeaways
- Bullish earnings estimates helped lift the S&P 500 to a record high on Tuesday, despite headwinds from rising Treasury yields.
- Strategists say strong earnings and rising yields are byproducts of the U.S. economy’s rapid growth.
- Some investors worry that growth is too dependent on building AI data centers, which relies on a handful of tech companies whose finances are strained by massive investments.
Conventional wisdom has it that rising Treasury yields put pressure on stocks by raising the risk-free capital rate and raising borrowing costs for businesses and consumers whose spending fuels the economy. Still, U.S. stocks posted new record highs on Tuesday, a day after the 10-year Treasury yield closed at a 24-year high above 5.3%.
Despite the incongruity of yields and stocks rising simultaneously, market strategists say both trends are driven by a growing economy. “Most of the rise in interest rates has to do with stronger economic growth, not increased inflation fears,” says Jeffrey Buchbinder, chief equity strategist at LPL Financial.
Real yields, or the return a bond investor can expect after accounting for inflation, are at their highest levels since 2007, according to the Cleveland Fed. The fact that they have risen faster than inflation expectations this year indicates that rising nominal yields reflect economic growth, according to Mason Mendez, global real assets analyst at Wells Fargo.
At the same time, stocks were supported by the market’s expectation that upcoming third-quarter results will reflect the strength of the economy. Analysts forecast that the S&P 500 grew earnings 29.5% last quarter, its third straight quarter of growth above 25.0%, according to FactSet.
Several quarters of exceptional growth have only increased Wall Street’s confidence in the profitability of American companies. According to Christian Galipeau, chief market strategist at the Franklin Templeton Institute, full-year earnings estimates for the S&P 500 have increased every week this year, “which explains the ribbon’s resilience in the face of rising oil and bond yields.”
While analysts predict that all 11 stock sectors will post higher profits than a year ago, growth is expected to be strongest in areas benefiting from what are otherwise thorns in the side of the economy. High oil prices resulting from the Middle East conflict likely caused the energy sector’s profits to double last quarter. Struggling oil prices have also hampered the Federal Reserve’s progress in controlling inflation, forcing officials to raise interest rates in September and announce more hikes to come.
Likewise, the construction of AI data centers — the largest investment round in the United States since the 19th century railroad boom, according to Wells Fargo — has become something of a double-edged sword for the economy and the stock market. Demand for AI-enabled hardware continues to outstrip supply, driving up prices and increasing the tech sector’s profits by about 65% in the third quarter.
At the same time, construction has forced tech giants to borrow, increasing demand for capital and perhaps helping to push up bond yields. “When you see 10-year-plus corporate bonds being issued at 100% higher than last year, you have to imagine there’s a bit of crowding out,” says Charlie Ripley, chief investment strategist at Allianz Wealth Management.
Some investors predict that AI spending will continue to counter headwinds from rising interest rates. “As long as the market is more focused on construction and increased investment in technology, we think this market can hold up well even if rates rise a bit,” says LPL’s Buchbinder. According to him, the 1990s, when the development of telecommunications coincided with the Internet bubble, constitutes an instructive parallel. “The 10-year Treasury yield averaged about 6% in the second half of the 1990s,” he says, “so the stock market certainly handled higher rates well then.”
But one of Wall Street’s keenest fears is that AI development will follow too closely the trajectory of the telecom boom, with hyperscalers adding too much computing capacity and speculative fervor pushing stock prices to unsustainable heights. Investors also worry that the concentration of the AI economy — a small group of chip and tech hardware companies benefiting from huge investments by an even smaller group of hyperscalers in a nascent technology — makes it a less than ideal growth engine.
This concentration has been reflected in the stock market in recent months, as tech mega-caps have rallied and the average stock has weakened. “It generally takes more latitude to have a very durable and sustained bull rally,” says Buchbinder. “We think this market will expand again,” he adds, “but it will probably take a drop in oil prices for that to happen.”
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