US Strategy Weekly: Inflation, Bonds, and Equity Yields

This strategy weekly is being written prior to the release of December’s CPI report, and many commentators are suggesting that the report could be a market moving event. Most economists are expecting inflation to trend lower in 2024, but with the caveat that tariffs could increase inflation. However, December’s CPI report is coming out before tariffs can be used as an excuse for inflation, and if inflation is higher than expected, the market is apt to respond poorly.

This belated fear of inflation – belated because inflation data has already been flat to higher for several months — is hiding another issue which we have discussed previously. The underlying issue of this inflation fear, in our view, is that stock prices have been driven up by speculators betting on an accommodative and rate-cutting Federal Reserve to support the financial markets and their investments. In our view, a fear of inflation and higher interest rates is irrational at this juncture since a stronger economy that provides good corporate earnings growth should counterbalance the risk of higher interest rates. In other words, the real concern for investors should be earnings growth. Nonetheless, if inflation fears shake out speculation in the equity market, it is a good thing in the long run. Speculators are the icing on the cake, the real cake is investors who buy for fundamentals not momentum. Momentum works in the short-term; fundamentals work in the long term. In sum, focusing on fourth quarter earnings results and corporate projections for this year are the important issues in coming weeks.

However, as the 10-year Treasury bond yield rises to 4.78%, analysts have begun to focus on the S&P 500’s earnings yield and are concerned. We see this shift in the consensus’ focus from momentum to fundamentals to be a long-term positive.

The earnings yield (earnings divided by the S&P 500 price) is a good short cut for assessing the appeal of stocks versus bonds; however, like most fundamental benchmarks, it varies depending upon one’s inputs. The current IBES 2025 earnings estimate of $273.91 creates an earnings yield of 4.7% and the S&P/Dow Jones estimate of $271.22 generates an earnings yield of 4.6%. These are in line with, or slightly below the current bond yield, however, stocks also have a dividend yield. The current dividend yield of 1.3% generates a total equity yield of 6% for equities. This means the earnings yield still favors equities, but by a slim margin. The risk is that things could change later this year. Bond yields, which are threatening the 5% level, could move higher this year, which is why some institutional investors are shifting money from equities to bonds. Still, earnings growth in 2025 could be better than expected and this would favor equities. However, if the economy is stronger than expected and interest rates move higher (a natural event in a strong economy), earnings growth could exceed expectations and continue to favor equities. In short, earnings growth and higher interest rates can exist together, and history shows that this is often the case.

Data Shows Strength

Most recent economic releases are pointing to a stronger economy. The NFIB small business optimism index jumped 3.4 points in December to 105.1, the highest level since October 2018 and the second consecutive month above the long-term average of 98. The uncertainty index plunged 12 points to 86, its lowest level in six months. Both indices are showing great optimism after the re-election of Donald Trump, which is not a surprise given the promise of less regulation, lower energy prices, and a business-friendly environment; however, this is the opposite of the tone of many financial articles. A bigger surprise in the survey was the improvement reported in actual sales and earnings in December. Although the net index remains in negative territory, the actual earnings index increased from a low of -37 in August to -26 in December. Similarly, actual sales trends improved from a low of -20 in October to -13 in December. Small business owners also showed great expectations for the economy (up 16 points to 52), sales expectations (up 8 to 22), and credit conditions (up 3 to -2). See pages 3 and 4.

December’s employment report was much stronger than expected with an increase of 256,000 jobs and the unemployment rate inching down to 4.1%. What impressed us more was the improvement in the household survey which indicated an increase of 478,000 jobs and a decrease of 235,000 unemployed during the month. This combination lowered the unemployment rate to 4.1%.

Our favorite indicators are the year-over-year increases in jobs as reported by the establishment and the household surveys. In December, the establishment survey indicated job growth of 1.4% YOY, slightly below the long-term average of 1.7%, but still a healthy increase. The household survey showed jobs growing 0.3% YOY, which is low, however, it was an important reversal from the 0.4% YOY decline reported in November. The household survey has been on our radar because of the negative growth rate seen in November, so this report was good news. See page 5.

The December jobs report was also in line with the recently released JOLTS report for November. This report showed total nonfarm job openings of 259,000, with the majority of these openings in the professional and business services sector. This was a favorable development; however, it does not explain why the decline in the unemployment rate in December was greatest for those with less than a high school degree. The unemployment rate for this group had been as high as 7% in August but fell from 6% to 5.6% at yearend. The unemployment rate for those with a bachelor’s degree or higher fell from 2.5% to 2.4%. In sum, the job market has been improving on many levels. See page 6. In addition, average weekly earnings grew 3.5% YOY in December, which remains above the level of inflation which is currently 2.75%. This means real earnings are increasing. See page 7.

However, there is a potential problem for interest rates in 2025 and it may not be inflation. White House data indicates that the fiscal 2024 deficit was $1.5 trillion or 6.6% of GDP. This is well above the long-term average of deficits-to-GDP of 3.6%. The White House estimates the current fiscal 2025 deficit will be $1.4 trillion, representing 6.1% of GDP. These deficit levels are unsustainable and represent a major challenge for the incoming administration. Interest payments on government debt totaled $881.7 billion in fiscal year 2024 which was 13.1% of total government outlays and is up from 5.3% in fiscal 2020. See page 9. Our only consolation is that the incoming administration has focused on the deficit as a problem, rather than ignoring it.

Market and Breadth

Many prognosticators are turning bearish for 2025, however, to date, the charts of the indices do not reflect anything other than a normal pause in an uptrend. The S&P 500 is testing its 100-day moving average, the DJIA is trading slightly below its average, and the Nasdaq Composite is trading well above this benchmark. The Russell 2000 is the index to watch since it is getting perilously close to testing its 200-day moving average. This will be an important test of market strength or weakness. See page 13.

The 25-day up/down volume oscillator is at negative 2.01 this week, neutral, but down significantly from a week ago and potentially closing in on an oversold reading of minus 3.0 or less. An oversold reading that lasts more than five consecutive trading sessions is a warning and would be a signal that the bullish momentum that has been in place since the October 2022 low has been broken and a decline of more than 10% is on the horizon. Again, an important test is on the horizon for the equity market. See page 14.

Gail Dudack

Click to Download