The stock market has shown resilience despite surging bond yields, with the 10-year Treasury yield increasing by 100 basis points to a two-decade high since January. This phenomenon is largely attributed to robust corporate earnings, which have been strong enough to offset the negative impact of higher discount rates on future profits. Record profits have effectively made stocks cheaper in terms of valuation, leading to a stable equity risk premium—the difference between the S&P 500 earnings yield and Treasury yields—since the beginning of the year.
The current market environment is described as a "mid-cycle market" by Morgan Stanley strategist Andrew Sheets, where rates are rising alongside "hot" market conditions. Morgan Stanley anticipates median S&P 500 EPS growth in the mid-teens this year, with earnings revisions near cycle highs. Historically, the earnings-bond yield relationship has only explained about 10% of stock-versus-bond returns over a 12-month period, though this increases to about 50% over a three-year outlook. This optimism regarding growth is a key factor in the stock market's ability to withstand 5.1% Treasury yields.
However, the gap between the S&P 500's earnings yield and Treasury yields, known as the yield gap, has narrowed to its tightest since 2004, diminishing the relative appeal of stocks. On Friday, the US 10-year Treasury yield stood at 5.167%, while the S&P 500's 12-month forward price-to-earnings ratio of 19.3 times implied an earnings yield of 5.19%, resulting in a yield gap of approximately 3 basis points. Some measures even show the earnings yield below Treasury yields, with the 30-year Treasury yield exceeding the S&P 500's earnings yield by nearly 0.5 percentage points. This poses a challenge to equity valuations, as investors will demand higher returns from stocks when Treasuries alone offer yields above 5%.
Despite these challenges, strong earnings growth, particularly from AI and data center investments, continues to act as a significant buffer. Q2 earnings across the Russell 3000 index saw aggregate operating income increase by 28.2% year-over-year, an acceleration from Q1. Energy and Information Technology sectors showed the strongest growth, with operating income rising 128.4% and 51.9% respectively. While AI infrastructure beneficiaries played a major role, earnings strength has also broadened across other sectors, with 71% of companies in the Russell 3000 index showing positive operating income growth. This fundamental strength in corporate earnings is a crucial support for equity prices, allowing the market to tolerate rising yields better than historical patterns might suggest.
