Equity investors are focusing on the wrong data this earnings season: Klement

Reuters

3 days ago

LONDON, July 29 (Reuters) - The earnings season is ramping up, and investors are once again focusing on whether companies will beat or miss expectations. However, the major driver of share prices in 2025, and arguably in the long run, is found in the bond market.
With 160 companies in the S&P 500 (.SPX), opens new tab having reported, the average earnings surprise is an 7.2% beat of analyst expectations. This is in line with what we have seen in six of the last eight quarters. And when all reports are in, it is very likely that – barring some major negative surprises – the average will still be between 7% and 8%.
This relative consistency reflects the fact that the relationship between companies and investment analysts has evolved into an elaborate dance. Companies guide analysts to a low earnings number, and analysts typically don't question this guidance too much, as few want to get on the bad side of the companies they cover. When the results are released, companies can then handsomely beat "expectations", resulting in a share price rally. Earnings season has thus become more Kabuki theatre than a source of real insight.
Most investors are aware that quarterly earnings results are largely irrelevant for long-term investment returns, which are dominated by other factors. But fewer may acknowledge that even over shorter periods like 12 months, the real driver of share prices tends to be bonds rather than earnings.
I have measured the sensitivity of share prices in the U.S. and Europe to changes in earnings growth, inflation and 10-year government bond yields using data for the last 20 years. If the equity market records an average earnings surprise of 10% over a 12-month period, the market rises by about 3%. But if 10-year government bond yields rise by 100 basis points, stocks tend to drop by 9% to 10%.
This shouldn't surprise anyone, since equities reflect the net present value of future cash flows. An earnings surprise of 10% may change the expected cash flow for this year and maybe even the next couple of years. But if government bond yields rise, this changes not only the cost of doing business - and hence future cash flows - but also increases discount rates. And that means that all future cash flows are worth less today.
Hence, a relatively small change in bond yields creates a large change in equity valuations.
Normally, government bond yields don't move 100 bps in a couple of months, but few would describe the current economic and political environment as normal.
The U.S. fiscal folly – embodied by President Donald Trump's recently passed "One Big Beautiful Bill" – is expected to increase deficits for years to come and thus push Treasury yields higher over the long term.
More imminently, the latest U.S. inflation data indicates that tariffs are starting to put upward pressure on prices in some areas of the economy like cars, clothing and household furniture, which has also started to nudge Treasury yields higher.
And then there is Jerome Powell, aka Schrodinger's Fed chair. Is he still in office or has he been fired by Trump? We won't know until we open our news app and check.
For now, Powell remains in office, but if he is fired before his term ends, markets are unlikely to take it in stride, the limited volatility in recent weeks notwithstanding.
Indeed, even the perception of the Fed losing its independence has the potential to cause turmoil.
A team from the Peterson Institute of International Economics, opens new tab has tried to simulate the market impact of a loss of Fed independence.
In this scenario, they assume Powell's replacement would push the Fed to do Trump's bidding and cut interest rates, allowing inflation to average 4% rather than 2% within two years.
They estimate that this could create a sharp move higher in 10-year Treasury yields on the order of 120 bps after a couple of years. But history has shown that when markets panic, such a move can happen within days or weeks.
Put together, we appear to be witnessing a rates-driven sea change, opens new tab as Oaktree Capital co-founder Howard Marks warned in 2022. Treasuries are at risk of experiencing years of rising or elevated long-term yields, which would be a major drag on equity returns.
Marks emphasises that the secular decline in bond yields since the 1980s explains much of the high returns we have become accustomed to in stock markets. If yields are indeed moving higher, investors will need to see much higher earnings growth simply to stand still.
(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank).
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