ROI-'G force' driving world markets may need Fed and bond brake: Mike Dolan

As the final quarter of another tumultuous year approaches, markets face a stark reality: economic growth and earnings ​are running hot, leaving the Federal Reserve and other central banks to hike rates aggressively or risk letting inflation become entrenched. For bond ​investors, there's little comfort either way. What's clear is that, for the remainder of 2026, there's little ‌or ​nothing to substantially change the picture of hot growth and earnings — infused by the ongoing business investment boom in AI infrastructure that most expect to run at least through the end of the decade.

This is the "superglue" that Deutsche Bank strategist George Saravelos says is holding together the prevailing moves across global markets right now. "There is simply no other way of explaining the huge rise in yields - almost exclusively driven by neutral rates - equities close to record ‌highs, credit (spreads) at their tights and cross-asset volatility so subdued," he wrote.

He added that big capital expenditure (capex) booms are rare, with only two since World War Two comparable to this one: the late 1980s and mid-2000s. What's more, they tend to be multi-year events, averaging about three years. This one is shaping up to be the largest since 1945 in terms of cumulative spending as a share of world gross domestic product (GDP). With inflation rates running hot for that reason and aggravated significantly by the parallel energy shock, nominal US GDP growth was likely above 8% in the second quarter and is on track to top 9% ‌in the current quarter.

The third-quarter picture is fluid still, but the Atlanta Fed's "GDPNow" model is tracking real, inflation-adjusted growth at 5.1%. Meanwhile, the Cleveland Fed's inflation "Nowcaster" sees headline inflation, measured by the Fed's favored personal consumption expenditures gauge, hitting 4% this month. About a third of that GDP growth ‌is estimated to be driven by the AI spending surge, which shows no sign of slowing.

Meanwhile, the third-quarter earnings reporting season is almost upon us. Annual profit growth for S&P 500 companies, which topped a whopping 50% in the second quarter according to LSEG, is expected to top 30% again in the third quarter and roughly 28% in the fourth. While tech, communications and energy are clearly the outliers driving the expansion, the breadth of the earnings boom is unusual. Those Q4 estimates blend 43% annual growth in the materials sector, 16% in utilities, 15% in consumer discretionary, and 14% in healthcare.

As Barclays pointed out, the full-year 2026 earnings growth estimate of some 34% is most striking because it's built on an already healthy double-digit earnings expansion last ⁠year and puts it "among ​the strongest non-recovery earnings expansions in modern market history." On the basis of those numbers ⁠alone, it's little mystery why the Fed has already faced down White House pressure for even lower interest rates and is now expected to deliver as many as four more rate hikes over the coming year, on top of the one it delivered a couple of weeks ago.

And, repricing to account for that, Treasury securities from 3 to 30 years now yield ⁠more than 5% — the highest since before the banking crash of 2007/08 on many tenors. 'G FORCE'

So why doesn't the Treasury borrowing squeeze slow things down and prompt a rebalancing? AXA Group Chief Economist Gilles Moec says one reason the bond market is not sowing the seeds of its own stabilization — by reining in growth and calming the ​rate horizon — is that higher yields are not having much effect on financial conditions in the wider economy. At least not yet.

Looking at the Chicago Fed's National Financial Conditions Index, and even adjusting for historical quirks, Moec said financial conditions are "accommodative" today relative to the average, whereas ⁠they were "restrictive" in the autumn of 2023 when 10-year yields last topped 5%. "None of this means that the US real economy can resist indefinitely higher interest rates," he wrote. "But it implies that financial conditions need to tighten significantly more before a “feedback loop” sets in."

As it stands, the alarming rise in benchmark borrowing rates has seen equity prices fall back relative to their 12-month forward earnings estimates. ⁠At ​multiples of less than 19 for the S&P 500 and a little over 16 for the MSCI All-Country World Index, those valuations are their cheapest in almost three years — even if still slightly above long-term averages. The thing is that price restraint, unlike earnings revisions, merely lifts estimated earnings yields in tandem with bond yields, rather than producing the divergence between them that would actually signal a switch.

Morgan Stanley strategist Andrew Sheets says this is all "racing the denominator" — or the "g" for growth in investment algebra. He said that, over the past 30 years, the gap between earnings yields and bond yields ⁠explains as much as half of the relative performance between the two asset classes over the subsequent three years. "Markets, after all, are not equations solved once a quarter. They are arguments about the future. And when growth is strong, investors are more willing to give g the benefit ⁠of the doubt," Sheets wrote. "The question isn't whether the denominator matters. It's how long 'g' can ⁠stay this fast."

If the AI story — the infrastructure part of it at least — remains the dominant "g force" and expands internationally, as it's already starting to do, then any thought of speed bumps moves well into next year at the earliest. The Fed and the bond market may have more work to do. (The opinions expressed here are those of Mike Dolan, a columnist for Reuters.)

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