by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Price discovery never rests
For the DCF model, the battle between the numerator (cashflows) and denominator (cost of capital) has morphed into a battle between rate scares (higher rates force valuations lower) and growth scares (fears about the AI train slowing down and causing the earnings “bubble” to burst). The former produces a positive correlation between equity and bond returns, and the latter produces a negative correlation. Price discovery is always happening, and usually the climb up the stairs takes longer than the climb down.
While earnings and margins continue to boom, the cap-weighted index has struggled to get out of its own way since early June as the AI space continues to correct. The market is now broadening nicely, with 59% of stocks above both their 50-day and 200-day moving average, but you wouldn’t know it from looking at a price chart of the SPX.
Questions continue to mount not only about the financial sustainability of the AI buildout (who is going to buy all that debt and at what price?) but increasingly also about the politics. What if the upcoming midterms produce a blue wave big enough to slow down the proliferation of datacenters? Suddenly, you could come up with a scenario in which that endless backlog of GPU demand slows down, and with it the semiconductor earnings. We will find out soon enough, and if that blue wave ends up not materializing, we could see sharp rallies across the AI space.
For now, worries about the AI wave slowing down and becoming systemic to the economy have brought the 10-year yield back down to 5.0% and has reduced the prospect of a Fed rate hike this week. Rate worries have been replaced by credit worries (at least in high yield), so the cost of capital hasn’t really changed that much. A big question for asset allocators continues to be the value proposition of Treasuries. They are attractively priced yes, but will they provide negative correlation when we need it the most?
Let’s explore.
The stock market is broadening out again and the “jaws” are closing between the cap-weighted and equal-weighted S&P 500. This has not been a bullish broadening so far, given the zero-sum dynamic of the AI space selling off more than the ex-AI stocks are rallying.
Correlations are on the move, and the pressure on AI stocks is pulling down the stocks/bonds correlation, even though the stocks/oil correlation remains deeply negative. Growth concerns are overshadowing inflation/rates concerns for now.
The GS AI basket is now sitting on support after a 22% drawdown since early June. As the bottom panel below shows, that drawdown has led to a negative correlation between bonds and the AI/ex-AI pair.
Here’s another look at the AI/ex-AI pairs trade and its correlation to both the S&P 500 index (vertical) and the BBG LT Govt index (horizontal). It is now firmly negative against bonds. The eurozone banks are also heading in that direction.
It’s interesting that the S&P ex-AI basket (from GS) is now far less correlated to the S&P 500 index than the equal-weighted S&P 500 (SPW), while both are similarly correlated to bonds.
Credit worries are a thing again, from French spreads to ORCL and CRWV CDS. The bond market is regulating as it always does (or at least when not financially repressed), and the glass-half-full take on widening AI spreads is that this is a good thing, in that a more disciplined allocation of capital today will prevent a bursting bubble tomorrow. I tend to agree with this. The counterpoint, however, is that the bubble might not be in valuations but in (circular) earnings, and that a slowdown in the datacenter buildout could cause the seemingly endless backlog of semiconductor demand to slow.
Yields have put in what appears to be a trading high at 5.36% and are back into the yellow zone (around 5%). Real yields have dropped as well, with the 10-year down to 2.64%. It’s interesting that the current AI-related growth scare happened when the real yield poked its head above the economy’s trendline (potential real GDP growth). Perhaps the economy’s speed limit acts as a natural brake for real yields with respect to growth.
With growth scares replacing rate scares for now, expectations for a Fed hike this week have all but disappeared. But based on the SOFR curve the Fed is still expected to hike two more times in the coming months.
Earnings season is off to a good start with 122 companies reporting so far and 80% beating estimates by an average 560 bps. Trailing earnings are up 33% from a year ago and the n12m estimate is up 39%. The difference between the n12m estimate and trailing earnings is 19% and decelerating. That suggests that a peak in the second derivative is forming. Investors rarely pay up for peak earnings growth, and this in part explains why the P/E-multiple is down 16% from a year ago. The other factor is of course the rising cost of capital.
Per the DCF model, the market’s intrinsic value is the present value of future cashflows. With earnings growth very strong, a rising cost of capital may not reverse a bull market but it could slow it down. Market history is full of examples of earnings-driven bull markets being interrupted by a tightening in financial conditions. One example is the 1994 Greenspan rate cycle, and another is the period from late 2014 to early 2016 when energy spreads blew out. A 2022 “echo” scenario remains a plausible scenario into 2027.
How important are rates compared to earnings? Strong earnings growth will generally win the day over a rise in the cost of capital, and on that basis this bull market has hung in there nicely despite rising yields. Much of the market’s long-term valuation (5-year CAPE ratio) can be explained by just a few macro factors: margins, credit spreads, and yields. Below I did three regressions (covering 1960-2019). One is of margins and spreads vs the 5-year “forward” CAPE (which uses n18m estimates since 1985 in an attempt to be less backward looking) and the other also includes the nominal 10-year yield, and the third one adds in the 10-year term premium.
Note the divergence in the chart below between the models that include rates and the one that doesn’t. You can also clearly spot previous bubbles, including 1987, 2000, and 2021, when none of the P/E multiple at the time could be explained by these three variables. We are not there today, provided margins and credit spreads hold up (which they are). The point of the chart is to highlight how damaging rising rates can be if they are not offset by growing earnings.
Correlations
History shows that the higher nominal yields go, the more correlated bond and equity returns become. Makes sense since the risk asset must compete against the risk-free asset. In the chart below I show the 10-year yield on the horizontal axis and the 2-year (104-week) correlation of equity and bond returns on the vertical. The size of the dots shows the 13-week correlation to highlight periods when secular regimes of positive correlations are interrupted by short bouts of negative correlations. At 5% we are currently in the “low positive” correlation regime, not unlike the late 1990’s. That suggests to me that the current growth scare (which has produced a negative 13-week correlation) will ultimately give way to the prevailing trend of positive correlation.
The state of the 60/20/20 model
With bonds providing a port in the storm for now, it’s a reminder that bonds have become a viable asset class again, regardless of their sometimes-lacking anti-correlation credentials. They may not continue to be that port in the storm for long, but at least we are getting paid to take the risk (via high real yields).
Commodities continue to be a successful diversifier, providing competitive returns and a negative correlation. They are in a sweet spot on the efficient frontier (which below is from the April 2025 “launching point”).
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.
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