Inflation, interest rates, and earnings growth

Much of the stock market’s action can be explained with just three variables: inflation, interest rates, and corporate earnings. With expectations for all three on the move, now seems a good time to take a closer look at the trend in each:

 Inflation. As oil and fuel prices have jumped with Iran’s closure of the Strait of Hormuz, so have inflation expectations. Year-to-year growth in the U.S. Consumer Price Index is expected to reach 6% for the June quarter, up from the 2.7% expected three months ago, according to a survey of economists polled by the Federal Reserve Bank of Philadelphia. 

While consensus forecasts call for inflation to be trending lower by the fourth quarter, most such projections assume the Strait of Hormuz will open and fuel prices will recede. The longer energy prices remain high, the more those higher costs will feed into the supply chain. The Producer Price Index, which tracks wholesale costs and tends to lead consumer prices, rose 6% from year-earlier levels in April, the biggest jump since 2022.

 Interest rates. Bonds have already been impacted by the worsening inflation outlook, pushing yields on 30-year Treasury bonds to a two-decade high of nearly 5.2% in mid-May before pulling back. Yields on benchmark 10-year Treasury bonds, which are less sensitive to long-term inflation expectations, have also risen. A breakout above the 19-year high of nearly 5.0% reached in 2023 would be discouraging.

 Earnings growth. By nearly every measure, the March-quarter reporting season was one for the record books. Earnings for the S&P 500 Index are on pace to climb more than 25% from year-earlier levels, the highest since 2021, according to FactSet. 

What to watch

Because investors look forward, the trend and the potential for surprises are what matter. Since February, rising bond yields and inflation expectations have countered stronger-than-expected earnings, holding the Dow Industrials and S&P 500 Equal Weight Index to little change. A decisive upside breakout in these indexes would be bullish, while an upside breakout in 10-year Treasury yields would be bearish.