Equity valuations under pressure with U.S. Treasury yields up

• Canada Consumer Price Index rises slightly in July.
• S&P 500 Index earnings growth for the second quarter came in ahead of expectations, with a decline of about 8%.
• 10-year U.S. Treasury yields exceed 4%, a viable alternative to equities.

Canadian consumer price index (CPI) data was released this week, with inflation accelerating slightly to 3.3% on a year-over-year basis. Food — including groceries and take-out deliveries — made up 16% of the CPI calculation, with shelter making up 28% of it. These categories rose by 7.8% and 5.1% respectively, on a year-over-year basis. Due to base effects from a year ago, along with higher mortgage interest costs, we expect Canadian inflation to remain within the range of 3% to 3.5% for the remainder of 2023, before decelerating again in 2024. However, we also believe the recent moderation of inflation should mean the Bank of Canada will pause making any further interest rate increases.

U.S. earnings season is wrapping up this week, with 466 companies in the S&P 500 Index having reported so far. Over 300 of them experienced positive sales growth and 268 reported positive earnings growth. Overall, earnings growth declined on average by 7.74% (compared to the previous quarter). The energy sector was a significant laggard this quarter: if we exclude it from the index, earnings growth only declined by 0.89% (oil and gas producers saw earnings fall by 54%). The price per barrel of crude oil is hovering at around US$80 this week (as measured by the West Texas Intermediate price) from a high of US$122 last summer. This was a 34% drop in crude prices, being much of the reason for the drop in earnings year-over-year.

After seven strong months of equity gains for the S&P 500 Index, downside volatility has started to increase, as pressure builds on valuation. Since the peak in equities on July 31, the S&P 500 Index has dropped by over 4%, alongside a gain in the 10-year U.S. Treasury yield of 36 basis points over the same period. The 10-year yield on U.S. Treasuries crossed over 4.3% during the week. The last time yields were this high was prior to the Great Financial Crisis in 2007. This upward trend in yields can be attributed to a combination of factors: the weakening expectation of achieving a 2% inflation rate in the U.S.; an increase in Treasury supply to cover fiscal deficits; and the continuation of quantitative tightening as the U.S. Federal Reserve (the Fed) reduces its balance sheet. The Fed has been rolling off assets as they mature at a pace of US$1.2 trillion annually.

Looking ahead, while it continues to appear an economic soft landing is achievable, equity volatility may continue as we head into a seasonally weak period for stocks and investors weigh valuations against higher bond yields.

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