Making Sense: October Market Update

Making Sense

Market Update | October 2026

Recorded October 21, 2026

Amy: Hello, everyone. I'm Amy Thomas. Today is Wednesday, October 21, 2026, and I want to welcome you to our monthly Market Update series. Today, Brent Ciliano and Phil Neuhart will take a deep dive into what's happening in the markets and the economy and answer some questions for you.

As always, the information you're about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only. This should not be considered as tax, legal or investment advice. And with that, Brent, we're ready to go, so I'll turn it over to you.

Brent: Well, thank you, Amy, and good afternoon, everyone. Hope all of you are well. Phil, I can't believe it's getting cooler outside. Almost time to start our holiday shopping. But I'm excited for this presentation because Blake Taylor put together a scary-good presentation.

Phil: Oh, wow.

Brent: I’m excited to get into it.

Phil: Good job, Blake.

Brent: I worked all day on that one. So let's jump right in. As we normally do, Phil, we're going to talk about what's going on in the broad economy. Adding a couple more things, this time around we'll talk a little bit about midterm elections. I hope everyone is out there either voting early or casting your ballots ahead of time. That would be good. We're going to talk a little about markets and updates. We're going to talk specifically about corporate earnings, valuations. We're going to talk a little bit about fiscal policy this time around. So let's jump right in, Phil.

Phil: Yeah. Let's jump in to the economy. We're going to start broad. This is GDP, gross domestic product. We're showing both Real and nominal GDP here, just year-on-year growth. What you'll notice is nominal GDP is on the rise. This is not inflation-adjusted, growing north of 6%. So if you're a business owner or an investor and you look at a company whose revenue growth is 6% to 6.5%, it's basically in line with nominal GDP.

Real GDP, though, is in the low twos in terms of growth rate. And why is that? It's inflation. We'll talk about that more in a moment, but inflation is taking a bite out of growth.

If you look, though, over the last, say, 15 years, potential growth in the US really is roughly 2%. In the 1990s, it was much higher. Why is that? We had more population growth, more productivity growth.

Now, both productivity and population growth are slower. AI might help on the productivity side, but right now, potential growth in the US is kind of in the low twos. So what are we seeing in terms of drivers of GDP? Here, we're showing the evolution of 2026 growth forecast from the consensus.

So what are consensus economists expecting from a growth perspective? You'll notice that starting with the war in Iran, both GDP and personal consumption, which is about 70% of GDP, have fallen modestly. Not dramatically, but we've seen a bit of a deterioration. You would expect that. Why? Higher gas prices, higher diesel prices, et cetera. But the swing factor, the thing that has really helped support growth, is private investment.

And when you look at that blue line, one, that's not normal. To see private investment—this is expectation. The expectation to go from sub 1.5% to north of 4% in the course of 10 months. That is unbelievable. But it's about AI, right? It's about data center build out. And we're going to talk more about that, of course, today.

But this is what everyone is focused on. It's not just from an equity market perspective, right? We're in the middle of an earnings season now. It is also from a growth GDP perspective, really important to think about AI.

Brent: Yeah. And it's an incredible stair step up, and it's amazing that the forecasts just keep rising. And when we take it forward and we think about what you just said, you look at the chart on the left and we think about more than two-thirds of all GDP is consumption, that dark blue line, people spending in nominal terms continues to be high.

More than 6% nominal spending clearly is showing that the economy is running pretty hot. But again, a big part of that that we'll get into is higher prices, right, taking a big impact. So when we look at the gold line and specifically look at real spending, you can see that 2.6% real—when you kind of look at that trend, Phil, across—2.6%, even adjusting for the impacts of higher prices, consumers are still spending. And we're going to talk a little bit later about that k-shaped economy when we think about the rise in financial assets. Homes are still hanging in there. People feel wealthier, and it's translating to higher consumer spending.

Phil: Certainly, higher-end consumers feel wealthier. It is interesting that that sort of two handle on real spending is very similar to GDP. The consumer remains—even in the world of AI—the most important variable for the global economy, not just the US economy. The US consumer is paramount and is still the driver.

Brent: But when you look at the chart on the right and we think about the personal savings rate, so at the margin, consumers are starting to get a little tapped out. We're seeing that savings rate decline. We're seeing credit card utilization start to rise. Delinquencies, while they had been rising, they're modestly in check. But it's something that we're going to have to keep watching because if inflation continues to persist at the levels that they currently are, it'll be interesting to see if consumers can kind of keep their mouth and nose above the water line as it relates to spending.

So let's talk about the elephant in the room, which is inflation. I think this is the most talked about thing, not just in economics but just in life in general—impacting growth, impacting spending, impacting monetary policy. It's going to be a big topic in midterm elections. So certainly we're seeing here, whether we look at CPI which is the dark blue line, or PCE in the gold. Sixty-seven months and counting of inflation above the Fed's 2% target.

And really, over the intermediate term, no signs of really slowing down and it's something that we're going to have to kind of keep an eye on. And when we think about some of the impacts specifically driving that is certainly higher energy prices. Here, dark blue line is diesel fuel, and we're looking at 4-week moving average. The gold line is regular unleaded gasoline. And you can see specifically for diesel, still 4-week moving average highest that we've seen.

So when you think about goods inflation, foods inflation, long-haul and intermediate-haul carriers transporting these goods around the country, and when you think about what that does to the impact of overall prices, higher energy prices are certainly adding to that inflation picture.

Phil: It finds its way into the system, and it's why we have a Fed that certainly sounds quite hawkish these days. So a little bit more on the consumer. We—and if you watch us each month, we talk a lot about the k-shaped recovery—that the higher-end consumer is doing quite well, while lower income and middle income are struggling. We've shown this a lot of different ways, but we did just recently get some fresh data from the Federal Reserve we wanted to share with you all.

So if you look at the change in median household net worth from 2022 to 2025—and by the way,this is when inflation exploded to the high side—what is the change in net worth adjusted for inflation?

So you can't just say, oh, well, that's because the prices of assets went up. Let's look at the first quartile. So this is the lowest-income quartile, right? The bottom 25%. First of all, median net worth is only $1,700. That's a whole conversation for another day in terms of retirement savings, et cetera—really a problem. But adjusted for inflation, the median household net worth for that bottom quartile has fallen 56%.

Brent: Incredible.

Phil: So when we say, look, if you live paycheck to paycheck and prices skyrocket, what do you do? Well, you access your credit card.

Brent: That's right.

Phil: You access any savings you do have. That is what we have seen play out. Second quartile, median of about 100,000 in that quartile, down about 2%. So still, if you feel poorer and you're in that second quartile, mathematically the median person is or the median household is. Third quartile, now you're getting into that 50% to 75%, kind of upper middle class. You're starting to move towards that world as well, up just slightly, 4%. Now let's get to upper middle and upper class, the 75th to 89th percentile, right? So you're talking, you know, kind of one in four, that top percentage, not counting the very highest—up 12%. Well why is that? Now you're starting to get into the world where people own stocks. They own their home. Others own their home as well, but their home.

Well home prices are at all-time highs and the stock market's at all-time highs. Now let's talk the top 10% of households. Now here, you're talking the median net worth of $5 million. That of course is pulled higher by billionaires and others that would pull those numbers higher, but the median, hopefully, adjusts for that—about $5 million. That number's up 19%. So you're 20% wealthier. What do people do when they feel wealthier?

Brent: They spend.

Phil: They spend more. All the data shows that, all the studies. I think we feel that in our own households. When you feel wealthier, you tend to spend more. So yes, there are consumers that are spending more. Yes, that's pulling those numbers higher when you look in the aggregate, but as you can see here, it's really driven by that top quartile—75% to a 100% quartile are what are pulling spending higher with double-digit net worth gains.

Brent: Well, and it's when you break down, you know, the population, you put them into quartiles. This is why it's so fundamentally important for the labor market to continue to do what it’s doing because as long as you're gainfully employed, you're going to continue to spend. But when you don't have the residual net worth to fall back on—if God forbid you lose your job or you get into tough times—it's certainly going to have an impact on the economy and spending.

Phil: So you might say, okay, well, that data is interesting, but I want to look at it another way. Well, here we are actually looking at hotel room rates since 2025. And we are showing what they call luxury and upper upscale and economy and mid-scale. Brent, you stay in the luxury, I tend to stay in the mid-scale. So what is the average daily room rate? Well, the luxury and upper upscale, which of course are that top quartile of net worth folks, those prices have gone up rapidly. Why is that? Demand. If prices are going up, it means you can raise prices. That is how the economy works.

Where are you not seeing that? In the economy at mid-scale. In fact, actually down since 2025. Why is that? The demand looks different. So people in the upper quartiles are feeling wealthier. They're traveling, vacations, whether that's in the US or internationally, that is pushing rates higher, another sign of this k-shaped recovery.

So we can't really talk about, as you said, consumer finances and not talk about the labor market. The good news—and the reason that you are not seeing massive deterioration like you would in a recession in consumer finance—is because people generally have jobs, right?

The unemployment rate remains in the low fours. If you look at this chart on the left side, even longer term. It's very rare for the unemployment rate to start to rise, which it has since 2023, but really flatten out, which you see there. Usually, when the unemployment rate starts rising, it keeps rising. We were talking about that in 2023. And the truth is people like us have been pleasantly surprised that over the last several years, we've just kind of flatlined in this low hire, low fire.

Brent: That's right.

Phil: So the unemployment rate for many is viewed as kind of a lagging labor market statistic. Let's look at a leading statistic: initial jobless claims. This comes out every week, Thursday mornings at 8:30, something we keep an eye on. These are just people claiming jobless benefits. It's just counting, right? So it's pretty good data in our view.

Initial jobless claims, the gold line here—fresh people each week counting, going in and claiming jobless insurance or jobless claims—unbelievably low. Look how low that is. I mean, you're talking the lows that we were seeing before the pandemic. Continuing claims, those who are still receiving unemployment insurance, also low—the blue line. It's moved up modestly, but really just flat.

Look, it's below a lot of the levels we were seeing in a good economy in 2017, 2018 and 2019.

Brent: And there's so little variability. You and I were questioning whether or the data was accurate, right? When you think about how many years, not weeks or months, how many years that we've basically seen continuing claims or initial jobless claims basically staying flatlined. It's a very amazing picture.

Phil: And at some point, the labor market's going to swing one way or the other, right? It's going to strengthen or weaken. But right now, we're in kind of this equilibrium, which makes the Fed's job quite interesting.

Brent: Right, so let’s pull together the inflation picture. So when we look at the Fed's dual mandate of price stability and full employment, it's been a very vexing situation for the Fed to really navigate the current circumstance, and you can see the incredible variability that we've had just this year alone, Phil. We came into the year expecting three cuts, and now we're sitting at about three hikes through the end of next year.

So just a big turn of events, and we've had one 25-basis-point hike already in September. We have a meeting next week on October 28th, and right now we're sitting at basically only about a 15% probability of 25-basis-point hike, so more of a sand pat for this meeting, especially before midterm election, you would might expect that.

Though I would argue maybe economically, you probably should if you truly believe that you're in a situation where prices are somewhat out of control. But when you think about what's happening with the meeting in December, we're sitting at almost a 90% probability of a 25-basis-point hike. So all signs point to rates going higher. And if we think about where we are again through the end of next year, the path for rates, yields are potentially higher.

Phil: Absolutely.

Brent: So it is that favorite time of year where you and I love talking about politics and we love talking about elections. Joking aside, let's get kind of an update, Phil, on where we are as of right now. And big picture, when we think about what's going on within the House or within the Senate, I think looking at prediction markets specifically, we're thinking about divided government. Let's look at the left and look at the House of Representatives, and you can see a little bit more polarizing in where prediction markets are. Blue line Democrats, red line Republicans, you can see almost a 90% probability of the Democrats taking the House.

But when you move over to the right and you look at what's going on in the Senate, while the probability of the Democrats winning the Senate has moved up slightly, I would argue when you think about the prediction error baked into a lot of this, I would argue that the Senate is probably more of a coin flip than it is skewed one way or another. But by and large, it looks like at least for now, Phil, that we might have divided government, which at least from a market perspective has historically been decent.

Phil: Yeah. As market folks, divided government is not a problem for us, right? Checks and balances, things having difficulty passing unless there's really consensus on both sides of the aisle, the market tends to like.

Brent: So one of the things that we have seen as it relates to markets and midterm elections, going back to 1950, post-World War 2, 100% of observations for the 12-month period following midterm elections, we've seen the S&P 500 post a positive return, with an average return of about 15.1%. So as it relates to equity markets, post-midterm elections despite geopolitical noise, volatility, potential change in Congress, it hasn't impacted stocks in a negative way. And, you know, fingers crossed that trend continues post these midterm elections.

So let's shift gears away from the economy and talk about markets. Let's talk about this current bull market that we're in, which is now officially hit its 4-year anniversary back on October 12th. And you can see almost a 130% cumulative return from October 12th of 2022. And you could see along the way, Phil—outside of the tariff tantrum that we had last year and after the largest military conflict in more than 20 years—equity markets only off about 9%, and we continue to make higher highs. Along the way, volatility has been relatively sanguine, and it's interesting when we think about intrayear drawdowns being about 15%. We've been on the shorter side of volatility along the way.

We'll have to see whether or not equity markets continue, but by and large, this bull market seems rather robust. And I know that you're going to be talking about corporate earnings and profitability and what that looks like from a valuation.

Phil: Really an incredible run in the S&P 500, with a lot of worries along the way. So one worry we have heard often and justifiably is, well, that's true, Brent and Phil, since 2022 the market's up a lot, but so much of it is focused on the Magnificent Seven or the top 10 stocks. A small percentage of stocks have really pushed us higher. And one, that is true. We have seen some broadening this year, by the way, with small caps, other asset classes doing well. But certainly the largest names have driven us higher.

So we started asking in recent weeks, well, what does that actually mean for forward returns? Because the thinking is—and this is kind of consensus thinking—is the market's concentrated. That is a risk to the market. And we started saying, well, I've heard this for the last 3 years, and the market has just moved higher. What is the statistical significance of this?

So here, we're going to talk statistics, guys. Have a sip of coffee. We are looking at something called the McClellan Summation Index. This is MSI for any technicians in the room. We're looking at it versus 12-month forward S&P 500 returns. And we're just saying, does the breadth of the market, right, MSI is just a market breadth indicator. It's basically looking at the number of stocks in the S&P 500 moving up or down and saying, is it broad, is it not?

We know, of course, that the market has not been broad. It's been quite narrow. Is that predictive of 12-month-forward S&P 500 returns? Returns over the next year. Is it significant? And the answer, we're showing a t-stat here. So put on your statistics hats from college. The absolute value of a t-stat, if it is above or below 1.96, it is statistically significant, right?

Brent: Two standard deviations.

Phil: At 95% confidence interval, two standard deviations. What you find here is that it is not significant. In fact, the sign changes even. What it's showing is that breadth is not really predictive of forward market return.

Again, complicated concept, but something we think is important is just because the market is narrow, it does not tell you that much about forward returns. What we think tells you more about forward returns is earnings. So as we flip ahead here, this is earnings growth rate estimates for 2026 and 2027. This is consensus. This is bottom up, folks who cover stocks on Wall Street, summing all of that up and looking at the growth rates.

So coming into this year, 2026 estimates were for sub 15% earnings growth. Call it 13% to 14%, as you can see in the dark line here. That's still really good. Long-term average is 7.5%.

I've never seen this in my career. I've done this over 20 years. That number has moved up dramatically and is now north of 30%. And by the way, as you can see, it's really stair stepped up all year long. This is not just a one-time event. This is not normal. In fact, normally, this line slopes downward because people who cover companies fall in love with those companies.

Brent: Optimistic, start cutting.

Phil: Optimism and they start cutting. To go from sub 15% to over 30% of growth rate is incredible. So you say to yourself, well, how is the stock market up 13% year to date? This chart tells you why. So then let's look at next year. Earnings growth moderates to about 15%, and those numbers have kind of moved sideways, I'd say. But remember, next year's growth rate is on top of 2026 that's gone up dramatically. So 15% on top of 30%?

Brent: It's craziness.

Phil: It’s incredible. So we have heard this narrative of, well, the growth rate is slowing. Well, I certainly would hope so. I mean, if we do 30% next year, that's incredible, and the market should be pricing that more dramatically than it is.

But earnings growth, again, long-term average, 7.5%. This is quite, quite incredible.

So let's look at S&P 500 operating earnings per share over the years. So you can see 2021, 2022, 2023 kind of eh period. We're coming out of the pandemic. We had the recovery from 2020, but not wonderful. What you'll see as you look to 2027 at $424 of S&P 500 earnings is a more than doubling from those levels, right? So this has been an incredible run. We are not just talking about one good year of earnings. We are talking about multiple good years of earnings, really starting in 2024 where we have marched higher, and years like this, earnings have actually outpaced price.

Brent: Yeah. And this is outside of a recessionary environment. I mean, that's just incredible when you see that degree of growth and just, you know, that kind of hockey stick up is just incredible.

Phil: And looking under the hood, a fair question is, well, what about margins, right? Are margins improving? And the answer is they are dramatically. On the right side here, we're showing operating margin, 12-month-forward. S&P 500 at 22%. That is an all-time high.

And the question would be yes, but is this driven by those really profitable, very big companies? The short answer is absolutely it is. But if you look at the S&P equal-weighted, where all 500 companies have the same weight on this margin calculation, right? So a very big tech company has the same weight as a transportation, as a railway, let’s say. They're still all-time high, 15.3%. Still below the weighted as you'd expect, but extremely high.

This is a broadening of earnings, and we are seeing this. If you watch the 493, those earnings expectations are starting to catch up with the top seven.

Brent: Well, and I think what's interesting, and let's tie this to the statistics chart that you used, while breadth is not statistically significant in predicting forward 12-month returns, you and I would both say we're incredibly excited to see the broadening of earnings growth and margin growth and expansion within the residual 493 as it relates to the stability and continued growth of the market across the board.

Phil: Look, good news spreading to other companies is always good news. Even if it's not statistically significant on market performance, we'll take it all day long.

Brent: Well, and a question that you and I get all the time is, well, sounds great, Brent and Phil, but the market is just so expensive. We have a lingering AI bubble and things are going to go wrong, and I don't want to put money into the market when stocks are expensive. So what we're looking at here is the forward PE ratio. In essence, in English, what are investors willing to pay for a dollar of next 12-months earnings?

And what you can see from the start of the Iran war, where stocks were trading in at more than 21 times, we are now trading at 18.8 times forward earnings. So we've seen valuations from the start of the war—and actually the beginning of the year—fall pretty significantly. And if I compare that, we are now below both the 5-year and 10-year forward PE ratios.

So when we think about the expensiveness on a forward basis for the S&P 500, we are cheaper than the 5- and 10-year average, which is just pretty incredible.

Phil: It's incredible to say that if you liked the stock market at the beginning of this year and the only thing you watch is valuation, which we do not recommend, but if the only thing you watch this valuation, if you like the stock market at the beginning of the year, you should like it more now. That is quite incredible considering that the market's up more than double digits.

Brent: Well, and let's take it further. Let's break that down into two cohorts here. The dark blue line is the top 10 largest firms, and the gold line is the residual 490. And what you can see for both is that valuations on a forward basis have come down. But as you just highlighted, Phil, the Mag Seven are certainly in our top 10 firms here. Look at how much their valuations on a forward basis have fallen, right? So when you go from pandemic high all the way down to where we are now, we've seen many of the best companies from a quality perspective just get cheaper because their forward expected earnings as it relates to their price have come down precipitously.

So whether you look at the top 10 companies or the residual 493, across the board, valuations on a forward basis are quite interesting.

Phil: As market watchers, this is good news. We like for valuation to decline because earnings are outpacing price. We certainly don't want price to decline. That's not fun for anyone. But when earnings are outpacing price, that brings down things like a PE ratio. That is good news.

So what is our 12-month S&P 500 price target? This is 12-month-forward. We are not changing this this month, so I'll be brief, but we're at 8,300 on the S&P 500.

That's up about 8% from the closing level on October 20th. You can see bear case and bull case, some symmetry there, which is not always the case by the way, of about 18% up or down. Of course, you could have extreme bear and extreme bulls. We're talking about kind of the central outcomes here. Eighty-three hundred on the S&P, this is what we said when we moved this price target, is driven by earnings expectations, which it has not been driven by valuation. In fact, in this file, one of the few files I still work in, Brent, we have been lowering the valuation estimate, and it's still pushing us higher on the S&P.

I will say, and we say this all the time, markets do not move up in straight line. We do think there's going to be volatility. We think that there's a lot going on around AI and other things that will drive volatility. By the way, a narrow market is not predictive of future returns, but it is predictive of future volatility. So we're going to bounce around, but we think that as long as the fundamentals remain in place, there is upside.

Brent: Well, and I think the fabulous earnings momentum that we have seen combined with valuations falling lends to the durability of equity markets continuing to push higher, right? And equity markets and financial markets in general can be irrational sometimes longer than people can remain solvent. But when you think about the underlying fundamental picture of these equity markets, it looks quite solid.

Phil: So we've touched on stocks. Let's talk about fixed income, which might really be the more important market right now—not only from if you're a business owner the rate side of things but also for investors—balance and portfolios, as we'll talk about more in a few moments.

So first let's just talk about the state of play. Here, we're showing the US Treasury yield curve. The vertical axis here is Treasury yields. The horizontal axis is the date, the duration, the maturity date of those treasuries. So 1 month all the way out to 30 years. Look at where the yield curve was, this blue line on February 27th.

Brent: That's crazy.

Phil: Right before the war broke out. Much lower, kind of a curve lower in the belly, and what we have seen since the war broke out. Well, one, the front end of the curve has moved higher. Why is that? Expectations around the Fed, as we already discussed, have changed. And further out in the curve, we've moved higher as well. So rates have moved up. This is a real focus when we're on the road from clients because if you're accessing lending markets, of course, it's more expensive. But also from clients because if you feel overweight equities in a portfolio, there is an alternative.

As I will point out here, this is not only a US phenomenon, right? We're seeing a discord in Western Europe. The issue with sovereign debt, and we'll be talking about the fiscal situation in the US in a moment, but when you're looking at those charts around the US, it's not just a US story. This is global. Rates are moving higher. Cost of capital is moving higher around the globe. Now, I will point out for a lot of these, if you think about the 10-year Treasury, for example, between 5% and 5.25%. That is high compared to the last cycle since the financial crisis, the last 15, almost 20 years now. It is not high historically. And as the stock market is showing us, we can absorb a 5% to 5.25% 10-year Treasury. There is a level that we can't absorb. But we can absorb that, and we have throughout history.

Brent: Yeah, and when we go move forward and we start to think about fixed incomes and balance in portfolios, fixed income recently in the last couple weeks has started to catch a bit as we think about where that level might be.

So what are we looking at here on this chart? The dark blue bars are the average fixed income yields for these fixed income sectors over the last decade, and the gold is the latest yield to worst.

What you can see if I go left to right, taxable bonds and municipal bonds, current yield to worst relative to 10-year average is 80% higher. So despite the fact that we've caught a bid and, you know, bond prices have risen and yields have come down a little bit, still very, very attractive points for both fixed income, the taxable and municipal side. Five and a half percent for taxable bonds relative to the forward expected return from a consensus perspective for US equities, which is around 6.5% over the next decade. Very attractive yield and old total return characteristics relative to volatility profiles.

And specifically in municipals, at 4.5% nominal on a tax-equivalent basis, you're in the 7% range on a tax-equivalent yield perspective. So a very attractive entry point if you've been underweight fixed income. And certainly, as we think about forward expected returns, while we're still quite optimistic on equity markets over the short and intermediate term, when we think over longer-term cycles, we think that expected returns for both stocks and bonds over the next decade might be closer and more in line than what we've seen over the last decade, where stocks relative to bonds had a huge spread in the first quartile of spreads when we look at history. So again, fixed income looks attractive.

Here, corporate bond spreads, both high yield and investment-grade, investment-grade bonds here in the dark blue high yield in gold. Still relatively tight versus their longer-term histories. Though you can see on the far right, over the last couple weeks we have seen high yield and investment-grade spreads start to widen out at the margin. Usually, historically, once spreads start to move in a certain direction, they tend to go relatively further in that direction. So to your point, I think we're going to see some volatility, not only in equity markets but also in spread product as we get into the end of the year and into 2027.

Phil: There's been a lot of buzz—sorry to interrupt—there's been a lot of buzz particularly around artificial intelligence data centers and what that might mean for corporate bond spreads. So it's certainly worth keeping an eye on.

Brent: Absolutely. And when we kind of move forward and we think about that whole stock-bond interaction here, we usually talk about equities having this equity risk premium. In essence, what is the compensation that you're getting relative to the inherent risk that you take on by owning a long-duration asset like stocks versus something like a 10-year Treasury?

So dark blue line here is what we call the S&P 500 earnings yield. So in essence, it's the inverse of the PE ratio. It's effectively earnings over price,and what that ratio is sitting at about 5.33% here, versus a 10-year Treasury at about 5.13%. So you can basically see that the equity earnings yield and the 10-year Treasury are effectively on top of each other, which usually on a forward basis kind of means that you end up having a little bit more balance in returns over the longer term.

Phil: Yeah, I think this is good news for diversified investors. So something we haven't touched on in quite a while, at least a couple quarters, has been the US federal debt and fiscal situation. But we wanted to bring it in this month because one, we're getting a lot of questions on the road about it. And also, with the recent rise in Treasury yields, longer-term yields, stuff that's not as correlated with just the federal funds rate, I think in the sauce has been a real deterioration in US fiscal situation.

This is a global phenomenon, by the way. France is seeing that play out right now, Japan and others as well. So let's talk about the US. This is US federal debt, percentage of GDP. You can see that the deficit, as it's often called, has risen or the debt has risen dramatically. The deficit is now running at $2 trillion or 6% of GDP.

That deficit of course has pushed this debt-to-GDP number dramatically higher. You normally do not run 6% deficits except in coming out, in the middle of a recession. World War 2, you know, really extreme situations. For us to be in expansion, and yes, there is a war, but these deficits were happening before the war. This is rare to be multiple years past the 2020 recession. These deficits I think are weighing on investors' minds. I think they are finding their way into the term premium, keeping longer-term yields higher.

Brent: Well, it leaves you very little room if God forbid we do have a recession or we do have a geopolitical conflict. The amount of wiggle room that you have to basically stimulate the economy is restricted when you're running this high of a level.

Phil: That's right. So let's look in the details. Now we're showing federal government net interest expense. It's percentage of spending and percentage of revenue. So this is just if you run a business, your debt service, right? What percentage of your revenue and spending is having to go to pay the interest on the debt you have issued?

Well, what has happened? One, since the pandemic, debt issuance has skyrocketed because we're running really big deficits, but also interest rates have risen. So it is much more expensive for the government to borrow. The rate of change here is incredible, as you can see, quite unprecedented, and the level in terms of the history we have here is around all-time highs. This is a real weight on the US government, and it is contributing to that deficit.

So let's look at federal outlays as a share of GDP. What is driving these deficits?

First, the gray bar. This is that net interest expense we just spoke to. One, that is rising dramatically, right? Look at how small the gray line was, say, 10, 15 years ago because rates were so low and deficits weren't quite as explosive. Okay. Now let's talk mandatory spending. This is spending that is in law, right, it would take a change of law.

Brent: Yeah, two-thirds majority.

Phil: Yeah, exactly. So this is entitlement, Social Security, Medicare, Medicaid, et cetera, other mandatory spending. That is roughly in 2025, 60%. That, by 2035, is expected to grow to 62%. I should point out that net interest expense is expected to grow from 14% to 19%. Pretty incredible in terms of the share of total outlays.

So now let's talk about discretionary spending. This is spending that technically is at the discretion of the budget process. This includes defense, by the way. I wouldn't view defense as that discretionary, but that is the terminology the government uses. One, you can see that the share of mandatory spending has grown through time. The share of discretionary has shrunken, meaning it's really hard to fight these deficits.

And the share of discretionary is expected to fall further, 27% to 20% in 2035. What does this all mean? It means that the mandatory, meaning mandatory spending and net interest expense—you have to pay your bills—is going to be over 80% of total outlays by 2035, meaning it's really tough to fight this. It would take a change in laws, change in entitlements, change in things like Social Security, things that are very unpopular and get you unelected to actually fight these deficits. Food for thought, not totally uplifting.

Brent: Yeah, I was going to say, end on a positive note here, Phil.

Phil: Yeah, exactly, but it's something we wanted to outline, and we'll be taking this on the road to show our clients as well.

Brent: Excellent. Well, Amy, I can see that we've got a lot of questions in the queue, so why don't we jump into Q&A?

Amy: Hey, before we jump into questions, just a reminder that we have several publications available throughout the month, and you can find those on FirstCitizens.com/Wealth/MarketOutlook.

Well, thank you guys. Brent, I don't think you really have any choice. I think you have to be Brent Crude for Halloween.

Phil: Wow.

Brent: That is a great idea for a Halloween costume.

Amy: You're welcome.

Brent: Just a barrel of Brent Crude.

Brent: That's right.

Amy: I can't think of anything scarier.

Brent: I kind of look like a barrel.

Phil: No you don't, Brent.

Brent: Thank you.

Amy: So Brent, thinking about the headlines and what's going on, fixed income and interest rates just continue to cover everything. How are you thinking about the role of fixed income in portfolios?

Brent: Yeah. Well, I mean, look, we have always believed that fixed income plays a significant role in balanced and diversified portfolios as we think about both the ability to provide a high degree of current income, as well as diversification as it relates to broader equity and risk asset risk. We think core bonds do play a significant role in diversifying those portfolios. Certainly, as we highlighted, Amy, yields are higher than we've seen over the last decade. Many folks have somewhat forgotten about fixed income because yields have been so low for so long.

I think there's some people that are questioning the diversification benefits of fixed income in times of stress. We certainly had 2022, which challenged everyone's views on the role that fixed income plays. I would argue that there's always going to be periods of time in history where correlations converge and things don't work as you expect. That doesn't mean that you abandon them in your portfolio allocation, your portfolio construction.

Phil: The best predictor of fixed income return is its yield to worst.

Brent: That's exactly right.

Phil: So if yields are higher, the expected return for fixed income is higher.

Brent: Yeah, and when we did that analysis before, roughly you end up capturing about a 110% of your current starting yield to worst as far as expected returns over the duration horizon. So if you haven't been an investor in fixed income over the last decade, now you should really be considering that as far as a portfolio diversifier, and we certainly are in our portfolios and always have.

Amy: Phil, we're in the middle of earnings season. There's some big names coming out this afternoon. What are you thinking about, what are you watching for and how is that going to inform your outlook for the rest of the year?

Phil: Yeah, so it's still early, but a few facts. One, according to Bloomberg's measure, 83% of companies are beating on the bottom line. Again, very early, but good earnings season so far. Earnings expectation year-on-year growth is supposed to be roughly or estimated to be roughly 30%, which again, as we talked about earlier, is an incredible number. If you look at the Magnificent Seven versus the other 493, Magnificent Seven is expected to grow around 33%, 493 around 28%. So it's converging. You're starting to see not just the Magnificent Seven driving earnings growth. We have a lot of results yet to come.

What are we watching? In terms of themes, everything AI. So I don't just mean the hyperscalers and their CapEx. That definitely matters. We saw last earnings season the market start to look more at free cash flow. Free cash flow yield, measures like that, rather than earnings for those hyperscalers because at some point, given depreciation, you want to know, what's the cash flow, right? That's really the game that the market's trying to pay attention to. We will be paying attention to that from the hyperscalers, and of course, their CapEx estimates are those going up as they have for many quarters. But when you think about AI, it's not just about those hyperscalers. It's other companies.

What are we seeing in terms of margins outside hyperscalers? Is AI starting to have an impact? Anecdotally, talking to a lot of clients, and we have clients of all kinds, everything from innovation to folks who own blue-collar businesses, AI adoption has risen dramatically the last several quarters. I'm really interested to see what companies are saying relative to AI and productivity growth as well.

Then beyond AI, what are we seeing from pricing power? We are seeing inflation. Diesel prices are coming in. That's a real cost for many companies. Are they passing that on to consumers or not? The transports, for example, would be very important there. So what are we seeing from margins? Earnings growth, revenue growth, all of that always matters, but we're really interested in that manager commentary. What is management saying about these various themes, such as energy cost, AI, et cetera?

Brent: Yeah. Well, I mean, I think it's going to be interesting as it relates to equity prices because undoubtedly the bar has been raised an awful lot, right? So as Phil showed that chart, Amy, of earnings growth expectations continuing to rise, I think it's priced into markets, right? So it'll be interesting to see whether or not we are through peak earnings in the cycle, whether we continue to rise. Certainly from a total compound perspective, rising 30-ish percent this year and maybe 15% next year geometrically is still significant overall earnings-per-share growth. But do we start to moderate from here?

And how does the market think about that glide path down from peak earnings to something more manageable? We don't think that we're going to immediately fall right back down to the long-term average. Usually, cycles tend to moderate at an interesting pace, and we're going to have to monitor that and how that impacts expectations and pricing of markets.

Amy: And speaking of pass-through prices and consumers, higher prices are already weighing on individuals, but we're not really seeing the economy take a hit. What is supporting the economy overall?

Brent: Yeah. That's—and Phil and I talk about this all the time—it's the power of the k-shaped recovery, right? High-income consumers continue to spend. And when you think about the average high-income consumer, they pull out their iPhone, they look at the value of their financial assets. The equity market just hit its 4-year anniversary like we talked about, up over 120-something percent, almost 130%. Financial assets have done really, really well, Amy.

Home prices have risen significantly. While rates are certainly higher, home prices have risen, and they haven't really fallen, right? They sort of leveled out a bit, right? So you feel wealthier as it relates to your total net worth as a percentage of your disposable income is still near all-time high.

So consumers feel wealthier, and that's allowing them and facilitating their ability to spend and making them feel potentially richer than maybe they actually are and continue to spend, and that's what's driving consumption.

Phil: Absolutely. That's the consumer side, and you mentioned economy broadly. One, Brent's 100% right about k-shaped recovery. The other thing we did point out, and I should highlight, is data center build out.

This move higher, as we're showing here in private investment expectations, just so far this year is really remarkable and has been an incremental driver. Now I will say with data centers, when we are on the road, there is a lot of NIMBYism, not in my backyard. Data centers are kind of becoming, well, what nuclear became, which is—I'm okay with it in concept, I just don't want it in my town, right?

And so it's not that there's not pushback. A lot of these planned data centers, I think, may have a slower rollout than many expect. But nonetheless, we are talking about hundreds of billions of dollars finding its way into the economy, and that has been a real swing factor.

Brent: Well, yeah, that's part of the broader AI story. I mean, we talk about the energy utilization, we talk about data centers, but we also don't know 2 years from now, 3 years from now, 5 years from now, what are going to be powering a lot of these large language models. Do we really need all the energy that we think that we do as it relates to technological development? These things tend to usually get bigger or, sorry, smaller than bigger and tend to be faster processors. Just think about the evolution of chips and nanotechnology. Things get more efficient over time.

Phil: And we've already seen sort of Moore's Law but with GPUs faster than it was with CPUs. So that ramp up has been incredible, and hopefully we're at a point, we're getting to a point where more output per chip with less energy usage. That'll be really interesting to see where are we in 3 to 5 years.

Amy: Great reminders. Thank you, guys, for answering questions. And to our listeners, we hope you found this information helpful and thank you for trusting us to bring you this information. We look forward to seeing you again next month.

Authors

Brent Ciliano CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8540 Colonnade Center Drive | Raleigh, NC 27615

Brent.Ciliano@FirstCitizens.com | 919-716-2650

Phillip Neuhart | SVP, Head of Market & Economic Research

Capital Management Group | First Citizens Bank

8540 Colonnade Center Drive | Raleigh, NC 27615

Phillip.Neuhart@FirstCitizens.com | 919-716-2403

Blake Taylor | VP, Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8540 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com | 919-716-7964

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