Which will ascend faster, earnings or interest rates?

Rapid earnings growth has been the key upward driver of the S&P 500 this year, but rising interest rates have dragged on these market gains. In a simple valuation construct, it’s a race between earnings in the numerator and cost of capital in the denominator.  We discuss our expectations and uncertainties for earnings and the cost of capital below and explore S&P value sensitivity to both; but remember, earnings per share (EPS) growth is secular, whereas the cost of capital will eventually stabilize to a norm. Put plainly, earnings win the long-term race.

This year’s unusual leap in S&P EPS, record margins/ Return on Equity (RoE), and the leap in long-term real risk-free interest rates or long-term Treasury Inflation-Protected Securities (TIPS) yields to highest levels in about 25 years, calls for revisiting the concepts and forces, both cyclical and secular, that drive EPS and real rates.  

S&P 500 EPS: Up 25% 2026, 10-15% in 2027, then 8-10% trend until 2030

As discussed in prior notes, we expect S&P EPS of $345-350 this year, $375 in 2027 and trend growth of 8-10% to nearly $500 in 2030. Yet analysts estimate $410 for 2027, if that proves correct, we think trend growth slows to 6% keeping our ~$500 2030E EPS intact. 

S&P EPS growth is supercharged this year owing to an investment spending boom on tech equipment and other capital goods related to building and powering Artificial Intelligence (AI) datacenters. The details of this topic are not our focus right now, but rather the circumstances at play that demonstrate that return on capital even at the margin does not necessarily mean revert to the cost of capital possibly for a very long time; not for a company, not for the biggest of companies and not even for all S&P 500 companies in aggregate possibly for a long time.

Innovation smashes diminishing marginal productivity of capital assumptions. While money is fungible, capital is varied, physical and intangible, often complementing rather than substituting for labor. This is a good thing, yet with great uncertainties for those in the race. Many complexities to consider but given robust S&P EPS growth through cycles and persistently climbing margins and return on invested capital (ROIC), don’t underestimate the legs on this numerator. Competition curbs excess returns, but innovators deploy capital into an entirely new arena.   

Real Rf interest rates: Real interest rates loosely linked to real growth

Despite its record size relative to gross domestic product (GDP), if the S&P’s terrific return on capital casts doubt on diminishing marginal productivity of capital (when varied via innovation) or any limit to total capital productively deployed, then the link between GDP growth and S&P’s return on capital at steady state comes undone. Moreover, to the extent that GDP growth is driven by more capital deployed, the return on that capital should reflect risks and uncertainty of productive deployment and success should earn more than a risk-free return.

That is why we shrug at real GDP growth and real Rf interest rate equilibrium theories, which have been unreliable guides for long periods in the US (+/- 300 basis points (bp)) and elsewhere. We think real risk-free interest rates are more determined by concepts like the degree of sacrifice of foregoing consumption today for more tomorrow, balancing risk-adjusted investment opportunities with savings (noting government propensity to borrow), what real interest rate promotes a central banks inflation target, and contemplating that in an affluent society perhaps taking no risk deserves no real return (after-tax). Another complex topic, so we use history and gently apply any perceived shifts in such forces and heed market set rates.

What we expect and sensitivities: 2030 estimated 10-year TIPS 2%, 19x forward S&P P/E

We expect the S&P 500 to reach 10,000 at 2030 end, delivering a 7% total return with dividends. This assumes a long expansion with 2030 S&P EPS about $500 and the trailing price-to-earnings (P/E) ratio about 20x and forward about 19x, on a normal basis with the S&P 500 afterward generating about 6.5% long-term EPS growth, which is normal with current retained earnings ratios for reinvestment. A 19 forward normal P/E aligns with a 5.25% real cost of equity, every 25bp change is 4.5% to the normal P/E. The equity risk premium should reflect all macro risks, including today’s elevated real rate uncertainty. We see the real cost of equity at 5.0-5.5% with 10yr TIPS yield 2.0-2.5%.

Our recent CIO Day set 12-month S&P 500 target of 8400 uses our EPS and 4.5% 10-year Treasury yield.

Alpha could be a bigger difference in coming years, seek it from the core

A little alpha can go a long way over time and make a bigger relative difference in a more normal returns equity market. Moreover, a little alpha in what remains the largest allocation of most household portfolios, large cap U.S. equities, can cause the biggest active management impact to total portfolio return. We think core active strategies have the most flexibility to pursue truly idiosyncratic and diversified alpha. We find that Value is too often a trap, and it misses too many opportunities at the strong runners which find ways to increase economic profits. But we also think that Growth has become too concentrated and narrow, given that Growth is mostly Tech now. Neither a Value nor Growth tilt alone is an alpha strategy; it takes many factors or assessments to identify alpha.