- Equity valuations are constrained by rising bond yields that reflect investor fears of persistent inflation, but Goldman Sachs thinks stocks can continue to rally if higher-for-longer interest rates are driven by resilient economic growth as opposed to hawkish policy.

Around a third of the 229 firms that have reported results so far have beaten consensus sales estimates, but two-thirds of companies have beaten EPS estimates with an average surprise of 9%.

Concurrent with the flood of generally positive micro earnings results, macro PCE inflation data released last week corroborated investors’ views that Fed cuts are not imminent.

Since the start of 2024, the number of 25 bp cuts implied by the fed futures market has declined from six to fewer than two, Goldman said. The 10-year nominal Treasury yield has increased from 3.9% to 4.7% and the real yield has climbed from 1.7% to 2.3%. 

Even in the face of climbing rates, the S&P 500 has returned 6% this year and is just 4% below its all-time-high. 

“We expect earnings growth will lift the index by 3% to our year-end target of 5200. While our economists expect continued disinflation that will lead to rate cuts later this year, the delayed interest rate cuts should constrain equity valuations,” the bank added.

While “higher for longer” rates are not necessarily an insurmountable obstacle for stocks, certain parts of the equity market are more likely to lag if rates keep climbing.

That said, earnings results this week were a reminder that earnings growth is ultimately the key driver of equity prices, Goldman added.

Unlike previous episodes where investors flocked to “quality” stocks, the earnings growth environment today is healthy. This time last year, the strength of “quality stocks” could be attributed to investor concerns about a hard landing, but the growth backdrop has improved substantially during the past 12 months. 

During most previous periods of strong S&P 500 profit growth, “quality” stocks such as those with high returns on capital have typically underperformed and traded with much less of a valuation premium relative to their lower-quality peers. 

Today, rather than growth, concerns over the cost of capital are supporting quality. If the Fed proceeds with cuts later this year and those concerns recede, quality stocks will likely give back some of their recent outperformance.