EQUITIES COMMENT- Exceptional Earnings Growth Boosts Stocks Despite Bond Headwind

Oct 7

5 min read

Exceptional earnings growth is powering stock gains this year. For the TSX Composite, earnings are forecast to increase more than 25% while the U.S. S&P 500 earnings are expected to gain more than 30%. These growth rates are about three times the long term average. Energy is experiencing strong earnings growth due to the higher oil price. In the U.S., Technology stocks are the largest contributors to the outsized growth. This is connected to the expansion of AI (Artificial Intelligence) and tremendous demand for computer chips.

The graph above shows the performance of stocks since the beginning of 2026. All indices are up 10% or more. During the third quarter, the TSX increased 1.6% including dividends and was ahead 20% over the last year. The S&P 500 had returns of 2.4% and 18% in Canadian dollar terms during these same periods.

The primary headwind for stocks that emerged in the third quarter was an increase in global bond yields. At the end of September, the 10 year Canada bond yield was 4%, an increase of more than .50% from the end of June. Higher bond yields can cause problems for stocks because they become more competitive for generating income. Investors may choose to sell lower yielding, riskier stocks and buy higher yielding, safer bonds. This results in a stock prices falling and dividend yields increasing.

The previous graph shows the yield on the 10 year Canada bond and the dividend yield on Fortis, a utility stock, over the past year. You can see that the yield on the 10 year Canada bond has been rising through most of that period however, the increase accelerated in the last quarter. Meanwhile, the dividend yield on Fortis was declining and reached a low early in the third quarter. This was unusual considering the rise in bond yields. However, because electricity distributors like Fortis will benefit from the increased power demands of data centres, investors were focussing more on the growth potential of the company and less so on the dividend. As bond yields continued to rise, the low dividend yield eventually became a consideration. The stock price for Fortis at the end of June was $81.25 and the dividend was $2.56 for a yield of 3.2% (dividend divided by stock price = yield). At the end of September, the stock had fallen to $75.17, the dividend was the same and the yield had increased to 3.4%.

The positive influence of higher oil prices and the AI buildout along with the negative effect of increased bond yields can be seen in the sector returns so far this year.

Energy has been the top performing sector in both Canada and the U.S. due to the increase in the price of oil and the lack of progress on resolving the war in the Middle East and Ukraine. Both conflicts have had significant negative impacts on oil production and transportation.
U.S. Technology stocks, particularly the semiconductor manufacturers, are benefiting from incredibly robust demand for computer chips with no sign of a slowdown in sales yet.

Even though Canadian Financial stocks had a negative return in the quarter, the year to date gain is still 17%. We discussed the factors affecting Canadian banks in our last Equities Comment.
Sectors that are underperforming this year include Consumer Discretionary and Staples. Lower income consumers are struggling with the higher cost of living so sales are weak in some segments.
During the third quarter, interest rate sensitive sectors like Utilities, Communications and Real Estate struggled as competition from bonds increased. In the Energy group, pipeline stocks also suffered.

Turning to the TSX Composite and S&P 500 as a whole, forecasters are expecting double digit earnings growth to carry on through to 2028. Similar gains are expected in most major regions of the world. A combination of higher commodity prices, increased defense spending and booming AI is expected to support this unusually positive outlook. Should earnings meet expectations, returns of approximately 10%-15% including dividends are possible for the TSX and S&P 500 over the next year. We are now assuming p/e multiples, which have declined in 2026, contract further. However, given rapid earnings growth, p/e multiples above the historical average can still be justified.

What risks do we see for our forecast?

Bond yields rise further due to inflation worries – The increase in the oil price is putting upward pressure on inflation. In both Europe and the U.S., central bankers raised interest rates during the third quarter. If the conflicts in the Middle East and Ukraine ease and oil prices fall, inflation should come down and reduce the odds of bond yields rising much further. However, if oil prices remain at current levels or increase, we could see additional rate hikes and even higher long term bond yields. In recent weeks, the 10 year U.S. Treasury bond surpassed the high reached in 2023 and is now at a level not seen since the early 2000’s.

Economic growth disappoints - If oil remains higher for longer, growth for the global economy is likely to be reduced. Canada is also dealing with a more negative trade environment thanks to our largest trading partner, the U.S. Poor productivity (tied to low investment) and slower population growth are also weighing on the Canadian economy. On the bright side, there is more optimism that investment will increase in this country, particularly in defense, mining and energy.

Commodity prices weaken – Gold is down 4% this year mainly due to strength in the U.S. dollar linked to higher interest rates. If gold remains at these levels, earnings for the TSX could be revised down. Oil below $75 would also put the TSX earnings forecast in jeopardy.

Developments in the field of AI disappoint investors – There are concerns about AI and how it will affect profitability for the Tech sector, particularly for software companies and firms that are making very large capital investments. As well, there is such strong spending now to expand data centres, if it were to slow below the levels currently anticipated, this could negatively impact not just the semiconductor stocks but other beneficiaries of AI such as industrials and utilities. Reasons for a slowdown include the possibility of increased regulation for AI developers and growing resistance to the construction of data centres due to high power and water needs.

At this time, we are not making any changes to our year end forecasts for the TSX (35,500) or the S&P 500 (7,800). For 2027, our targets are 38,000 for the TSX and 8,600 for the S&P 500. Continued conflicts in the Middle East and Ukraine have raised the risk of disappointing economic growth, increased inflation and higher bond yields due to the rise in the price of oil. For now, exceptional earnings growth is supporting stocks even in the face of higher bond yields.