Strong Retail Sales and Rising Yields Signal Resilience

The latest economic data reveals a resilient economy, led by strong retail sales and a surprising drop in jobless claims. Despite some weakness in manufacturing, industrial production, and housing, overall economic strength is reflected in the projected third-quarter real GDP growth, expected to come in at a robust 3%—largely driven by productivity gains. This productivity led rebound is very positive and this confirms that despite tighter monetary conditions, the real economy remains strong.

A notable development is the recent growth in bank deposits. After a prolonged period of contraction following the Fed’s aggressive tightening in March 2022, deposit growth is now accelerating at an annual rate of 5.5%. This increase implies a similar growth of the money supply which is a positive sign for broader financial conditions.

The Fed has only made modest progress in cooling the economy, with the labor market remaining unexpectedly strong. This raises an important question: Is the neutral rate—the interest rate consistent with full employment and stable inflation—higher than anticipated? Earlier this year, I estimated the neutral rate at around 3.5%, but the latest data has pushed my estimate up toward 3.75%. (The Fed, recall, indicates a neutral rate of 2.9%.)

This recalibration of the neutral rate has direct implications for long-term bond yields. Historically, the 10-Year Treasury yield has traded about 100 basis points above the Fed Funds Rate, and even wider in non-recessionary periods. With the Fed Funds Rate likely settling around 3.75%, this puts the 10-Year yield on a trajectory toward 4.75%.

On the equity front, corporate earnings are strong and with the VIX still elevated around 20, this is not the backdrop for the start of a bear market. There remains considerable caution among investors, with many hedging against potential geopolitical shocks or election uncertainties. The current under-loved bull market could see significant upside. While I’m not predicting a "melt-up," it is important to acknowledge the market’s upward momentum could continue as fundamentals remain supportive.

The battle between growth and value stocks continues to oscillate, with mixed results in tech names like ASML and Taiwan Semiconductor dictating back and forth sentiment. However, we aren’t seeing any definitive trend between growth and value yet. Small-cap stocks, in particular, face a mixed outlook as higher-for-longer financing costs weigh against a better environment for earnings.

As we head into the final stretch of the election season, betting markets have started to lean toward a Trump victory, though margins remain narrow. Importantly, even a victory by Harris would not lead to significant market disruptions, provided the Senate turns Republican as is widely expected. A split government would dampen the prospects for major legislative changes, particularly around tax increases or other progressive policies, and risk markets view this favorably.

Ultimately, markets prefer policy stability and less regulatory pressure, and the prospect of the Trump tax cuts being extended in 2026 is seen as a tailwind for equities. While the geopolitical risks remain, there’s a reasonable chance that markets will continue their bullish trajectory into year-end, especially if fears of a recession recede further.