Weekly market wrap

Earnings illuminate the path through the inflation haze

Key points:

• First-quarter results are providing additional confidence that S&P 500 earnings are on track to grow around 10% this year. The solid acceleration in earnings supports market gains.
• Recent data suggest that economic growth and the labor market might be softening. When viewed through the lens of the Fed, a gradual slowdown could help bring inflation to target.
• All eyes will be on the April CPI, which is expected to tick down. Our base-case scenario sees inflation moderating further in the months ahead, leaving room for one or two interest-rate cuts later in the year. 
• We recommend positioning portfolios for all scenarios but with a bias for lower rates. If inflation stays stubborn in the near term, mega-cap tech will likely remain in favor. But if disinflation resumes, we think there is significant upside in parts of the equity market that have been left behind. We favor mid-caps, as they provide a nice middle ground for investors looking for catch-up potential without sacrificing quality.

Inflation and the Fed continue to dominate the narrative as financial markets navigate a "high for longer" interest-rate environment, one that the new generation of investors has not experienced before. The outlook for rates is no doubt a key variable for the economy and stock valuations. But in a world where investors interpret every single datapoint through the prism of its implications for Fed policy, one of the most important determinants of long-term market returns – corporate profits -- is often overlooked. As the first-quarter earnings season wraps up, we offer our take on the state of corporate America, which provides a valuable compass for evaluating the overall trajectory of stocks. We also discuss our views on inflation as the spotlight turns to the CPI release this week.

Rising earnings keep the bull market intact

• Last week the S&P 500 extended its May gains and is now less than 1% off its record high¹. The rebound over the past three weeks was helped by a better-than-expected earnings season, which coincided with the market rally and points toward continued economic and profit expansion.
• Diving into the details, about 90% of the S&P 500 companies have now reported earnings for the first quarter. Results have so far exceeded analyst estimates by 8.5%, which is the biggest upside surprise since the third quarter of 2021, with earnings growing 5.5% from last year. Backing these results is still strong though gently slowing economic growth (more on that later), translating to near 4% revenue growth². Additionally, profitability has been improving after being under pressure for all of 2022 and part of 2023, as input-cost inflation has moderated.

• From a sector standpoint, communication services, consumer discretionary and technology continue to stand out for their strong growth, but other areas are also delivering solid results, namely industrials, financials and consumer staples. The only three sectors that are seeing earnings declines for the quarter are energy, materials and health care, with the latter reflecting a quarterly accounting loss from Bristol Myers². Artificial intelligence remains a key theme that continues to benefit the mega-cap tech and the Magnificent Seven stocks specifically, but the benefits to the enablers of this technology could over time spread to those companies that can apply AI to improve existing processes or to enter new markets.
• Zooming out again, first-quarter results for the S&P 500 and company guidance provided additional confidence that earnings are on track to grow slightly more than 10% in 2024². In a typical year, analysts usually reduce their initially optimistic earnings estimates over the course of the year by about 4%, (the average since 1994)². But so far 2024 earnings revisions have not followed the historical path lower and have held steady despite worries about interest rates and the economy. 

• The upshot is that while uncertainty around the Fed-policy outlook and likely upcoming worries around the U.S. presidential elections could be catalysts for volatility in the months ahead, corporate earnings remain in a solid uptrend, supporting the market gains. Stocks are near record highs and about 8% above the prior bull-market peak in early 2022, but so are earnings².

OK or good may be better than great as it relates to economic data at this juncture

• Besides earnings, markets have also found some comfort in bond yields declining so far this month. The 10-year Treasury yield fell back below 4.5% after a brief visit to a six-month high at 4.7%, driven by expectations that the Fed will be able to deliver its first interest-rate cut later this year¹.
• Recent economic releases, like the advanced estimate of first-quarter GDP, the Purchasing Managers' Index, the April job gains, and last week's jobless claims indicate that economic growth and the labor market might be softening. When viewed through the lens of the Fed, a gradual slowdown of the economy at or slightly below its potential growth rate, which is around 2%, could help bring inflation to target and will likely be welcomed by policymakers. Therefore, investors at this point in the central-bank policy cycle are rooting for a mild slowdown instead of more signs of economic strength.
• As it relates to market expectations, after this month's FOMC meeting, where Fed Chair Powell suggested that it is unlikely that the next policy move would be a hike, the bond market is now once again pricing in two rate cuts for the year¹. We think that current expectations are realistic, as the Fed has a bias to cut rates. Nonetheless, absent of a substantial weakening in the labor market, which we do not expect given that corporate profits are looking up, it is the path of inflation that will almost exclusively determine the timing of the first cut.

Which path will inflation take?

• No doubt a lot of progress has been made since inflation peaked at 9.1% in June 2022, but we are not there yet¹. Markets are akin to children in the back of a car, less concerned with how far the journey has progressed, but rather eagerly awaiting the arrival at the destination. After three back-to-back upside inflation surprises to start the year, confidence that inflation is moving toward the 2% target is shaken, and the journey has got bumpier. 
• Given this backdrop, all eyes will be on the CPI release on Wednesday. On an annual basis, headline CPI is projected to decline to 3.4% from 3.5%, and core CPI, which excludes food and energy, is expected to tick down to 3.6% from 3.8%¹. If realized, it would be a good first step in reestablishing a pattern of better readings that would be more consistent with moderating prices.
• For the Fed to hit its year-end projection, core inflation would need to rise at a monthly rate of 0.17% vs. the 0.36% average over the past three months¹. A similar acceleration in prices occurred in the first quarter of both 2022 and 2023, but with widely different paths in the remaining nine months. In 2022 inflation continued to come in hot leading to a spike in prices, while in 2023 inflation cooled consistently the remainder of the year.
• While the monthly readings are volatile and hard to predict, we see further disinflation ahead. Oil prices are back below $80, wage growth is softening even with the unemployment rate below 4% for the 27th consecutive month, used car prices are on the decline, and rent inflation for newly signed leases has declined near 0%¹. Our base-case scenario sees inflation moderating further, leaving room for one or two interest-rate cuts later in the year.

Positioning portfolios for all scenarios but with a bias for lower rates

• Scenario 1: If inflation stays stubborn in the near term and continues surprising to the upside, mega-cap tech will likely remain in favor. The Magnificent Seven are companies with solid balance sheets and plenty of cash, and therefore they are less impacted by high borrowing costs. Beyond U.S. large-cap stocks, where investors might hide in a high-for-longer interest-rate environment, international stocks may become a more meaningful contributor to portfolio returns as a potential divergence between the Fed and other central banks emerges. Weaker growth and faster disinflation in other parts of the world are prompting many major central banks to pivot to rate cuts ahead of the Fed. This could help boost valuations of international stocks.
• Scenario 2: If the disinflation trend has simply been delayed rather than derailed, as is our view, we think there is significant upside in parts of the equity market that have been left behind. Over the past three years the S&P 500 is up 25%, while mid-cap stocks are up 10% and small-caps are down 6%¹. We favor mid-caps for now, as they provide a nice middle ground for investors looking for catch-up potential without sacrificing quality. With both the policy rate and bond yields at peak and likely declining over the next two years, value-style investments could get a lift, while intermediate and long-term bonds are likely to outperform CDs and other cash-like investments. 
• The bottom line: With uncertainty around the inflation and interest-rate outlooks high, appropriate diversification across asset classes, regions, investment styles and sectors is important. However, the combination of rising corporate profits, the continued economic expansion, and the potential for more downside than upside in yields provides a positive backdrop for markets as the bull market continues.

Angelo Kourkafas, CFA
Investment Strategist

^{Sources:  1. Bloomberg, 2. FactSet}

Weekly market stats

^{Source: FactSet, 5/10/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Morningstar Direct 5/12/2024.}

The week ahead

Important economic releases this week include CPI inflation and retail sales data.

Review last week's weekly market update.