Wall Street rallied last week following several positive data points with equities and fixed income posting solid gains – the S&P 500 index increased +2.4% and the US fixed income aggregate index traded higher by +1.5%.
Performance was largely driven by the lower-than-expected inflation reports early in the week which showed price increases are falling more quickly than expectations. CPI came in at 3.0% and core-CPI came in at 4.8%, both modestly beating expectations. The trend was corroborated by the core-PPI release on Wednesday which also fell more than expectation – coming in at 2.4% vs 2.6% expected – and encouragingly, prior releases were also revised lower. Going forward, it will become more difficult for CPI to decrease off higher readings last year (more on that later); inflation is structurally biased to increase through the rest of 2023. Even still, following the inflation reports, several Federal Reserve Board Members indicated that the July rate hike was highly likely to move forward but the conviction for a following rate hike has seemingly diminished. Markets are now expecting the Fed to hold rates after the July meeting.
On Friday, earnings season kicked off in earnest with several of the largest banks reporting better-than-expected earnings. JPMorgan, Citigroup, and Wells Fargo all reported beats on revenue and earnings while several other large companies in healthcare, consumer discretionary, and industrials showed promising results. There has been a lot of negative sentiment around earnings and this quarter is no different. Prior to earnings season, analysts were expecting -9% earnings decline year-over-year. That would mark the worst earnings season since the second quarter of 2020 when S&P 500 profits fell over -30%. Should another negative quarter be posted by the end of earnings season, the market will have three quarters of consecutive earnings declines and analysts are expecting another negative quarter in Q3. Over time, companies generally communicate conservative guidance to the market and post earnings and revenues beats so there is still optimism that the market will avoid four straight quarters of year-over-year declines, particularly if the economic data continues to come in better.
There are several reasons companies provide lower earnings guidance, but the primary reason is that missed earnings are generally very bad for stock performance. Q2 may show several corollaries to Q1; the market was expecting the April earnings season to show a drop of -8.1%, but the results came in better than expected (-3.1%), albeit still negative. The chart here shows that expected growth (white line) is persistently below actual growth (orange).
The negative fundamental pressures fly in the face of the year-to-date rally in equities. The chart below shows valuation as measured by forward price/earnings (purple line) and forward or expected earnings/share growth (blue line) compared to S&P performance (white line). The clear takeaway is that the market rally has been entirely driven by multiple expansion. This can usually only be sustained for a short periods as fundamentals (earnings) are the primary driver of long-term market performance.
A quick word on inflation… As mentioned previously, CPI is set to rise off more difficult comparisons in the second half of 2022. According to the data below from Crestmont Research, if we assume CPI rises at a 3% annualized rate through year-end 2023, the year-over-year CPI will rise which could complicate the Fed’s policy path.
Source: Bloomberg, Crestmont