It’s Always About Earnings — Evening Brief – 07.17.24
The equity markets are posting new highs on ever more incrementally positive news, whether it be inflation trending down, albeit slowly, or a resilient jobs market. Over the last four weeks or so, however, the gains have arguably been spurred by clearer signs from the Federal Reserve that looser monetary policy conditions will be implemented before the end of the year.
The market appears to be preoccupied with the possibility of a September interest rate cut by the FOMC, with the probability hovering in the upper 80% to low 90% range over the past two weeks. However, it is neglecting the fact that we have transitioned from a situation at the beginning of the year, when the markets anticipated six or seven rate cuts by January 2025, to one, possibly two, cuts by the end of the year. We have been here before. Markets price in a strong probability that the Federal Reserve will soon begin cutting interest rates, only to discover otherwise. Is this time different?
Keep in mind that we have global inverted government bond yield curves which haven’t resulted in a recession (yet), an inflation shock which necessitated rapid interest rate hikes to stifle demand, which hasn’t led to a recession (unlike every inflation episode in the 1960s and 1970s), and government debt-to-GDP ratios in most developed countries at truly unprecedented levels, which limits future options for fiscal stimulus along with other issues.
The contradiction of sustained market strength despite broader economic concerns has persisted for nearly a year now, largely due to robust corporate earnings. This strength in earnings has been a critical factor for several reasons: Earnings still significantly exceed long-term trend projections; in a world of increased discount rates, today’s earnings are more important than earnings tomorrow. Both discretionary and quantitative hedge funds at the corporate level tell us that over the past year or so, share prices have been especially sensitive to earnings beats and misses.
Therefore, it is not shocking that equity markets continue to reach new highs while earnings remain healthy when aggregated to the index level. The rub, however, especially for U.S. equities, is that the downside risk is exacerbated when a high price-to-earnings ratio is backed by exceptionally high earnings.
As the CAPE (Cyclically Adjusted Price Earnings Ratio) and other measures imply, values are high. Forecasting S&P 500 returns depending on earnings-based and dividend-based models still shows somewhat unfavorable results. Should income revert to long-term norms, the economic environment is hardly sufficient to sustain an ever more elevated price-to-earnings ratio.
The second and third quarter earnings seasons hold the most potential to upend the current market narrative. The large U.S. banks kicked off earning season for the second quarter last Friday and the results have been mixed so far. While Citigroup, JP Morgan and Wells Fargo’s earnings exceeded expectations, their income statements revealed the ongoing toll of higher interest rates and reflected concerns about a cooling economy.