Stubbornly high inflation, a debt ceiling brawl, a brief banking crisis and the prospect of even higher interest rates: The past six months brought much to unsettle even the most optimistic investor.
Yet at the halfway point of 2023, the tone among investors is noticeably more upbeat than it was over the past 12 months, when the Federal Reserve ratcheted up interest rates to stymie demand in the economy and curb inflation.
Investors have welcomed data showing that the economy remains on more solid footing than was expected at the start of the year. Corporate profits have surpassed expectations. Inflation is easing, albeit more slowly than forecast, and policy-makers have signalled that they expect interest rates will soon reach their peak. The more time that has passed without investors’ worst fears being realized, the more optimistic they have become.
“We anticipated more damage,” said Kristina Hooper, chief global market strategist at the fund manager Invesco. “We have been pleasantly surprised.”
The SandP 500 stock index is set to end the first half of 2023 roughly 14 per cent higher, after some analysts at the start of the year expected the market to fall steeply. The rally has been so strong that early in June, the SandP 500 stood 20 per cent above its October low – the technical threshold for the start of a bull market.
Even smaller companies, more exposed to the ups and downs of the economy, have begun to join the rally. The Russell 2000 index, which tracks the smallest 2,000 companies in the Russell 3000 index, has risen 6 per cent in June, after falling 0.7 per cent through the first five months of the year.
As companies gear up to present their financial results for the three months through June, such optimism rests on a shaky foundation. Twelve months ago, investors feared that historically high inflation could linger and that the Fed’s determination to lower it could go too far, tipping the economy into a recession and upending financial markets.
Although a robust economy has defused recession fears, inflation has remained high. If it doesn’t slow down fast enough, the Fed might keep interest rates elevated for longer – tightening the screws on the economy.
“It wouldn’t have been thinkable to have a 5 per cent interest rate before the pandemic,” Jerome Powell, the Fed’s chair, said Thursday. “And now the question is: Is that tight enough policy?”
Far from fretting that an impending slump in the economy will weigh on corporate profitability and drag down stock prices, investors are beginning to believe that company earnings are poised to grow again.
“Within the equity market, the single biggest surprise has been the resilience of earnings,” said Stuart Kaiser, an equity analyst at Citigroup.
On the surface, Wall Street’s forecasts still appear to contradict such a rosy reflection, with analysts expecting the worst round of earnings reports since the initial impact of the pandemic in 2020. That equates to a fall in earnings for the SandP 500 of nearly 7 per cent from a year ago, according to data from FactSet – an acceleration from a drop of around 2 per cent for the first three months of the year.
Much of the current quarter’s expected contraction, however, is in the energy and materials sectors, where a slowdown was expected after historically high earnings last year. Energy company earnings are expected to be roughly half what they were a year ago, while materials companies are braced for a 30 per cent decline, weighing on the broader index.
For example, at Chevron, the pandemic recovery led to record profits as energy demand soared. The company’s earnings per share are expected to be 46 per cent below the second quarter of 2022, but that would still be far better than the company managed before the pandemic.
Elsewhere, seven of the 11 major sectors in the SandP 500 expected to report earnings growth from a year ago. Importantly, analysts forecast renewed earnings growth for the index as a whole starting in the coming quarter.
“Given the expectations for a return to earnings growth, it will be more important than usual to monitor the guidance provided by companies for the next few quarters,” said John Butters, senior earnings analyst at FactSet.
Bank executives will have had a full quarter to digest the impact from March’s turmoil, which resulted in the takeover of three banks by regulators. Treasury Secretary Janet Yellen recently warned that further bank consolidation could be around the corner.
Investors will also have a chance to hear from some of the companies that have benefited from the enthusiasm over artificial intelligence, jolting the stock prices of a clutch of chip makers and other tech companies sharply higher.
Nvidia, arguably the biggest beneficiary of the AI boom, has risen more than 180 per cent this year, adding more than $600-billion to its market valuation and making the chip maker one of a select few companies worth more than $1-trillion.
Apple, the largest company in the SandP 500, reached a record high in the stock market this week, pushing it within reach of becoming the first company to be valued at more than $3-trillion.
“The big risk is around tech and the AI theme,” Kaiser of Citigroup said, cautioning that the soaring valuations of some companies are predicated more on hopes than current realities. “They will be under the microscope,” he said.
Most important for gauging the broader health of the economy will be consumer companies like PepsiCo and McDonald’s, which have minimized their rising costs tied to interest rates and inflation by successfully charging consumers more.
With signs that households across the country are beginning to tighten their purse strings as savings built up during the pandemic dwindle, it’s uncertain how long they can continue absorbing higher prices.
Despite the bullishness of investors, companies appear to be more vigilant of the potential for the economy to start sagging. A survey of optimism among small businesses ticked higher in May but remains close to its lowest level of the past decade. A similar survey of manufacturing businesses from the Federal Reserve Bank of Philadelphia has also edged higher recently but remains sharply lower than two years ago.
Business chiefs have opted for more conservative management strategies, backing away from tactics to lift their stock prices, like repurchasing their own stock or paying large dividends.
Nonetheless, among the small number of companies that have already reported earnings, the trend has been against them. Jeffrey Harmening, the chair and CEO of General Mills, said on the company’s earnings call Thursday that it was starting to see a slowdown in sales, “as consumers are feeling the pinch from inflation.”
FedEx, a bellwether for the economy, reported lower volumes across its business. “We’re all watching the consumer,” noted Brie Carere, the company’s chief customer officer.
Policy-makers who are trying to engineer a gentle slowdown in the economy will welcome some weakness. But should their efforts falter, earnings could fall faster, leading to layoffs, higher unemployment and the beginnings of a more severe downturn.
“We know that normally, the labour market is the last shoe to drop,” said Roger Aliaga-Díaz, Vanguard’s chief economist for the Americas. “Once you see the labour market weakening, you’re already there.”
One of Wall Street’s most widely talked-about recession indicators compares the difference between yields on short-dated government bonds with yields on longer-dated government bonds. Typically, investors require more interest to lend to the government for longer. When that relationship – known as the “yield curve” – inverts, as it did last year, typically a recession follows.
Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, said she hoped that didn’t happen, “but it seems like a lot to ask.”
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