Less Inflation, Better Earnings, and a Bit of AI
What happened last week?
- The S&P 500 rose 2.42%
- The Dow Jones advanced 2.29%
- The Nasdaq composite gained 3.32%
Inflation, as measured by the Consumer Price Index (CPI), retreated to 3.0% y/y and other inflation measures showed signs of moderation, too.
This week, the market will focus on the 2Q23 earnings season with 60 S&P 500 companies scheduled to report their results.
3 Things to Know
A better-than-expected US economy
This less-than-perfect 2023 economy has exceeded most investors’ bearish expectations. In fact, several of CGWI’s major concerns have not materialized, leading it to raise its allocation to global equities.
The US economy, meanwhile, is seeing a sharp drop in inflation as well as a moderation in hiring. US employers added 209,000 workers in June, still unsustainable in the Fed’s view.
Yet, private sector job gains of 149,000 last month were the lowest of the post-Covid expansion period and are decelerating.
The healthcare sector accounted for more than 40% of private sector hiring.
Cyclical services like leisure and hospitality added only 58,000 jobs over the entire second quarter and the boom in demand for services is subsiding.
Just as the demand for goods surged during Covid and abated in 2022, we think record swings in demand for services will follow the same pattern in 2023–24.
Lower bar for earnings season
Corporate earnings season began last week with early reports from large banks. In the coming weeks, reports will come from large tech firms, industrials and retailers.
Following a long “tradition,” Wall Street research analysts have cut their estimates for upcoming earning reports, lowering the bar for success.
An aggregation of the second quarter EPS estimates equates to a 14% annualized EPS reduction. In the first quarter of 2023, managements were effective in limiting expenses and maintaining margins.
This cleared the decks for a true earnings surprise. However, both managements and analysts have been cutting near-term estimates for most of the past year.
With inflation abating and the economy slowing, maintaining margins will become somewhat more difficult. Yet, the same forecasters estimate earnings in Q3 will surge and keep growing rapidly.
In short, as the economy experiences rolling recessions, reaching the projected EPS levels for the remainder of ’23 will be quite difficult.
Tech’s resurgence
2023 has seen a huge tech-driven rally. Hype around Artificial Intelligence propelled mega-cap equities through the nearly forgotten collapse of three US regional banks.
Embedded in tech valuations is a lot of hope around long-term earnings growth. Indeed, expected earnings beyond 2025 explain 90% of the price an investor pays for the S&P 500 Tech index.
We do not view tech’s long-term outperformance as unjustified. In fact, tech earnings have mostly kept pace with their rising share of overall market cap as the sector sells products that are indispensable to daily life.
Companies that hold the keys to cutting edge processing power and troves of data will continue to benefit from AI buildout.
But as we approach tech earnings in the coming weeks, clients over-exposed to expensive technology and under-allocated to more beaten-down sectors run the risk of some portfolio disappointment if the AI hype doesn’t generate further positive news.
See our weekly CIO Strategy Bulletin for more details