The importance of earnings season

Forecasts suggest that this will be the 14th consecutive quarter of year-on-year revenue growth for the S&P and the third consecutive positive quarter for earnings per share (EPS).

Meanwhile, the latest macroeconomic data has raised the question of whether 'the economy will experience a soft landing with slower positive GDP growth, or whether it will accelerate again later this year.'

By: Phil Orlando, Chief Equity Market Strategist at Federated Hermes Inc.

With yields rising and P/Es contracting, we need good earnings in the first quarter.

There is a popular saying on Wall Street that one surprisingly aberrant data point is a blip, two are a fluke, but three in a row marks a new trend. The decline in inflation, which last year was thought to be heading towards the Fed's 2% target, has stalled in recent months and appears to be accelerating again. At the time, the consensus view was that the US economy was heading for a recession by the end of 2023. But the labour market has been strong and forecasts of a hard landing have disappeared. The current debate is whether the economy will have a soft landing or no landing at all. Federal Reserve officials, who last month assured us that there would be three interest rate cuts this year, are now backtracking with determination, with some warning that their next policy decision could be to raise rates.

With interest rates rising sharply, the timing of potential cuts uncertain, volatility increasing and high price/earnings multiples (P/E) beginning to contract, the incipient first quarter earnings and earnings reporting season has taken on inordinate importance.

Earnings season

The S&P 500 earnings season is already underway. According to FactSet, revenues are expected to increase by 3.4% y-o-y, down from the 4.4% expected at the end of December. This would be roughly in line with the actual increase of 3.7% year-on-year in the fourth quarter and would mark the 14th consecutive quarter of year-on-year revenue growth for the S&P.

Earnings per share (EPS) are expected to increase by 3.2% y-o-y in the first quarter of 2024, down from the 5.7% expected at the end of December. While this would be a sequential decline from the actual increase of 8% in the fourth quarter, it would also represent the third consecutive positive quarter, after three consecutive quarters of declining earnings. Thus, the earnings recession appears to have bottomed out in the second quarter of 2023. It is important to note that, in recent months, company managers have issued negative earnings forecasts for the first quarter 2.4 times higher than those who gave positive forecasts. This is not unusual as many companies try to create an upside surprise by convincing Wall Street before their quarterly report. In fact, according to UBS, the long-term average upside surprise over the last five years is 1% for revenues and 4.8% for EPS.

Hard landing, soft landing or no landing?

The Commerce Department will release first quarter GDP on Thursday. While economic growth should be positive, it could be sequentially slower, at around 2.4% for the second consecutive quarter, down from 3.4% in the fourth quarter of last year and 4.9% in the third. (Federated Hermes estimates GDP growth of 2.2% for the first quarter of this year; the Blue Chip consensus is 2.1%; the Bloomberg consensus is 2.5%; and the Atlanta Fed's GDP forecast was recently raised to 2.9%). Importantly, the Blue Chip consensus has eliminated any negative quarterly GDP estimates for 2024, suggesting that the forecast of a possible recession is off the table. The current economic debate is whether the economy will experience a soft landing with slower positive GDP growth, or whether it will accelerate again later this year. We remain in the soft landing camp.

Financial markets

Benchmark 10-year Treasury yields moved from 3.81% overbought on 1 February to 4.69% oversold earlier this week. From a technical point of view, there is not much resistance between this level and 5%, so we could retest the October 2023 level in the coming months.

The volatility index (VIX) has moved from an overbought level of 13 on March 21st to an oversold level of 21 today, as investors are becoming increasingly anxious about growing geopolitical risk in multiple scenarios.

Equity investors, however, largely ignored these developments over the past five months, with the S&P soaring 10% in Q1 2024 - the market's best opening period since 2019 - amid a powerful 28% rally since 27 October. But the S&P is down nearly 6% in the past three weeks, in line with our forecast for a healthy, long-overdue and much-needed 5-10% equity market correction. Rising Treasury yields call for a narrowing of P/E multiples.

Barbell year for equities

After the strong performance of equities in the first quarter, we expect a choppy second quarter due to Fed related uncertainty, followed by a volatile third quarter as investors begin to discount their election concerns. However, we continue to expect a strong post-election rally that will allow us to end the year in record territory.

Have the Magnificent Seven run out of steam?

We continue to believe that the so-called Magnificent Seven will disproportionately bear the brunt of the damage of this correction. In the last 18 months to 31 March, the Magnificent Seven soared a combined 99%. While the S&P rose 37%, the "forgotten 493" rose a paltry 22%. Consequently, we have been expecting a reversion to the mean of this valuation imbalance. The outperformance of growth versus value has outperformed a two standard deviation event for the third time in the last 40 years: the bursting of the Y2K tech bubble, the reversal of the Covid bubble in 2020 and today. We therefore expect this rotation to continue to widen.