Stock Markets Close Upbeat First Half, but Worries Linger

Stubbornly high inflation, debt ceiling battles, a brief banking crisis and the prospect of further interest rate hikes have left even the most optimistic investors uneasy over the past six months.

But as 2023 comes to a halfway point, investor sentiment is now muted compared to the past 12 months, when the Federal Reserve has been gradually raising interest rates to stifle economic demand and curb inflation. , has become significantly more optimistic.

Investors welcome data that the economy is on a stronger footing than expected at the start of the year. Corporate profits exceeded expectations. Inflation is easing, albeit more slowly than expected, and policymakers expect interest rates to hit highs soon. The longer an investor’s worst fears go unfulfilled, the more optimistic they become.

“More damage was expected,” said Christina Hooper, chief global market strategist at fund manager Invesco. “We are pleasantly surprised,” she said.

The S&P 500 is expected to end the first half of 2023 up about 14% after some analysts expected the market to fall sharply at the start of the year. The rally was so strong that in early June the S&P 500 index was 20 percent above its October low, the technical threshold for the start of a bull market.

Small and medium-sized businesses exposed to economic ups and downs are also beginning to join the rally. The Russell 2000 Index, which covers the 2,000 smallest companies in the Russell 3000 Index, rose 6 percent in June after he fell 0.7 percent through his first five months of the year.

As companies gear up for earnings reports for the three months to June, such optimism rests on shaky foundations. Twelve months ago, investors worried that historically high inflation could be prolonged and that the Fed’s determination to cut inflation could go too far, sending the economy into recession and disrupting financial markets. rice field.

A strong economy has dispelled fears of a recession, but inflation remains high. If the economic slowdown doesn’t pick up fast enough, the Fed could keep rates going up for an extended period of time, tightening the screws on the economy.

Fed Chairman Jerome H. Powell said Thursday that “5% rates were unthinkable before the pandemic.” “So the question is, is the policy strict enough?”

Far from worrying that an impending economic downturn will weigh on corporate profitability and drive down stock prices, investors are beginning to believe corporate earnings are poised to grow again.

“The single biggest surprise in the stock market is earnings resilience,” said Stuart Kaiser, an equity analyst at Citigroup.

On the surface, Wall Street’s forecasts still seem to contradict such a rosy reflection, with analysts expecting the worst earnings report since the initial impact of the 2020 pandemic. That equates to a nearly 7% decline in S&P 500 earnings. The year-to-year decline has accelerated from a decline of about 2% in the first three months of the year, according to FactSet data.

However, much of the contraction expected this quarter will come from the energy and materials sector, which was expected to slow after posting historically high earnings last year. Energy companies’ profits are expected to be about half what they were a year ago, while materials companies expect a 30% decline, weighing on the broader index.

For example, Chevron achieved record profits as its recovery from the pandemic led to a surge in energy demand. The company’s earnings per share are expected to be 46% lower than in the second quarter of 2022, but still far better than the company’s pre-pandemic operations.

In addition, seven of the 11 major S&P 500 sectors expect year-over-year earnings growth. Importantly, analysts expect new gains across the index starting next quarter.

“Given expectations for a return to earnings growth, it will be more important than ever to monitor the guidance companies provide over the next few quarters,” said John Butters, senior earnings analyst at FactSet. Stated.

Bank executives will spend an entire quarter digesting the fallout from the March turmoil that led to regulators buying three banks. Treasury Secretary Janet L. Yellen recently warned that further bank consolidation may be on the horizon.

Investors will also get the chance to hear stories of companies that have benefited from the artificial intelligence craze, sending stock prices skyrocketing for dozens of chip makers and other tech companies.

Possibly the biggest beneficiary of the AI ​​boom, Nvidia is up more than 180% this year, boosting its market valuation by more than $600 billion, making the chipmaker one of the select few companies worth over $1 trillion. became one.

Apple, the largest stock in the S&P 500, hit a record high in the stock market this week, pushing it within reach of the first company to exceed $3 trillion in valuation.

“The big risks are in the technology and AI theme,” said Citigroup’s Kaiser, warning that some companies’ soaring valuations are based more on expectations than current reality. “They will be examined under a microscope,” he said.

The most important measure of the health of the broader economy is consumers like PepsiCo and McDonald’s, who have been successful in raising prices to consumers, thereby minimizing the rising costs associated with interest rates and inflation. would be a company

There are signs that households across the country are tightening their purse strings as their savings piled up during the pandemic dwindle, making it unclear how long they can continue to absorb rising prices.

Despite investor bullishness, companies appear more wary of the potential for the economy to begin to falter.a Survey of Optimism Small business sales rose in May but are still near their lowest levels in a decade.a Similar survey The share of manufacturing from the Federal Reserve Bank of Philadelphia has also increased slightly recently, but is still significantly lower than it was two years ago.

Business executives are opting for more conservative management strategies, forgoing tactics to boost stock prices, such as stock buybacks and large dividends.

Nevertheless, among the handful of companies that have already announced earnings, the trend is in the opposite direction. General Mills Chairman and Chief Executive Jeffrey Harmening said on Thursday’s earnings call that sales were starting to slow “as consumers are feeling the pinch from inflation.”

Economy leader FedEx reported a decline in transaction volumes across its operations. “We are all focused on the consumer,” said Brie A. Carrere, the company’s chief customer officer.

Policymakers looking to engineer a gradual slowdown in the economy will welcome some weakness. But if their efforts falter, the decline in earnings could accelerate, leading to layoffs, rising unemployment and the onset of an even deeper recession.

“We know the labor market is usually the last to go down,” said Roger Arriaga Diaz, chief economist for the Americas at Vanguard. “If you see a weakening labor market, you are already there.”

One of the most widely discussed recession indicators on Wall Street compares the difference between short-term and long-term Treasury yields. Investors usually need more interest to lend to the government for the long term. When this relationship, known as the “yield curve,” inverts, as it did last year, it’s usually followed by a recession.

Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research, said she hopes that doesn’t happen, but “seems like there’s a lot to ask.”

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