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The Baton Pass

By J. Keith Buchanan, CFA, Senior Portfolio Manager

With the 2024 Olympic Games just around the corner, the market is doing its best impression of one of my favorite events, the track relay. In the previous earnings season, corporate reports also coincided with macroeconomic data that showed resilience in the jobs market, inflationary stubbornness, and subdued expectations of the Federal Reserve becoming less restrictive with monetary policy decisions. From the beginning of the last earnings season to the end, the market went from assuming six rate cuts to four then three rate cuts. Yet the market made multiple new highs as earnings blew through expectations with large cap stocks making historic moves after positive readouts and recasting the narrative away from the negative feedback loop of macroeconomic data implications. When the optimism from the Fed grew weary, corporations took the baton and pushed the bullish narrative forward.

The skittishness and the increased volatility set a stage of anxiety at the start of this quarter. The drumbeat of worries about a tight labor market and sticky inflation weighed on markets in early April. Now we have seen the market really pull back as the focus has shifted to the Fed. The market is pricing in one or two cuts in 2024 and even that will not start until September as a result of better-than-expected economic data and rhetoric from the Fed. Market participants were worried yet again. Could corporate earnings surprise enough to the upside to overwhelm concerns about the path forward for interest rates? This moment is turning out to be another test of whether the baton can be successfully passed yet again whereby corporate earnings propel the market forward in the face of economic uncertainty.

At this forward valuation of 20 times earnings for the S&P 500 Index, the market is pricing in some optimism and, as a result, there is room for downside if disappointments arise. Guidance thus far has been mixed. It is a crucial time for a pulse check on corporate profitability as higher rates put more scrutiny on equity valuations and the underlying earnings. Analysts expect 11% earnings growth over the course of this year and 14% next year on 5-6% top line growth. Those are lofty expectations, especially if the Fed is expected to remain more restrictive than the market expected just a quarter ago. Nonetheless, corporate profitability is healthy as revenues grow beyond the rate of inflation and margins expand. This loosely corresponds with a solid but low single-digit real growth environment.

We continue to watch this earnings season and the macroeconomic developments surrounding it as the baton pass attempt continues. Our expectations align with the market that the baton will not touch the track.

Source: FactSet

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