Wall Street is largely positive on the U.S. stock market, with bullish sentiment at high levels and major indexes having recovered much of the ground they lost in a recent correction. Nonetheless, investors may not be paying enough attention to one of the most significant—and most positive—trends in the economy.
Recent trading has been largely driven by the specter of inflation, the prospect of which has resulted in volatility returning to markets in dramatic fashion. However, the focus on that issue—along with the steps the Federal Reserve might have to take to combat such a scenario—has overshadowed the fourth-quarter earnings season, which has largely supported the idea that American corporations are faring well in the current environment.
“We’ve been ignoring corporate news. The market has been focused on higher bond yields and rising rates, and those two concerns have overshadowed earnings, which have been strong,” said Mark Grant, managing director and chief global strategist at B. Riley FBR Inc., who added that “investors need to consider all these factors” and that he expected fundaments to return to the foreground of investor attention soon.
The degree to which earnings have waned in evident important this quarter has been notable. According to Goldman Sachs data, which goes back to 2005, stocks that top analyst profit forecasts have historically outperformed the broader market by a median of 105 basis points (1.05 percentage point) in the day after reporting, while the ones that disappoint underperform by 211 basis points. This quarter, however, positive surprises have only resulted in median outperformance of 70 basis points, while negative ones resulted in median underperformance of 164 basis points.
“Investors have largely looked through one of the strongest earnings seasons on record,” wrote Goldman Sachs, noting the “muted” responses to both positive and negative corporate results.
This trend has limited the broader market’s advance, as the news this season has been atypically good. With the season more than 80% over, 54% of S&P 500 SPX, -0.55% companies topped earnings expectations, “the highest percentage since 2010,” according to Goldman. Top-line results have also been “exceptional,” the investment bank added, “with more than half of S&P 500 firms posting results a standard deviation above the consensus estimate [for revenue], the largest share since 2004.”
The renewed focus on inflation began earlier this month, when the January payroll report showed wages accelerating at their fastest pace in years. That sparked concerns that inflation could be returning to the economy after years of dormancy, which in turn underlined fears that the Federal Reserve could become more aggressive in raising interest rates to combat such a scenario. Typically, rising rates and bond yields are seen as factors that contribute to the end of bull markets; however, current levels of inflation are seen as well below what is considered worrisome.
The wage-growth figure sparked a decline that took the S&P and the Dow into correction territory—defined as a 10% drop from a peak—for the first time in about two years. The selloff was broad, with each of the 11 primary S&P 500 sectors seeing sharp drawdowns. That represented something of a reversal from recent activity, as both volatility and correlations had been hovering near multiyear lows.
In something of an ironic point about the newfound focus on inflation, many experts dispute the idea that an inflationary or rising-rate environment will be back for stocks or corporate profits.
According to S&P Dow Jones Indices, for every 100 basis point increase in interest rates, every sector, investment strategy, and market-capitalization size category rises. Small stocks see the biggest gain, rising an average of 7.3% on every 100 basis-point rise, while midcap stocks gain 5.9% and large-cap stocks advance 2.5%, on average.
“While rising long-term rates will ultimately become a negative for profits and multiples, we do not see current levels as a reason to de-risk and sell equities,” wrote Dubravko Lakos-Bujas, the chief U.S. equity strategist and global head of quant research at J.P. Morgan Securities. “In fact, the recent rise in rates coincided with stronger economic growth, positive earnings revisions / guidance, and expansionary fiscal policy (tax reform and higher government spending).”
He added that the negative impact of rising rates on corporate profits and multiples is “gradual,” and that “we don’t believe equity derating is likely this year given expansionary fiscal policy, supportive global central banks, and attractive leverage and opportunity spreads.”
Corporate earnings could continue to be a positive driver for markets going forward. While recent strength has largely been the result of organic growth, they’re expected to receive an additional boost going forward from the recently passed tax bill. According to Goldman, consensus expectations for earnings have been revised higher by 7% since Dec. 22, when the bill was passed. All 11 primary S&P 500 sectors had their estimates revised higher in that time, led by the energy and telecom sectors, which saw mean estimates rise 19% and 17%, respectively.
