Indicators such as this week’s milestone inflation print, strength in corporates and a new era of capex spending may show there’s room to run.
Our Top Market Takeaways for July 14, 2023
Market update
Have you missed the rally?
Heading into Friday, stocks are having one of their best weeks of the year. The S&P 500 is now up +18.5% year-to-date, and the first half was the second-best since the turn of the millennium (with 2019 at the top of the stack).
But the year isn’t over yet, and there’s still a whole second half to go. If you’ve been on the sidelines while stocks roared higher—despite all the recession obsession—you might be wondering if you’ve “missed it”, and whether it’s still worth jumping in now.
We see opportunity, but the trick moving forward may be to look beyond the leaders of the rally thus far, and broaden your horizons. Today, we explore why.
Spotlight
3 reasons for the bull case
1) This week’s U.S. inflation print seemed to knock down one of the biggest bricks in the proverbial wall of worry.
The headline Consumer Price Index (CPI) rate dropped 100 basis points (bps) to 3.0% year-over-year, marking its slowest pace since March 2021 and 12 straight months of cooling. The core measure (ex-food and energy) also fell to 4.8%, unseen since October 2021.
Under the hood, forces against inflation broadened further: Prices for fuel, used autos, airfares and hotels (even as folks head out on summer vacations), meat, dairy, beverages (but the non-alcoholic kind) all fell
Shelter costs (think: rent) and core services ex-shelter (think: your doctor, barber, barista) were still sticking points, but all in all, this marks a stark contrast to where we stood just a year ago. Back then, headline inflation hit its highest at 9.1%. Your wallet may feel a bit better this summer.
Then and now: inflation is cooling for the summer
This chart shows the contribution to the year-over-year U.S. headline Consumer Price Index (CPI) in June 2022 and June 2023. The contributions and headline numbers are: June 2022—9.1% headline: - Core services: 3.2% - Core goods: 1.5% - Energy: 3.0% - Food: 1.4% June 2023—3.0% headline: - Core services: 3.5% - Core goods: 0.3% - Energy: 0.8% - Food: -1.5%
With inflation falling while growth stays strong, the probability seems to be rising that things might end up being okay. And while growth may yet slow in the face of higher rates, less economic pain seems needed to get the Federal Reserve’s job done.
2) Companies have weathered the storm better than expected, and earnings stand to recover from here.
That matters, given that stock prices tend to follow earnings over the long term.
Heading into Q2 earnings season, the Street expects earnings to contract some 7–8% year-over-year, but with growth ramping back up from there. Stripping out energy (which faces some tough comps this quarter after a strong 2022), it looks even better, at -1.7%. This means that the worst may soon or already be behind us, and it could shape up to be another stronger-than-expected quarter.
The worst could soon be behind us, with greener pastures ahead
The chart is a bar graph of quarterly earnings per share growth on a year-over-year as a percentage starting in the fourth quarter of 2013 and ending with expected earnings growth in the fourth quarter of 2024. The first data point in the chart is for year-over-year earnings growth up 11% from the prior in the fourth quarter of 2013. The chart doesn’t change much, but begins trending downward and dips to -1% for a year-over-year earnings decline in the second quarter of 2015. The chart moves neutral before continuing to fall further, with year-over-year earnings declining by -6% in the first quarter of 2016. From here, year-over-year earnings growth begins to rise, with earnings up 15% from the prior year in the first quarter of 2017. The chart continues to trend upward, with year-over-year earnings growth at 27% in the third quarter of 2018. The chart begins trending lower from this point, with year-over-year earnings declining to a growth rate of 1% in the first quarter of 2019 and eventually falling drastically to -34% from the prior year in the second quarter of 2020. From here, year-over-year earnings begin trending up, eventually skyrocketing to a growth rate of 89% from the prior year in the second quarter of 2021. The year-over-year earnings growth rate remains positive before turning negative, with a decline of -3% in the fourth quarter of 2022. The chart then shows the expected earnings growth per share rate with an expected decline of -7% in the second quarter of 2023. From here, the expected earnings per share growth rate turns positive all the way through the last data point, which is an expected 13% growth rate from the prior year in the fourth quarter of 2024.
Looking ahead, momentum also seems to be improving, not fading. Earnings expectations are rising again, and also broadening out globally:
Earnings expectations are rising again
This chart shows the next 12 months earnings-per-share (EPS) consensus estimates in U.S. dollars for the United States (S&P 500), Europe (Stoxx Europe 600), Japan (TOPIX) and China (MSCI China), indexed to December 31, 2019. The U.S. line initially drops to a trough of 79 by May 2020 before steadily rising to a series peak of 136 by June 2022. It is fairly range-bound from there, falling slightly before rising again to finish at 132 in June 2023. The Europe line draws down further to 72 by May 2020 and has since been rising to today’s levels at 127. The Japan line falls to a trough of 77 by June 2020 before rebounding to a high of 115. Since then, earnings estimates have drawn down, reaching 97 in October 2022 before jumping higher and falling again to 100 in June 2023. The China line falls to 91 in June 2020 before rising and remaining around 100 until February 2022. From there, the line falls to a trough of 82 in October 2022 and rises slightly to 87 by June.
As the Q2 earnings season ramps up, here’s what we’re listening for:
- What are the ripple effects of the bank stress? Banks kick it all off today. The first quarter was still pretty strong, but months later, how much of a threat are dynamics such as shrinking deposits, increased funding costs and tighter regulation? And given banks are bellwethers for the economy, is the spigot of credit still flowing, or is it drying up?
- Margins: Has cost-cutting worked? Amid last year’s uncertainty, companies tightened their belts, cutting costs to protect their bottom lines. Last quarter, tech showed those efforts paid off big time, but how have other firms fared? Consensus thinks margins will dip a bit this quarter (after improving last quarter), but we think they’re likely to beat estimates.
- The consumer: Still healthy, or fading? Consumers make up some 70% of the U.S. economy. So long as people still have jobs (look to the still-strong labor market) and inflation is cooling, households could keep on spending. Consumer names are expected to post the strongest earnings growth this quarter, but can the momentum continue (especially as some headwinds, such as the end of the student debt moratorium, lurk)?
3) A new era of capex spending is focused on transitioning the economy—and could offer support for years to come.
For one, AI is likely to boost productivity over the long term, and some companies are already monetizing it. Last earnings season, NVIDIA signaled that future sales could be a whole lot better than initial expectations (by a staggering $4 billion). But estimates for AI’s potential impact are also wide-ranging, and there are some kinks to work out (restrictions on AI chip exports to China, the accuracy of large-language models [LLMs], questions over data privacy, disruption of the labor market, to name a few).
We also tend to see de-globalization more as an opportunity than a threat. Shortages in the real economy have inspired a new era of capex spending dedicated to infrastructure, the energy transition and security. Earnings estimates for industrials companies are on the rise, and the promise of bills such as the Inflation Reduction Act in the United States and the European Green Deal offer long-term, secular support.
Shortages in the real economy are driving a new era of capex spending: three U.S. bills include almost $2.4 trillion in funding
This chart shows public spending and public capital over the next 10 years in USD billions. Across three separate bills, the expected spending is: - Inflation Reduction Act—$1.66 trillion: - Private Spending: $879 billion - Public Spending/Tax Incentives: $781 billion - CHIPS and Science Act of 2022—$167 billion: - Private Spending: $115 billion - Public Spending/Tax Incentives: $52 billion - Inflation Reduction Act—$550 billion: - Private Spending: $0 billion - Public Spending/Tax Incentives: $550 billion
Investment implications
Broaden and balance
We don’t think you’ve “missed it.” What’s more, investors could use this place of strength to broaden into other pockets of the market and find balance in portfolios.
For instance, while tech has dominated the rally in the more popular, market cap weighted S&P 500, the equal weighted index (where every company is an approximate 20-basis-point share) could offer a good complement. Tech exposure is cut in half, and industrials exposure is nearly doubled. The equal weighted index is also trading at an 8% discount to its 10-year average (versus the carket cap weighted index’s 9% premium). Given what we’re hearing from companies, and greener pastures for earnings, that discount doesn’t seem warranted.
The equal-weight S&P 500 could offer balance and value
The top chart shows the index weights by sector in the S&P 500 Market Cap Weighted versus Equal Weighted: - S&P Market Cap Weighted: - Technology 28.30%; Healthcare 13.40%; Financials 12.40%; Cons. Disc. 10.70%; Industrials 8.50%; Comm. Svcs. 8.40%; Cons. Staples 6.70%; Energy 4.10%; Utilities 2.60%; Materials 2.50%; Real Estate 2.50% - S&P Equal Weighted: - Technology 13.10%; Healthcare 13.10%; Financials 14.00%; Cons. Disc. 10.90%; Industrials 15.50%; Comm. Svcs. 4.00%; Cons. Staples 7.20%; Energy 4.50%; Utilities 5.80%; Materials 5.80%; Real Estate 6.10% The bottom chart shows the next 12 months price-to-earnings (P/E) ratio for the S&P 500 Market Cap Weighted versus Equal Weighted. Both series track each other closely from 2014 to 2018, starting around 16x and climbing slowly above 18x by early 2018 before falling to 12.5x by the end of the year. From there, the Market Cap Weighted Index P/E ratio climbs rapidly to 19x and the Equal Weighted to 17x before both fall to series lows around 12x, and bounce back to their highs around 25x shortly after in June 2020. Since then, the two series have diverged. While the S&P Equal Weighted has fallen more steeply and failed to rebound beyond today’s level at 15.9x (8% below its 10-year average), the Market Cap Weighted Index has bounced this year to 19.4x (9% above its 10-year average) after reaching 15x in late 2022.
From there, a stronger global economy could lend support to more growth-sensitive markets abroad. Two-thirds of our U.S. clients have little to no exposure to China, and half are materially underweight Europe. Both of those economies still face challenges, but a lot of bad news seems already in the price.
Finally, the nosedive in bond yields on the back of this week’s inflation print shows that today’s elevated levels may not last forever. Getting 5% on a T-bill may look attractive now, but with evidence growing that the Fed could be wrapping up its rate hikes, now could be the time to lock it in for longer.
Your J.P. Morgan team is here to discuss these dynamics and your portfolio.
All market and economic data as of July 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.
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