by Joseph V. Amato, President and Chief Investment Officer—Equities, Neuberger Berman
As earnings reports for the second quarter start to trickle in, and the S&P 500 Index grinds to within 7% of its all-time high, it is a good time to look back on the first half of the year in equity markets and think about what the next six months might have in store.
One big story of the year so far has been the resilience of the market, which was an unexpected result to us and many other participants. But that story has been complicated by another one: the “Tale of Two Indices,” which reveals how almost all of that rally was driven by a handful of mega-cap technology stocks.
Wide Disparity of Views
To assess the potential longevity of this rally, we need to determine what has been causing it and whether those causes can persist. But that, in and of itself, is a challenge. The market, and in particular the “Super Seven” stocks (Apple, Microsoft, Google, Meta, Nvidia, Amazon and Tesla) seemed to catch just about every tailwind we’ve seen this year—even though those tailwinds have been somewhat contradictory.
At first, this appeared to be about flows, as investors covered short positions and bought last year’s big losers. Then it seemed to be about their perceived defensiveness and long duration, as the mini-banking crisis triggered a dip in bond yields and policy-rate expectations. Then they were supported by the liquidity central banks released to arrest that mini-crisis. Finally, the “Super Seven” were caught up in exuberance around the productivity-growth potential of artificial intelligence.
But through it all, probably the most important dynamic for the entire market was a U.S. economy that has proven quite resilient. Purchasing Managers’ Indices have been rising and the dollar has been falling. First-half GDP growth will likely come in around 2.1%, and with the Fed close to completing its tightening cycle, investor enthusiasm has been buoyed.
The difficulty of untangling these dynamics, together with the strength of current momentum, has caused our Asset Allocation Committee to change its views on equities to neutral—acknowledging the potential for near-term upside even as it maintains a cautious medium-term outlook.
We are not alone in this stance. We have rarely seen such a wide disparity of views, not only within our Asset Allocation Committee but among equity strategists in general. Given that we are likely at an important inflection point, either beginning the next phase of economic growth or slowing under the cumulative weight of monetary tightening, that dispersion of views is understandable.
Earnings
While we recognize the current strength of momentum and sentiment, earnings are likely to be a key determinant of whether our Asset Allocation Committee ultimately reverts to its more cautious view on equities or embraces the recovery more fully.
According to FactSet, the consensus for second-quarter S&P 500 earnings growth has been declining all year and now sits at $52 per share. That would be a year-over-year decline of 6.4%, with the consumer discretionary sector leading the way and energy bringing up the rear. Given that expectations for first-quarter growth hit a low of -5.9% before coming in at -1.3%, the second quarter decline could end up around 4 – 5%. Almost more important than the actual earnings will be company guidance. We suspect the current, somewhat confusing, macro environment could lead companies to be cautious in their outlook.
For the remainder of this year and next, earnings growth is expected to resume. The consensus is $55 per share for the third quarter, which would be up 1% year-over-year; and $57 for the fourth quarter, up 8.5%. At $218 per share, the current estimate for the full year would put 2023 S&P 500 earnings up 1.1% on 2022. For 2024, FactSet’s analyst consensus is for growth of 12%.
Nominal Growth Is Heading Down
The headline? Analysts think S&P 500 Index profits have already hit their trough for this cycle.
We are not so sure.
At this stage, we believe investors, who tend to think in the nominal terms of corporate profits, are focused on high levels of nominal GDP growth. The current U.S. real GDP growth trend of 2% is not all that shabby, given the speed and size of the rate hikes we have seen. As last week’s U.S. inflation data should remind us, however, nominal growth is now heading downward.
In other words, the nominal-over-real divergence that we discussed as an upside risk to our cautious outlook a year ago is now a convergence that could reinforce our cautious view—especially if wage growth, which has remained stubbornly high, also starts to squeeze margins.
It is also worth putting S&P 500 earnings expectations into the broader economic context. The National Income and Product Accounts (NIPA) put out by the U.S. Bureau of Economic Analysis suggest that, nationwide, corporate profits have been steadily falling since the second quarter of 2022, and were down 12% from their peak in the first quarter of this year.
Delayed Is Not the Same as Canceled
It’s true that we have been taking stock as the economic growth and earnings slowdown we anticipated appears to have been delayed, and the market weakness we expected has not materialized—largely due to high nominal growth, resilient margins, a transient first-quarter spurt in global growth led by China reopening and the easing of Europe’s energy crunch, and the injection of liquidity following the mini-banking crisis.
But delayed is not the same as canceled. The slowdown so far may be mild, but we still think it is coming. We increasingly see it in declining bond yields, slowing NIPA corporate profits, the softening labor market, milder inflation and other leading economic data. As such, we will be looking for signs of the impact of declining nominal growth in second-quarter reporting, and potential knock-on effects on consensus earnings estimates for the rest of the year.
Our current neutral view of equities reflects the confusing cross-currents of the current inflection point—especially the resilience of the nominal economy and the lagged impact of monetary tightening that we think is yet to come. The next six months will be very telling on which way to go from here.
