Earnings And Artificial Intelligence Save Stocks Despite Inflation

The pace of earnings picked up steam last week, with 159 S&P 500 companies reporting, and will be followed by the busiest week with 175 scheduled to report. After the relative drag from bank and healthcare earnings over the previous weeks, the more diversified company mix boosted earnings expectations for the quarter. A more detailed preview of the earnings season is available here.

The S&P 500 rose 2.7% for the week, rebounding to 7.4% year-to-date. The 10-year Treasury yield rose to 4.62% from 4.66%, causing a 0.1% decline in the Bloomberg Aggregate Bond index. After a tough previous week, the Magnificent 7 soared by almost 6%. The Magnificent 7 consists of Microsoft
Microsoft
(MSFT), Meta Platforms
Meta Platforms
(META), Amazon.com (AMZN), Apple
Apple
(AAPL), NVIDIA
NVIDIA

SPDR Dow Jones Industrial Average ETF Trust
(NVDA), Alphabet (GOOGL), and Tesla
Tesla
(TSLA).

Notable companies with earnings this week include McDonald’s (MCD), Starbucks
Starbucks
(SBUX), Coca-Cola
Coca-Cola
(KO), Amazon.com (AMZN), Eli Lilly (LLY), Apple (AAPL), and Berkshire Hathaway
Berkshire Hathaway
(BRK/A, BRK/B).

At almost the halfway point in the reporting season, blended earnings, which combine actual with estimates of companies yet to report, have rebounded to match forecasts at the end of the quarter.

The most significant driver of the improvement in earnings came from the communication services sector, primarily due to earnings beats by Meta Platforms (META) and Alphabet (GOOGL). According to FactSet, the industrial, technology, and consumer discretionary sectors also boosted first-quarter earnings estimates.

Earlier in the season, the healthcare sector was punished by the accounting treatment of in-process research and development from acquisitions by Bristol-Myers Squibb (BMY) and Gilead Sciences
Gilead Sciences
(GILD). According to FactSet, better-than-expected earnings from Merck (MRK) and Gilead Sciences boosted the expected earnings growth rate for the healthcare sector to -28.1% from -30.5%.

Sales growth is closely tied to nominal GDP growth, combining after-inflation economic growth (real GDP) with inflation. With nominal GDP growth likely solid year-over-year for the first quarter, topline revenue growth for companies should have a tailwind. Sales growth improved last week and moved higher than expectations going into the earnings season.

So far, the blended earnings performance has underperformed expectations at the end of the quarter. Combining actual results with consensus estimates for companies yet to report, the blended earnings growth rate for the quarter equals the expectations of +3.5% at the end of the quarter.

Though first-quarter GDP growth of 1.6% last week was below the consensus estimates of 2.5%, the details were more vital than the headline. Domestic demand looks robust, excluding the more volatile components of inventories and net exports, which subtracted from first-quarter GDP growth. Real final sales to private domestic purchasers, which measures private demand in the domestic economy, remained healthy at 3.1 percent in the first quarter after increasing by 3.3 percent in the fourth quarter.

While the GDP report should not lead to any concerns about economic growth, the inflation component was more concerning. The pace of inflation measured by the Federal Reserve’s preferred measure, core PCE, accelerated to 3.7% quarter-over-quarter annualized.

The inflation surprise and continued economic growth sent the odds of a June Federal Reserve (Fed) rate cut to less than 15%. The probability of a July start to rate cuts is now one in three. The chance of a cut by the September meeting dipped below 75%. The total rate cuts expected in 2024 fell to one. Based on those expectations, the 2-year Treasury yield is 5% after being as low as 4.1% in January.

The bumpy last mile of the Fed’s fight against elevated inflation remains an obstacle for stocks as yields rise and the certainty around an economic soft landing is challenged. On the positive side of the ledger, the resilient economic growth illustrated by last week’s GDP report leaves the profit rebound story intact. In addition, the promise of artificial intelligence (AI) was bolstered by Microsoft (MSFT) and Alphabet (GOOGL) earnings. Even though Meta Platforms (META) fell as investors were disappointed by the expected future spending on AI capital expenditures, it reinforced the expectation of further spending on artificial intelligence technology.

The busiest week of earnings contains some bellwethers like Apple and Amazon.com that will be closely watched. The Fed meets with no change in short-term interest rates virtually assured, but Chair Powell’s comments will be scrutinized for clues on Fed rate cut timing in the wake of the hot inflation data. With the focus on inflation and the Fed in data-dependent mode, the monthly payrolls report on Friday will be notable. In addition, Berkshire Hathaway’s annual meeting occurs on Saturday with highly anticipated comments from Warren Buffett.