Banking on Earnings

This week, a batch of lower inflation data propelled several stock market indices to new highs. With consumer prices rising less than expected in May, fears of additional rate hikes are diminishing. While there's room for improvement in controlling inflation, we see a trend toward stabilization. Federal Reserve officials may not cut rates quickly, but they are headed in that direction. For the markets, this is a positive sign. Lower inflation expectations mean lower bond yields, which helps stocks perform better.

The Consumer Price Index (CPI) was flat in May and increased 3.3% from a year ago, compared to predictions of a 0.1% rise and 3.4% annually. The Core CPI, which excludes the frequent fluctuation of food and energy prices, offers a more reliable gauge of underlying inflation trends. It showed a modest increase of 0.2% for the month and 3.4% from a year ago, slightly below estimates of 0.3% and 3.5%. Inflation was lower across the board, with notable improvements in medical and transportation services. While housing costs remain high, current data indicates a gradual decrease in the months ahead. Inflation is moving slowly towards the Fed’s 2% target, and bond yields have dropped in response.

Still, not all stocks are benefiting equally. An increasingly narrow group of stocks leads the charge, especially those tied to artificial intelligence (AI) development. Apple recently joined the club after announcing AI integration in its newest smartphones. Lower rates also disproportionately benefit these companies through a lower discount rate, making their future earnings appear more attractive. The top ten stocks in the S&P 500 account for roughly 70% of its total return. While this type of concentration isn’t necessarily detrimental, a more diverse range of strong stocks would be preferable.

For this broadening to occur, more companies must show earnings growth in the second half of the year. So far, the S&P 500's unexpectedly strong earnings growth has been driven exclusively by the largest companies. However, this is expected to change in the coming months. Excluding the “Magnificent Seven,” the top seven tech giants, earnings growth for the S&P 500 has shown little movement over the last three quarters. It is expected to climb to around 13% in the final two quarters of 2024. This growth will likely come from increased productivity and profit margins. If this happens, we could see more participation in the market beyond just the AI leaders.

Thanks,
Preston May, CBE®
Research Analyst