• Earnings parade unofficially starts on April 12 with major US banks

• S&P 500 profit growth forecast at 5.1% y/y after downward revision

• Fluctuating expectations around Fed policy remain a key risk factor

Investors hit the pause button

Undoubtedly, the major US indices had a fantastic 2023, with the positive momentum being carried over to this year as the soft-landing narrative became more and more entrenched in market projections. This positive sentiment translated into solid gains for the stock market, which was also supported by a series of stronger-than-expected Q4 earnings announcements in January.

Throughout the first quarter, the upbeat corporate figures coupled with a barrage of strong macroeconomic data out of the US disproved markets strategists who were suggesting that earnings growth will falter as the economy would start feeling the wrath of high interest rates. However, heading into the earnings season, equity indices have been suffering some losses due to Fed rate cut expectations being scaled back due to fears of sticky inflation.

What’s expected?

As the Q1 earnings season approaches, analysts have been revising lower their earnings estimates, but still the S&P 500 is projected to deliver 5.1% earnings growth on an annual basis. From a sector perspective, Communication Services and Information Technology sectors are expected to be the relative outperformers, with their earnings expected to grow by 26.8% and 20.9% year-on-year, respectively. In contrast, Energy and Materials are set to have the biggest earnings declines from one year ago despite surging oil prices.

Of course, investors will be laser-focused on the performance of the ‘Magnificent 7’, which have been the main driving force behind the latest stock market rally. This time around though, attention will likely shift to the performance of the two black sheep within the pack, Tesla and Apple, as a second quarter of massive underperformance might jeopardise their place within the group.

Risks lie on the Fed’s rate path

The main downside risk for equities right now seems to be the hawkish repricing around Fed expectations. Markets started the year with a forecast of six rate cuts for 2024, which has now changed to three. In general, rising yields are negative for the stock market because they reduce the value of the firms’ future cash flows and also translate into high borrowing costs.

For a prolonged period, stock markets were neglecting rising yields due to the belief that pricing out rate cuts because the economy is performing better than expected outweighs the scenario of panic cutting to avoid a recession. Nevertheless, the latest losses in equity markets are suggesting that investors are starting to acknowledge the negative impact of higher yields.

Asymmetric risks due to inflated valuations

Last year’s rally has pushed major stock indices to ‘expensive’ territories not only from a price perspective but also relative to the value they are offering. Currently, the S&P 500 is trading at 21.1 times what analysts project earnings to be over the next twelve months. That’s under the assumption that earnings are going to grow at a stunning 9.9% pace in 2024, at a period where fiscal and monetary conditions are expected to remain tight on the fear of a secondary inflation wave.

Such multiples have been evident only during the dot-com bubble and pandemic years, which should act as an alarm bell on its own. In the absence of extremely low interest rates or above average economic growth, current valuations seem way overstretched. Hence, with stocks priced for perfection, there is ample downside potential in case fundamentals fall short of expectations.