Stocks have staged a promising rally in the weeks since the Federal Reserve instituted its largest interest rate hike in 28 years, with investors hopeful that the worst of the rate increases may be over, but a number of analysts warn that the bounceback could be short-lived as companies begin to cut earnings expectations in light of the increasingly grim economic outlook.
The S&P 500 has rallied about 8% to 3,960 points since its bear-market trough on June 16, the day after Fed officials raised interest rates by 75 basis points for the first time since 1994, but in a Wednesday note to clients, Morgan Stanley’s Michelle Weaver said she’s “skeptical” of the optimism as second-quarter earnings season ramps up in the coming weeks.
Weaver believes results should be a “negative catalyst” for stocks given ongoing inflation and slower revenue growth facing many companies, and says “it’s just a matter of time” before companies start lowering profit expectations for the fourth quarter and early next year.
Stocks have staged a strong rally that may continue, “but make no mistake, we don’t believe this bear market is over,” says the investment bank’s Michael Wilson, warning the S&P 500 could plunge as much as 15% more if the economy falls into a recession–he forecasts the odds of one over the next 12 months have jumped to 36% from 20% in March.
Others are similarly skeptical: The “best rally we’ve seen in months” has been fueled by hopes inflation and aggressive Fed action have peaked, says analyst Tom Essaye of the Sevens Report, but he notes “we haven’t seen an actual low” in either yet, with inflation only getting worse every month.
Morgan Stanley expects earnings season should be particularly bad for firms like HP and Logitech, as the “overconsumption” of technology falls from Covid-era highs, as well as financial services firm Lazard, which faces growing economic uncertainty in major market Europe.
In a Monday note, Bank of America’s Savita Subramanian said mega-cap technology companies—like Microsoft and chipmaker Intel—may face the “biggest challenges,” noting earnings for the largest firms in the tech-heavy Nasdaq have been lagging those of the S&P for the past nine months.
Major stock indexes plunged into bear market territory last month ahead of the Fed’s latest policy decision, and the gloomy sentiment has since ushered in growing fears of an impending recession and waves of layoffs among recently booming companies. To make matters worse, the U.S. economy unexpectedly shrank 1.6% in the first quarter, its worst performance since the Covid recession, and some economists forecast the economy shrank again in the second quarter, which would constitute a technical recession. “We don’t believe the Fed can stop the issues that are causing inflation without absolutely wrecking the economy, but at this point, it looks like they are resigned to the fact that it must be done,” says Brett Ewing, chief market strategist of First Franklin Financial Services.
“Earnings have been okay, but more spotty than in recent quarters,” says David Donabedian, the chief investment officer of $98 billion CIBC Private Wealth U.S., noting the economy is “getting more challenging,” as evidenced by companies like Johnson & Johnson and IBM lowering profit expectations in recent days. “Fed tightening together with less robust corporate earnings in the next quarter will not be a good combination for equities,” he adds.
What To Watch For
Big banks have already reported a mixed bag of results over the past week, but earnings season is just getting started. Electric-vehicle giant Tesla releases earnings after the market closes Wednesday, and social media giant Twitter is slated for Friday. The majority of firms should report by the end of August, according to Morgan Stanley.