Hotter inflation means the stock-market rally faces a critical test as earnings season begins

By Joseph Adinolfi and William Watts

With inflation data removing market's safety net, companies are facing more pressure to deliver on Wall Street's lofty earnings expectations

Investors are abandoning bets that the Federal Reserve will cut interest rates three times in 2024, removing a critical safety net for stocks.

Now, to prevent a recent selloff from accelerating, companies will need to deliver earnings growth on par with Wall Street's expectations, or they risk tripping up a rally that carried the S&P 500 nearly 30% higher over the five months that ended in March, according to FactSet data.

"It matters more than ever for the market that earnings continue to increase," said Chris Zaccarelli, chief investment officer for Independent Advisor Alliance, during a phone call with MarketWatch.

Stocks sold off on Wednesday after March inflation data showed the trend of disinflation that started in late 2022 remained stalled last month, pushing traders to largely abandon expectations for the Fed to start cutting rates in June.

This will likely invite more choppy trading in the near future, according to JJ Kinahan, chief executive officer of IG North America and president of Tastytrade. It also amps up the pressure for companies to deliver earnings that justify stocks' lofty valuations.

First-quarter earnings season swings into gear on Friday, with reports from a smattering of major banks and financial firms, including BlackRock Inc. (BLK), Citigroup Inc. (C), Wells Fargo & Co. (WFC), JPMorgan Chase & Co. (JPM) and State Street Corp. (STT)

At this point, earnings simply meeting expectations might not be enough to drive stocks materially higher during the next few months. But it could mitigate further weakness as rising yields put pressure on stocks' earnings multiples, Zaccarelli said.

The S&P 500 is trading at 20.5 times expected earnings in 2024, above the average from the past 10 and past 5 years, according to FactSet data.

Until recently, stocks had proven resilient even as traders have scaled back their rate-cut expectations and pushed Treasury yields higher.

But rising yields appear to finally be taking their toll on the market, as the S&P 500 was headed for its fourth week in the red out of the past five, FactSet data show.

This turbulence is raising the stakes not just for this earnings season, but for the rest of 2024. If stocks ultimately don't deliver, it could derail a bull-market run that has carried the S&P 500 higher by more than 40% since October 2022.

"So rates can go up as long as earnings look really good. But if rates are going up and earnings start to disappoint, there's very little, I think, room for error," Josh Emanuel, chief investment officer at Wilshire, said in an interview Tuesday afternoon.

A handful of companies that have reported earnings have already presented a mixed bag. Costco Corp. (COST) and Nike Inc. (NKE) revived concerns about consumers cutting back. But a strong report from Delta Air Lines Inc. (DAL) on Wednesday helped to smooth over these concerns, analysts said.

Investors will need to wait a few weeks to get a better picture of first-quarter earnings. The most consequential reports aren't expected until later this month, when megacap technology giants including Microsoft Corp. (MSFT), Meta Platforms Inc. (META), Alphabet Inc. (GOOGL) and Apple Inc. (AAPL) are due to release their results.

According to analysts' estimates, the top 10 S&P 500 companies by market capitalization are expected to once again drive the lion's share of earnings growth. These firms are forecast to have grown earnings by 32% during the first quarter, while the rest of the index's members are expected to see earnings contract by 4%.

The rest of the companies in the S&P 500 are expected to see earnings catch up to the market leaders later this year. By the fourth quarter, earnings growth for the top 10 firms is expected to slow to 17.2%, while the other 490 companies in the index are expected to see growth accelerate to 17.8%, according to FactSet data.

Mark Hackett, chief of investment research at Nationwide, told MarketWatch on Wednesday that broader earnings growth is integral for the rally to continue, since more stocks will need to rise to record levels to keep pushing the indexes higher.

Ultimately, the biggest threat to earnings could come from the Fed, since the longer the central bank holds off on rate cuts, the more difficult it might be for companies to grow earnings at or above the rate that Wall Street expects.

The "soft landing" economic scenario appears to be anchored to the expectation that the Fed will eventually start cutting rates, "and to the extent that they don't cut, then the risk grows that the lagging effects associated with tight monetary policy really start to weigh on economic activity" and dent earnings expectations, Emanuel said.

But "all bets are off" if the Fed shifts to considering another interest-rate hike, according to Zaccarelli.

To date, there are few signs that this will happen, even as some high-profile economists like Harvard's Larry Summers have warned that investors are underestimating the likelihood that the Fed will need to abandon its plans to cut rates.

Provided the Fed stays the course, Zaccarelli believes the bull market will likely endure, even if stocks experience some near-term turbulence during the second quarter. He pointed out that pullbacks of 5% or greater during bull markets aren't all that uncommon.

The S&P 500 SPX fell 1% on Wednesday to finish at 5,160, bringing its month-to-date drop to 1.8%, according to FactSet data. The Nasdaq Composite COMP shed 0.8% to finish at 16,170, bringing its loss since the beginning of April to 1.3%.

The Dow Jones Industrial Average DJIA shed 422 points, or 1.1%, to 38,461.

-Joseph Adinolfi -William Watts

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04-10-24 1652ET

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