While reporting season has not provided a boost, a clear takeaway is that the earnings recession is now behind us. CIO believes the earnings re-acceleration remains on track, and expect 9% earnings growth next year. (UBS)

First of all, markets continue to grapple with the trade-off between resilient economic growth and the risk that the Federal Reserve keeps rates higher for longer. Although we don’t believe last week’s blazing hot 4.9% GDP print likely fully reflects the actual growth story, it was yet another headline adding to this debate.

The third-quarter earnings season has also failed to provide a spark. Results have been generally in line with consensus, with around 75% of companies beating expectations. But you wouldn’t know it by looking at the reaction. Stocks have been disproportionally sensitive to any bad news, and to be fair, there has been some cause for concern. End-markets where investors had been looking for improvements have failed to impress, as capital market activity hasn’t picked up meaningfully, freight numbers have been mixed, signs of a slowdown appeared in some areas of consumer spending, and cloud results have been up and down.

We have also seen some weakness in forward guidance, with 4Q being revised lower. But importantly, we don’t believe this weakness should be overstated. We haven’t seen anything too far out of line with history, and much of the negative revisions have been due to nonrecurring items like lower COVID vaccine sales.

Overall, we see a disconnect between earnings perception and reality. Alphabet is a perfect example: While there were some headwinds from cloud performance, it’s rare to see a stock decline 10% with no change in forward profit estimates. Technical factors may be exaggerating these moves, as hedge funds' relative exposure to the “Magnificent 7” stocks reached extreme levels, which typically triggers a reversal.

Finally, the Israel-Hamas war has been another source of angst, although, in our base case, we believe this will have a mostly local impact to financial assets. As of now, the market seems to agree given Brent crude prices are only up slightly since the conflict began.

Still, it’s fair to say that investors are continuing to digest a meaningful rise in the degree of uncertainty—between higher rates, earnings, ongoing questions about the US economy, and worsening geopolitical tensions (which could dent consumer and business confidence). To put it simply, at this stage of the business cycle, there are periods in which people get worried.

Where do we go from here?

Taking all this together, it’s clear the risk-reward in equity markets is getting more interesting. While reporting season has not provided a boost, a clear takeaway is that the earnings recession is now behind us. We believe the earnings re-acceleration remains on track, and we still expect 9% earnings growth next year.

Valuations are also starting to look more attractive. While it’s never easy to predict what multiple we will settle in at, right now the S&P 500 sits at about 17x forward earnings, and if you strip out the Magnificent 7, it's closer to 15x. These multiples look fairly reasonable if you consider our base case of a soft landing.

Still, momentum is a powerful force, and it’s always hard to say what will break the cycle of negativity. Once positioning cleans up, technical headwinds could reverse and provide some support. But perhaps most supportive would be if rates continue to trend lower. Several important data points are due this week, including the employment cost index and payrolls, both of which will likely influence the near-term move in rates. We could see some continued rate relief if the data come in a way that shows the economy slowing but not plummeting. The Fed’s rate decision on Wednesday could also be a market catalyst. If the Fed considers the recent move higher in long-term rates to be equivalent to federal funds rate increases, there may not be a need to increase the fed funds rate at a future meeting.

Bottom line: While more downside is now already priced in, for the time being, investors should continue to brace for choppy trading as investors digest every data point around the economy, earnings, and more. Against this backdrop, we remain neutral on equities and continue to favor areas of the market that have lagged so far in 2023, in line with the recent rotation we’ve seen. More broadly, we continue to like high-quality fixed income given that yields remain attractive, and our view that rates will trend lower from here.

Main contributors: Solita Marcelli, David Lefkowitz

See the original report - Stock market correction: What comes next? , 30 October, 2023.